Avoiding index funds?

There are a lot of financial advisors who genuinely believe that index funds are terrible investments and stands:

"Index funds are risky"

The prime of this statement is that you will get all of the ups and all of the downs that the market delivers. The alternative would be to invest with an active manager that is able to fill out the market and use their analysis and intuition to outperform the index. The active management story sounds way better but is not really backed up with data. Vanguard publishes a study in 2018 to look at the performance of active managers in a bull market (when stocks are going well) and bear markets (when stocks are doing poorly). Active managers should outperform the index in bear market, the data show that more than 50% of active managers outperform the index in some historical bear markets. But in other bear markets, less than 50% managed to beat the index. For that reason, this should not instill confidence in anyone betting on active management to save them in a down market.

If active funds do not offer any protection when stocks fall then there is no basis to say that index funds are a relatively risky investment.

Active management also introduces a whole other element of risk. We know that the market as a whole is risky. It goes up and down in value as investors expectations about future change. For taking on the risk of the market investors expected a positive return, in other words, the risk of the market is a “priced risk”. An active manager is still taking on market risk but, they are also taking an “active risk” that their bets will end up paying off. Active risk is not a price risk!

Another common reason to avoid index funds is that you get no control over your holdings. You end up buying the whole bad stocks along with the good ones. With the right active manager will only get the good stocks while avoiding the bad ones. This is another great story with no good data to back up. The problem to pick the good stocks is that there is no way to tell what a good stock is. There is an enormous difference between the quality of the company and the quality of its stock returns.

Of the roughly 26,000 stocks that appear in the CRSP database, a comprehensive database of the US stocks, from 1926 through 2015 only 1000 of them was responsible for all the market returns in excess of treasury bills over that time period.

We can think this issue in another way, global stocks as a whole returned 8% per year on average from 1994 through 2017. If you miss the top 10% of performers each year, your average return drops to 3.6% per year. It is easy for an active manager to say indexing results in owning all of the good and bad stocks, what they are not able to tell you is which stocks are good and which ones are bad. The reality is that there are a small number of stocks that drive the market’s returns and it is next to impossible to consistently identify those stocks at least ahead of time.

When proponents of active management give these reasons for avoiding index funds it is always on the basis that active management is superior. "Smart investors only invest with skilled active managers", well if you can find one.

The idea that an active manager might be skilled, needs to be considered alongside the fact that their success may be due to luck. Even over long periods of time, some active managers will beat the market due to luck rather than skill, and this makes the process of finding a skilled manager super challenging. The abstract of the paper written by Mark Carhart concludes “The results do not support the existence of skilled or informed mutual fund portfolio managers”.

In 2010 Eugene Fama and Kenneth French again studied mutual funds in their article “Luck Versus Skill in the cross-section of mutual fund return”. They found that before costs there are both skilled and unskilled managers. However, the skilled managers are not skilled enough to cover their own costs.

Statistically, it would take 36 years of 2% alpha, which is 2% of excess risk-adjusted performance with a standard deviation of alpha of 6%, for manager skill to be statistically significant at a 95% level of confidence.

With no way to identify skilled managers ahead of time, the argument that skilled managers make index funds obsolete does not make any sense.