The Boring Newsletter, 2/26/2023

Hi Friendos!

In honor of the newly released 50th anniversary edition of Burton Malkiel’s book, A Random Walk Down Wall Street, this week’s topic is index funds. It’s a bit longer than usual due to the paramount importance of the topic.

I prefer investing in stocks and bonds using low-cost index funds, not expensive actively managed funds. An index fund tries to passively match the returns of an index (like the S&P 500 or a “total market” index fund); an active fund tries to beat their benchmark index (by picking investments the manager thinks will outperform). I will discuss exactly what I mean by “low-cost” in a future newsletter.

I learned about index funds in a finance seminar I took in college. We read academic journal articles about finance topics, like “On Persistence in Mutual Fund Performance.” The author wanted to know if active mutual funds that had outperformed in the past continued to outperform in the future. Conclusion: “The results do not support the existence of skilled or informed mutual fund managers.” Ouch.

Here’s a summary of what is now considered conventional wisdom in this literature:

1. Before accounting for fees, some active fund managers do beat the market, but not after fees. If an index fund charges 0.1% in fees, and an active fund charges 1% in fees, that active fund has to outperform by more than 0.9% to beat the index fund. They usually don’t.

  • Literature reference: here. One of the authors won a Nobel prize.

2. For an active fund, good past performance does not predict good future performance. This means that when I go to invest, I cannot predict which active fund will outperform.

  • Literature references: Carhart, Mark. 1997. On persistence in mutual fund performance. Journal of Finance 52, 57-82. Read it online here. Also see: Sharpe, William. 1991. The arithmetic of active management. Financial Analysts Journal 47, 7-9. Read it online here. For a more recent discussion, read this article, which also gets into how the industry has changed over the decades this literature has developed, and gives a full review of the many aspects of this debate, and concludes that active management may be more promising than what I suggest (I am not convinced any of this is real-life applicable for regular investors).

Standard & Poor’s puts together a scorecard every year to see how many active funds beat the market. For U.S. equity funds buying stocks of large companies, the current scorecard says over the last 15 years, only 10.6% of active funds beat the S&P500. 89.4% did worse. To recap: 9 out of 10 actively managed funds did worse than the index.

But I don’t think you should take my word for it. I think you should learn more about these things and decide for yourself. There are many excellent books on the topic. A Random Walk Down Wall Street is great if you appreciate a somewhat academic approach. I read it in 2004 and have often given it as a welcome gift to new analysts at my work place. It has a Wikipedia page!

(Yep, I have a notebook where I’ve tried to keep track of books read since I was in high school. You already knew I was a nerd!)

People are getting the message: in 1997, less than 8% of the $ invested in equity funds was indexed, in 2017 it was more than 40%. Morningstar, a great resource for mutual fund and ETF information, says that in 2022, “Passive Providers Clean Up” – people are putting their investment dollars to work at companies that offer low-cost index funds.

You can join the crowd and get into boring low-cost index funds.