In our previous column, we warned advisors about the arithmetically immutable risks of chasing the highest-yielding shares – a fad that has dominated the investment narrative for the last three years – and concluded:
“What the above examples demonstrate is that yield-hungry investors have been chasing the wrong yields. Rather than pursuing the big, stable so-called ‘blue chips’ they should be investing in companies that can grow. Find companies that can retain profits, and both capital and income will grow. But woe to you who buys a mature blue chip company with no growth – both your capital and the purchasing power of your income will decline.”
As a postscript, we warned advisers against the risk of index investing. Remembering that the big blue chips dominate the index, it makes sense that if the index constituents aren’t growing – Telstra and NAB’s share prices are persistently below where they were 15 years ago – the index cannot grow either, so why invest in the index?
And that brings us to today’s article, which amounts to a warning to advisers putting their clients into low-cost index funds and ETFs. I will argue that index investing is “dumb” investing and perhaps not even investing at all.
Lumbering blue chips
Australian indices are made up of the big lumbering blue chips – those mature businesses paying the bulk of their earnings out as a dividend. Retaining little or no profits means the equity of a business doesn’t grow. If the equity isn’t growing, neither can profits, and if profits aren’t growing, then any gains in the share price will be temporary in nature. Ultimately, any gain in the index, which is based on the shares of those companies, must also be temporary.
Take a look at the major Australian stock market indices today. It should come as no surprise that they are unchanged from a decade ago. Low returns and very high opportunity costs seem reasonable assumptions for today’s index investors.
The case for passive investment strategies is convincing and it usually leads with a claim of lower costs. The only problem with this claim is that while advisers may be very concerned with costs, their clients are less so. We built Montgomery by developing relationships with individual ultra high net worth investors. Rarely if ever have we had a conversation about fees or costs. What investors care about most is after-fee returns. Paying 1 per cent to earn a return of 15 per cent per annum over the long term is far superior and palatable to paying 0.1 per cent to earn 3 per cent.
And while it is true that you need to be selective about which managers you pay active fees to – generally you want to pay active fees for active management, which can be measured by a low level of “common holdings” – throwing one’s hands in the air and simply going down the low-cost route is a disservice to end investors.
Greater certainty?
Another argument trotted out by suppliers of passive index solutions is that they offer a greater certainty of relative performance outcomes. The largest suppliers claim to have done a good job of achieving their investment objective of closely matching an index in most market conditions.
The first problem with this claim is that it is not everyone’s experience. I can think of one university endowment fund in Australia whose returns from index investing are now 50 basis points below the index. For an index fund to make this up is almost inconceivable.
And while satisfactory “relative” performance is considered a noble aim, it says nothing about absolute performance. And I’d go further and suggest that relative performance, when it comes to index investing, is not a noble aim at all – especially if index investing is plain “dumb” investing and the indices themselves weren’t constructed with long-term investment returns in mind.
Not mediocre companies
Another argument offered for index investing is “diversification”. Investors, however, should be diversifying across a portfolio of extraordinary businesses, not mediocre companies. Given the broad Australian market indices like the S&P/ASX200 are dominated by large mediocre businesses, diversification into such indices can be described as “deworsification” – to borrow from famed US fund manager Peter Lynch.
The promise of diversification, low cost and access to overseas markets are the top three reasons for the popularity of index funds and ETFs, but their growth and popularity belies the fact that broadly diversified cap-weighted equity index funds guarantee “average” returns for a generation of investors.
Index investing, in particular when it is directed to cap-weighted equity indices, is dumb investing. In fact when Warren Buffett recommended index investing to the masses, he made the point that it suits the “know-nothing investor”. That is, the investor who has no interest in understanding a business or valuing it.
If you have read this far, you are indeed a professional planner and index investing should therefore make no sense for you. It should make no sense for your clients either – they are relying on you and paying you to be a “know something” investor.
Read Part 2 of “Index investing is dumb” from Monday April 11
