Index ETFs Dupe Investors Again! What to do …

Tim Fortier |

stock market etfOver the weekend I got an email from another index ETF vendor slamming active investing.  “Once again active managers underperformed their respective indexes.” The email criticized active management as “money wasting folly”. And it touted low-cost index ETFs as the solution for meeting my investment goals.

An article in the New Yorker seemed to chime right with the ETF vendor.  The author stated, “Seventy-two percent of large-cap mutual funds underperformed their respective index”.  And the average stock mutual fund was down three percent with hedge funds faring even worse. The conclusion ... “a sensible solution would be for investors to put their money in low-cost index funds and just keep it there”.

Now here is where I take issue with the vendor and the author. Knocking active investing outright makes no sense.  A sole focus on index ETF’s and funds is not a solution. Asking whether a fund or manager outperformed a particular index may be asking the wrong question.

Ok. I can agree with the low-cost part.  I am definitely a proponent of ETFs. But to say “just put your money in a low-cost index fund and keep it there” … this is not an investment strategy. Well…it is…just not a very good one for the current market. And it is likely not going to get anyone to his or her financial goals.

It’s no revelation that most active mutual funds do not perform as well as their respective benchmarks.  Charles Ellis, in his classic book Winning the Losers Game made this case clear.  He said, “ Over and over again these facts and figures inform us that investment managers are failing to “perform”, that is, to beat the market.”

And for the most part I agree with him.  But, where Mr. Ellis and I part ways is the focus on simply mimicking indices.  The whole fixation on investors beating some index is actually meaningless. And here’s why.

The Real Money Wasting Folly

Indices are nothing more than convenient artifices for organization and measurement.  Indices are not the goal.  Telling an investor to merely align their performance and their financial future to some indeterminate index is the real “money wasting folly”.

Those in the index camp believe as long as expenses are low and returns mimic index performance … all is well. But the question index investors repeatedly fail to ask is … “will index returns be sufficient enough to reach my financial goals?”

What if they aren’t? What happens if the next ten years is like the past 10 years? Or worse? There is enough empirical data to suggest this may be the case.

The ten-year average annual return on the S&P 500 is now 3.20 percent. Yet, many financial plans are built on the premise of average annual returns of 7-8 percent, or even higher?

Ed Easterling of Crestmont Research is perhaps one of the finest market researchers.  And he has published two excellent books on the subject of market cycles—Unexpected Returns - Understanding Secular Stock Market Cycles … and most recently … Probable Outcomes - Secular Stock Market Insights.

And here’s a quote from his recent book.  Easterling lays out four points on market cycles and their effects on investors:

"First, secular stock market cycles deliver returns in chunks, not streams. Second, most investors live long enough to have the relevant investment period extend across both secular bulls and secular bears. Third, investors do not get to pick which type of cycle comes first. Fourth, investors need to be aware that they will likely encounter both types of cycles.

Those who experience secular bears during accumulation are generally better prepared than investors who are spoiled by a secular bull. A secular bull market is a pleasant surprise to retirees who endured a secular bear on the way to retirement. For retirees who grew to expect a secular bull during accumulation, the unexpected secular bear can be considerably disruptive."

My point is simply this—"passive indexing" will subject your investments to cyclical returns. Returns provided by the market itself. Maybe it will be enough to fulfill your personal financial goals and dreams… but maybe it won’t.  And unfortunately, neither you nor I can pick what the market will do … and when.

It is my firm belief that investors need to think beyond passive indexing and consider other approaches … approaches with measurable expectancy.  (I talked about this in my article on Gambling Supermodels.)

By using low cost ETFs and index funds WITH an applied systematic and emotion-free investment process … investors can earn superior returns regardless of market cycles.

As Charlie Ellis metaphorically observed … “to win at investing is to first not lose”.  And I couldn’t agree more.

Check out the Portfolio Café for a free e-book on systematic investing.  And get insights on active “emotion-free” investment models to help you win in today’s markets.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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