Warren Buffett, one of the world’s most admired investors, has revealed that his will provides advice to his wife that she should put 90% of her money into a low cost index tracker fund1. I am often surprised by the poor quality of the public debate on the merits of active funds vs passive index tracking funds.
A typical article will state that most active fund managers underperform the market index and charge more than a tracker fund, so investors can achieve better performance whilst taking lower risks by going passive.
I am not going to argue here about whether active funds can outperform the market, although there is considerable evidence that certain value based strategies, of which Mr Buffett is a great proponent, can outperform in the long term. Instead I am going to discuss the claim that tracker funds are a low risk alternative.
If risk is defined as deviation away from an index return, then by definition, tracker funds are a low risk investment option. However I don’t believe most people think of risk in those terms. I suggest most people think of risk as the chance of losing money or, more generally, the chance of something going wrong. In that context an indexation strategy guarantees the same absolute risk as the overall market, whatever that may be.
So how are index funds related to climbing Mount Everest? The 20th Century mountaineer George Mallory is famously reported to have answered the question about why he wanted to climb Everest with the three word answer “because it’s there”. This is the same approach that index tracker funds use to decide which stocks to buy. They buy every share in the index because it is in the index.
Now “because it’s there” may be a very good reason for wanting to climb the highest mountain on the planet, I can’t think of a better one. But it strikes me as a strange way to go about deciding where to invest one’s money. There surely must be a question about whether this is a sensible default option for millions of savers?
At the start of the 20th century 49% of the UK stock market was comprised of railroad companies2. I suggest it would not have been a particularly sensible move to have put half an average investor’s money into that sector on a long term basis in 1900. These days companies and corporate financiers pay close attention to whether or not a share will make it into a particular index, aware that inclusion will guarantee buying interest from tracker funds. The FTSE 100 Index has been a victim of this trend with a large number of mining companies listing here during the early 21st Century to exploit these investors.
Index funds do not care about the strength of a company’s business franchise, its balance sheet, valuation or corporate governance structure. These are all true risk factors that should be considered when investing. The only factor that index funds use is the free float market cap of the business, which tells you little about its risk profile.
There are many alternate ways of selecting Fund Managers or investment strategies. I think that investors and their advisors should try to understand the investment approach and risk tolerances of the fund managers they appoint rather than leaving risk control to chance, or more accurately, to index construction rules.
At the very least, the active vs. passive debate needs to progress from simply looking at returns and costs to considering the true risks involved in either approach. Unfortunately the idea that index funds are low risk alternatives is so well entrenched that the active fund industry has a mountain to climb to change perceptions.
1. Buffett made this suggestion in his 2013 annual letter to shareholders. http://www.ft.com/cms/s/0/0fdc605a-a53d-11e3-8988-00144feab7de.html#axzz2vYbmAT4H
2. Triumph of the Optimists – Dimpson, Marsh & Staunton, Princeton University Press, 2002