Indexing is for those who aren't smart enough

(MoneyWatch) "Indexing is merely reflecting the market as a whole for investors who want to invest for the long term rather than trying to guess sectors. Indexing is the thing to do when you don't have the knowledge to select particular subsets of the market," said Ronald Cornew, an economist and president of Market Consultancy Corporation in Miami, Fla. With his "damning with faint praise" comment, Cornew is implying active management is the superior strategy -- you shouldn't index if you have the knowledge to select particular subsets, and if you don't have that knowledge, hire someone who does.

The only problem with that view is that there's an overwhelming body of evidence demonstrating that:

• Investors are overconfident of their abilities to pick stocks, time the market, and identify the few active managers that will (versus have) outperform their appropriate risk-adjusted benchmarks.
• Over the long term, the vast majority of investors, both individual and institutional, underperform.
• Since past performance of active managers has virtually no predictive value as to future performance (the exception being that poorly performing, high expense funds persist in their poor performance), there's no way to identify the few active managers that will outperform in the future -- past performance isn't prologue.

Damning with faint praise is typical of the criticism we hear from the active community. For example, in a recent interview with CNBC's Sharon Epperson, Doug Lockwood, of Harbor Lights Financial Group, had this to say about index funds: "An index is a ship without a rudder in a market like this. You're going to go up with it, your going, to go down with it. Sure, it's going to be cheap, but you have zero chance of outpacing the market if you're buying the index."

While Lockwood is technically right, his statement is filled with the typical problems and misdirection that we see when active managers discuss indexing. For example, while you have zero chance of outpacing the market, you have zero chance of underperforming. And since the vast majority of active managers underperform, and we have no way of identifying the few winners ahead of time, by indexing you're virtually guaranteed to outperform the majority of investors -- assuming you have the discipline to stay the course. William Sharpe made this point in his paper "The Arithmetic of Active Management."

The attacks on indexing are nothing new. They began immediately after Vanguard's John Bogle created the first index mutual fund in 1977. Fidelity's Chairman, Edward Johnson, assured the world that Fidelity had no intention of following suit when he stated: "I can't believe that the great mass of investors are going to be satisfied with receiving just average returns." (It's ironic that Fidelity is now a leading provider of index funds.) And a fund manager, National Securities and Research Corporation, categorically rejected the idea of settling for average. "Who wants to be operated on by an average surgeon?" Both statements are appealing to the all-too-human need to feel above average.

The attacks come because acknowledging the superiority of indexing is economic suicide for both the active community and the financial media. Nobel Prize winning economist Paul Samuelson noted: "[A] respect for evidence compels me to incline toward the hypothesis that most portfolio decision makers should go out of business -- take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives. Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed. Few people will commit suicide without a push."

Fellow author Bill Bernstein offered this analogy: "The debate between active and passive management is like the debate between astrology and astronomy. Take the case of emerging markets: If you're going to have an edge somewhere as an active investor, it ought to be in emerging markets. Well, there is no edge in emerging markets; the passive funds, particularly the value and small-loaded products from Dimensional Fund Advisors, have done spectacularly well."

In summary, if you want the best chance to have a story to tell about a great investment you made, take the active route. If you want the greatest chance of achieving your financial goals, passive investing is the winning strategy.

Image courtesy of taxbrackets.org.