|
 As the chair of the S&P Index Committee, I hear a lot of discussion as to why it is difficult for active managers to outperform the S&P 500. But for me, a more interesting question is what happens to the active/ passive comparison in other markets.
Passive investing is a bit of a misnomer. Index investors eschew market timing and stock picking not out of laziness or passivity, but because those activities usually reduce returns and increase risks. A better name for it would be the title I gave this column: ''Intelligent Investing.'' Rather than roll out yet another set of statistics demonstrating that indexes outperform between two-thirds and four-fifths of active managers over any period of a few years or more, a few references should suffice. Burton Malkiel's classic, A Random Walk Down Wall Street, was one of the first and is still one of the best commentaries on intelligent investing, and the latest edition continues to make the case for indexes. Jack Bogle's books and articles also present strong arguments for indexes, especially in terms of costs and the folly of attempting to time the market.
Even some of the adherents of ''fundamental investing,'' while arguing for different weighting schemes, largely avoid market timing and stock selection. At the risk of losing some readers, even in a journal devoted to indexes, I will assume agreement that among large-cap U.S. stocks, it is very difficult to consistently outperform the S&P 500 (or another broad-based index).
To judge if the same results will extend to smaller-cap stocks or to newer, emerging markets, however, we must start with an idea of why indexing works so well in general. Among the candidate theories are efficient markets, costs, unpredictability and dumb luck.
Efficient markets theory is the idea that all readily (and legally) available information is incorporated into stock prices quickly and that no one can get an edge to predict prices without inside information. If this is so, forecasting stock prices and picking stocks profitably is impossible.
(Predicting stock prices requires neither information nor skill; predicting them accurately requires both, however, and it is profitable accuracy that is impossible.) Investing results and academic studies largely support this. From a practical point of view, in a market where prices are readily available, where companies publish summary financial statements and stock trading, clearing and delivery are possible, indexing works.
Would indexing work in a market with no public information about either prices or financial results? Since that means virtually no data, it is hard to say. However, the private equity market in the U.S. has its ups and downs and it is not clear why or if long-run risk-adjusted returns are consistently and significantly better than the public markets.
The second issue is costs. No one is more consistent or more eloquent in arguing that cost matters and that low costs are the reason indexes work than Jack Bogle. Paying 1 percent or more off the top is much worse than paying one-fifth of 1 percent. In those heady and rare years when the S&P 500 returns 20 percent, some of us won't care about costs. But in years like 2007, when market returns are low, everyone will care. And that's all before taxes.
|
