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Sharpe: I think that indexing covers a multitude of sins, but I also think indexing is a good idea for a nontrivial part of your money. I'm not saying you have to index everything, but I'm a big proponent of indexing. It also has to be cheap indexing. There are index funds that egregiously charge 100-plus basis points, which is insanity.
IU: Are there asset classes where it makes sense to go with active management or is across-the-board indexing a good way to go?
Sharpe: Whenever you're doing active management, you have to think of it as you're betting your manager is enough smarter than the average active manager in that sector to overcome all the added costs. You could make the argument that if a sector is really well researched and there are a lot of people trying to find mispriced securities, the chance of finding an active manager that can cover costs and provide a net alpha is much smaller than in an area which is under-researched and under-examined. A number of consultants used to advise indexing the big markets and going active in the little ones or the obscure ones. Nowadays, however obscure the market is, there seem to be a lot of people studying it, so that game is a little harder to play, I think.
IU: Do you think fundamental indexes are a valid way to represent the market?
Sharpe: No. I love the way you stated it because I can answer it unambiguously. There are so many shares of IBM and so many shares of General Motors and so many shares of Little Widget Manufacturing, and to represent the market you buy 1% of the shares of IBM and 1% of the shares of General Motors and 1% of the shares of Little Widget Manufacturing—and then you've represented the market. Anything else can't represent the market, because when you add it up, you don't get the market. If you want to represent the market and if you want a return equal to the return on all the money invested in that market, you're going to own the same proportion of the shares outstanding of every security in the market period. A fundamental index is going to get a different return: If it is value-tilted, as most of them are, you're going to win when value stocks do better than growth stocks, and the index fund people will get the market's performance.
If you beat the market, some dummy somewhere who has taken the other side of your trades is going to be beaten by the market before it balances out. There's no magic in it: Basically, for everybody who overweights small cap or value, somebody else is going to be underweighting those relative to the market cap, and the index fund people are going to be fat and happy in the middle. You can call it whatever you want to call it, but it is a deviant position from the market, and if it beats the market, somebody else is going to get beaten by the market. It's that simple. But this sophistry that it's more representative of the market makes no sense at all, unless you suspend all the rules of logic.
IU: How important is international diversification?
Sharpe: I'd have to say probably less than it used to be. I think what we're seeing is a lot more correlation of markets around the world, and it makes a lot of sense. We've got much more integration of trade, and we've got much more integration of financial markets. In some ways, if you buy shares in all the companies that are headquartered in the U.S., then you've got probably a more global portfolio than if you'd done that 25 or 50 years ago. The benefit of having companies headquartered in different countries in your portfolio is probably less than it used to be, but that is not to say that it isn't there and it isn't worth doing.
IU: Do you think commodities have a place in the average portfolio?
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