deadcompanieswalking:
The best thing to ever happen to investors is only getting better with age.
Wednesday marked the fortieth birthday of the most investor-friendly idea in stock market history: the index fund. Forty years ago Vanguard
introduced the first fund that merely tracked the S&P 500. It has
appreciated 6,334 percent since inception, trailing the S&P by a mere .14
percent annually, all of which was the ‘expense ratio’ charged investors. Few,
if any other funds have matched or exceeded this annual return.
Today roughly $5 trillion is invested in index funds. Vanguard
is the largest index manager, with over $3 trillion in assets under management
(AUM). Other money managers now offer index products alongside their traditional,
actively managed funds.
Study after academic study shows that index funds outperform
most actively managed funds. The reason is simple. Fees. The average expense
ratio for actively managed stock funds is around 1.5 percent. It is somewhat less
for fixed income funds. As Vanguard founder John Bogle has convincingly shown,
a fund with a 1.5 percent annual fee (and the same pre-fee annual return) will
produce a much smaller total return over a multi-year period than a fund with a
.14 percent annual fee.
Investors have taken notice. According to the Wall Street
Journal, they have invested $409 billion in passive index funds in the last
year and pulled $310 billion out of actively managed funds over the same
period. Roughly 20 percent of all money in stock funds is now indexed, up from
zero 40 years ago.
I suspect this trend will accelerate. America’s
economic growth and thus profit growth will likely remain below historic levels for
years. Economists predict US productivity growth and population growth will
continue decelerating (see Northwestern economist Robert Gordon’s recent book The Rise and Fall of American Growth). Given
that interest rates are already at zero, this scenario all but guarantees
future market returns will be lower than the S&P’s roughly 9 percent annual
gain since the end of World War Two. As this occurs, the outperformance by
index funds vs. the average actively managed fund will be much more pronounced
than in previous years.
But don’t expect the asset management world to go down
without a fight. A week ago, the reputable money management firm Bernstein
issued a call to stem the indexing tsunami. The piece’s sensationalistic title–“The
Silent Road to Serfdom: Why Passive Investing is Worse than Marxism”—was
obviously meant to attract media attention, and paint Mr. Bogle’s invention in
the worst light possible. I’ve seen this kind of scare mongering in the asset management
industry for three decades now. When I started out, indexing was still in its
infancy, but people in my business were already shading the truth about it, and
for good reason: it represented a major disruption to our industry. Rather than
acknowledging the clear benefits of that disruption to the majority of
investors, many folks have chosen to demonize and misrepresent it instead. As Upton
Sinclair famously said: “It is difficult to get a man to understand something
when his salary depends on his not understanding it.”
I have always believed that most mutual funds and most hedge
funds will underperform the indexes on an after-fee, after-tax basis. Results
over the decades prove this. But I have also believed (and continue to believe)
that a small minority of managers can, and will continue to outperform. The
managers who accomplish this feat employ varying investment strategies, but
they almost always possess a similar combination of traits: an above average
IQ, some years spent working at firms with above average performance results, intense
intellectual curiosity, a cynical frame of mind, and a mistrust of groups and
group thinking (great investors are not joiners).
As importantly, consistently outperforming managers almost
always avoid growing assets under management beyond an amount where outperformance
becomes more difficult. While the optimum AUM varies by manager and by style,
it is almost always under $1 billion. Most managers who solicit assets beyond that
amount are amoral at best, dishonest at worst. The reason sub-$1 billion funds have a better chance of producing higher returns is obvious: pricing inefficiencies are likely greater in less liquid, less
analyzed securities. A number of stocks I have written about over the years illustrate
these inefficiencies, including homebuilder LGI Homes and apartment REIT Nexpoint
Residential Trust. Both companies were barely followed by Wall Street when I
visited with their managements, and far too small for larger funds to bother
investing in—and both have far outpaced the indexes since I purchased shares.
A final warning to investors: as this industry disruption
accelerates, the earnings, and stock prices, of asset management firms will
likely disappoint. Some firms—those with low cost structures, low fees on actively managed
funds, and a growing number of index funds/ETFs—will take marketshare and
survive. But others may not. The list of publicly traded money management firms
is lengthy. It includes household names like Franklin Funds, T Rowe Price, Legg
Mason, Waddell and Reed, and Janus. Unless these firm adjust to the new index
dominated world, their stocks could lag those very indexes for a very long
time.