Are Index Funds Unsafe?

Hi RIP readers,

I’m not gone, do not worry.

I’m traveling quite a bit these days, that’s why I’m not blogging much (and I miss it).

I’m back home now. Just for a little while: we’re planning a 3 weeks vacation to Portugal in September (so I’ll be gone again soon).

Vacations… sea… relax… not cooking, not cleaning the flat, not doing the laundry, not doing the dishes… pure joy!

No, not true. Ok, yes, I had fun, I spent time with my family and some friends, watched my daughter’s first steps and first “papà” (daddy in Italian) and got tanned. But I miss RIP-time: reading, thinking, writing, planning, philosophizing and so on. Prolonged traveling is not for me anymore.

Anyway, this period of my life with a small daughter and time available won’t come back. It’s unique, and we’re taking advantage of it. Portugal, we’re coming in September!

Now let’s jump on today’s topic!

“What the hell is this? Why are index funds unsafe? Didn’t you already discuss the issue a couple of times?”

Yeah, I know. The title is a bit clickbait-ish, sorry. But it’s not my fault. Blame Paula Pant!

Yesterday evening I was cleaning my dishes, and as I already told you cleaning dishes became a pleasant moment of my evening routine since I started using the time for reflection, mindfulness and YouTube/Podcast listening. Before attacking the pile of dirty dishes I estimate the time needed and select the appropriate source of enlightenment. Yesterday I tapped into my overgrown YouTube watch later playlist and selected a hour long (too long for yesterday dishes) Afford Anything podcast titled, as you may imagine, Are Index Funds Unsafe?

Here it is the full version:

Paula Pant’s podcast is one of my favorite, even though I skip 80% of the episodes and usually 80% of the content within the episodes I don’t skip. She interviewed many amazing guests (not you) and she likes to focus on controversies and disagreements instead of simply please her guests.

This episode is a Q&A, where she and Joe Saul-Sehy (former financial planner) answer to recorded (not live) questions from readers/listeners.

I want to focus on the first question, asked by someone named Rose, that starts at minute 2:59 and ends at minute 22:59. It’s a 20 minutes argument between Paula and Joe about Passive & Active funds investing. I wanted to participate to the discussion so badly that at one point I realized “wait… I have a blog, I can write about it there!”

So here we are 🙂

I’m going to guide you thru the debate and add my commentary to it. I enjoyed myself feeling competent in a debate between two experts in the field. If I (or you) ever want to become a financial advisor, I guess listening to debates and having the confidence to hold an opinion and understand its opposite is a good point where to start.

The (redacted) question posed by Rose is the following:

“We have a financial consultant that we pay 1% of our portfolio annually (portfolio size 1M). Our portfolio contains mutual funds. Should we switch to Index funds? The consultant says it’s riskier because with the index fund you own the whole market, and if the market goes down, your portfolio goes down as well. Current portfolio is 11 funds, only 3 of them has TER < 0.5%. The 3 funds in my IRA are all around 1% TER. I just found out that Vanguard has funds with 0.03% TER… should I switch to Vanguard?”

“Yes, YES, holy crap RIP, tell her YES move your money away from that criminal! RIP? RIP??? TELL HER TO RUN AWAY!”

Yeah, of course she should show middle finger to that guy, but let’s be more professional. BUT ROSE, IF YOU’RE READING THIS, MOVE YOU MONEY AWAY FROM THIS GUY!

First let’s analyze the question itself. Rose pays 10k each year to this guy in fees. Plus let’s assume 1% average TER for the funds in her portfolio. It’s another 10k to the funds manager. It’s 20k USD per year, or 3 times what Jacob Lund Fisker needs to survive for a year. 3 JLFs gone in the wind each year.

She said “Mutual Funds” and she’s interested in moving her money to “Index Funds”. That’s a syntactically wrong sentence. Mutual refers to the structure while Index refers to the strategy. There are mutual funds that track indexes. VTSAX, anyone? I assume that her mutual funds are actively managed and she’s thinking about switching to passively managed. Assumption that Paula and Joe also made.

Let’s analyze what her financial consultant told her: “do not move to Index funds because they are riskier: you own the entire market and if the market goes down your portfolio goes down as well“.

First of all there’s an enormous conflict of interest here. If Rose moves her assets to Vanguard the consultant loses 10k per year (ideally growing over time) plus probably a fraction (referral/sales fee) of the other 10k Rose pays in fund fees. So she shouldn’t be asking this question to her current advisor in the first place, she should look outside for a second opinion.

The consultant answer (as far as we know, since we weren’t there when they discussed) is silly! “With Index Funds you own the whole market“. Not always true. You virtually own shares of all the assets tracked by the index. Of course there are broad based indexes like MSCI ACWI IMI that tracks ~10k stocks, but there are also ultra narrow indexes. And what is the consultant implying? That the funds Rose currently owns are very narrow? Very risky… But that’s the main point: “if the market goes down your portfolio goes down as well“. Yes, true, but how can you promise that it won’t happen with the funds she currently owns? Are they manually picking stocks? Are they beating the market? Consistently over the last 10-15 years? After (2%) fees?? And even if they do, how can you ensure that “if the market goes down your current portfolio doesn’t go down as well“? Bullshit.

To be honest there’s a way out here. Rose’s current funds can be hedged against currency risks or heavy losses, and in that case “if the market goes down your current portfolio doesn’t go down as well” is true. But every kind of hedging has a premium attached to it, and it is proven (citation needed) to be inefficient in the long term. Plus still 2% fees are gone in the wind each year. Bullshit confirmed.

Btw, if a financial person gets compensated by a percentage of your portfolio and they get to decide which funds to invest your money in (potentially earning other referral fees for it) they’re not just a “consultant” but your actual asset manager. It’s ok to be assisted in your investing & retirement planning by an experienced person, but I strongly recommend you to understand how the person is going to be compensated and I encourage you to only use the help of fee based advisor, i.e. people that get paid by the time they spend helping you on a hourly basis. Avoid people who get paid by what they sell you (usually banksters) and think twice about people who get a percentage of your portfolio. If you really want someone to manage your assets for a percentage of your portfolio, go with roboadvisors.

So if I were asked the Rose question, I’d reply “you should very likely fire your financial consultant and open a Vanguard account. If you want to have support for the move, hire a fee based financial advisor that can help you understand what you’re doing and that can guide you through the change. Then you can easily walk alone. If we want to be 100% sure this is the right move, and give your current consultant the benefit of the doubt, please show me your current asset allocation and current funds’ ISIN or factsheets so we can take a deeper look at what you own right now. But I’d bet 100:1 that you’ve not performed better than the market after fees and taxes in last 15 years“.

That was an easy one.

A game I like to play when I want to check my knowledge on a topic is the following: I listen (or read) to an expert Q&A and I try to answer the questions before the expert, and then I check my answers with the expert’s ones. So I unpaused the podcast to listen to Paula’s and Jim’s answers, and that’s why I’m writing this post: to join (a bit late) the conversation.

Paula suggested Rose to immediately fire her financial advisor! She also assumed that “mutual funds” are stock-picking funds and not of any other hedged form. Let’s assume the same for the rest of the post, we’re no more helping Rose but entering a philosophical discussion in few minutes 🙂

Paula’s main point (freely adapted by me for clarity) is “to prefer an actively managed fund over a passive one in the same market means that you’re hoping that the fund manager is so good that they pick stocks that outperform the market, but statistically speaking most funds underperform the market“.

The “actively managed funds underperform the market” is a common assumption among the FI community, and I’ve seen some research (1, 2, 3, 4) but maybe we need a stronger data support here that once and for all closes the debate. Anyway, contrarian friends, Value Investing is still a thing, and with a lot of effort and extraordinary skills I think it is possible to consistently beat the market. Rockfeller, Graham, Buffett & Munger, Dalio… Have you heard about them?

Anyway, for the average person (like you and I) not willing to become the next Warren Buffett, having someone actively manage your money and paying them (and their consultant) 2% of your portfolio every year reduces the already small odds of beating the market.

Then Paula moved on talking about unknowns in Rose’s question: “what’s your current asset allocation? Do you want to change it? It makes sense to address this issue separately and be sure that your current split of stocks, bonds and other assets matches your plans, your age, your risk tolerance”. Very good point. And then blasted the consultant and raised same issues as I also did, good.

Then Joe jumped in and the debate started. He said “the advisor didn’t say passive is riskier than active, he just said that passive is riskier than what she has right now, and we don’t know what she has“. Technically correct, but as I said, I’d bet 100:1 that once unveiled Rose’s portfolio we’d laugh at it and fire the advisor anyway. Joe is a former financial advisor and there’s probably some confirmation bias at play here. For his entire life he has recommended funds, now he can’t blame active management as a whole but “it depends”. Well played Joe!

Joe then introduced a case that is crucial to the debate and that made me want to be there with them. Again, this is freely adapted by me for simplicity and clarity but I didn’t alter the point. Listen to the original if you want: “somebody wrote me about a fund they owned, an actively managed mid cap global fund. The person was upset that the fund TER was 1.1%. I checked on morningstar (it follows a praise to morningstar, which I totally agree with) to check what we have, what the person owns. I found out that morningstar rated this fund 4 out of 5 stars. According to morningstar, this fund’s TER is below average for the funds in the same category. So the person was upset they’re paying too much… no you’re not! (continue)”

Ok let’s take a break here. Good general advice: know what you own. Even better, know what you’re going to invest in before you invest in something. But the point that the price is fair because it’s below average for funds of its category is fallacious. Global mid cap is not a very popular index, so there are probably more actively managed funds than passively managed ones in that category. And guess what that means for the “average TER”? You guessed it right, it’s very high. What about S&P 500 category average TER? Couldn’t find on morningstar, but here’s on ETFDB: average TER is 0.37%. Why? Because it’s a category dominated by passive funds.

“So the person was upset they’re paying too much… no you’re not!” … Yes you Are!

Let’s move on. Joe continued about the guy’s fund showing how the fund outperformed the market compared to its benchmark index when the index was up, and underperformed when the index was down: “2018: fund -18%, index -14%, 2017: fund +52%, 28% better than the index (does it mean index 24%?), 2016 fund beat index by 15% (not clear what happened), 2015 fund performed +40%, beat index by 15% (again unclear)… it is up and down but 3-5-15 years track record the fund outperformed the market. if you joined the fund in 2009 (random starting date uh?) and you invested 10k in a fund tracking the benchmark index you’d now have ~32k after fees. With this fund you’d now have 47.5k after fees”

Let’s analyze what’s going on here. Joe is using this example to show that there are funds that consistently beat the market. Not many, but there are some. And if you discover you own one of them (or if you discover one of them exists) you should hold (or buy) and not complain if fees are higher than the average.

Note that the fund he used as an example performs like a 2x leveraged fund (doubling gains and losses, very risky), which is easy to make it shine during a bull market 🙂

Plus no, it doesn’t work this way! You can only look backward, and past performance doesn’t guarantee future results. Else we’d all be investing in what Warren Buffett is investing, isn’t it? The fund cherrypicked by Joe performed better than the market? Good for those who owned it during last 10 years (but not for those who jumped in in January 2018). Will it keep outperforming the market? I don’t know. Is it more likely that it outperforms the market (its benchmark) compared to other similar funds? Maybe, but it’s not guaranteed. Maybe instead of having 5% chances of outperforming the market for the next 10 years (like studies say) it has 20% due to having hired the right people to manage this fund, and having followed a good strategy so far. People change job, retire, quit and whatnot. Past good performance attracts dumb money which doesn’t incentivize keeping performance high. Maybe it was just a matter of high risk / high reward, and a serious downturn (30+ market drop) would wipe the fund out. If I had to bet who’s the winner among 10 actively managed funds with the same benchmark, and this one is the best performing I’d probably buy this one. But I’d still prefer a fund that tracks the index!

Paula tried to jump in, but Joe continued: “you could have quit the fund, you’d have had a quick win because you paid less in fees, but you’d be holding a cheaper and more mediocre fund instead, and you’d be 16k Dollars further away from your goals” … like his fund is guaranteed to not be mediocre! True that you’d be 16k Dollars behind, but that’s easy to tell in retrospective. You are already 1 Million Dollar further from your goals because you didn’t invest in a 99x Leverage fund shorting Argentinian Merval index on Monday August 12th 2019. Yes, a fund like that might have been expensive, like 5% TER and you complained, but if you sold it now you’d be holding some mediocre fund instead 😀

At this point I really wanted to jump in! And actually started complaining alone, and slowed down my dish cleaning activity to better formulate my thoughts.

Then finally Paula intervened, and I expected her to voice my own concerns, but she focused on another fallacious line of thought: “you described a fund that has in the last 15 years outperformed the market (did he? He showed 5 years of performances, and the fund performed worse during the negative year, 2018). What we know is that the majority of funds do not consistently outperform the market (the index) and those that do revert to the mean. Do not conflate results with statistical likelihood. Just because one particular fund has outperformed don’t think that it always will. That would mean that we have the ability to hand select actively managed funds”

So far so good, almost. My problem is with “those that do revert to the mean“. Do we have some data supporting the claim? The reductio ad absurdum that follows (“That would mean that we have the ability to hand select actively managed funds“) doesn’t fully satisfy me.

“But RIP, let me quote you, from few lines above: ‘Else we’d all be investing in what Warren Buffett is investing, isn’t it?’. Are you self contradicting?”

It’s a very thin line, but it’s important. I said that past performances don’t guarantee future results, while Paula said that “they revert to the mean”, which means that if a fund outperformed in the past it will underperform in the future – that’s what reverting to the mean means. According to Paula we should all be shorting what Warren Buffett invests in 🙂

The argument between the two grew as Joe continued: “we know that historically the fund managers who have had a history of beating the market are the ones who usually continue to do so”

Here’s the key point of the debate: it’s on the nature of the divergence from the market of actively managed funds. Let’s remove the dust from Signal Theory books: taken as a whole, Paula models the function over time of relative performances between market and fund as an Ergodic process, while Joe as a non ergodic but biased one. I think it’s a non ergodic unbiased one (or maybe ok, a little biased toward past successes)

To put it simple:

• Paula thinks that actively managed funds are given a deck of cards, and each year the fund manager flips a card: if it’s a A or K the fund beat the market, if it’s any other card the fund underperform. Small chance of success on any given year, but guaranteed reversion to the mean after 52 years. If you flip all the As and Ks at the beginning, good luck for the future.
• Joe thinks each fund flips an initial biased coin (say 90% head and 10% tail), and this initial coin flip defines which side of the coin means underperforming the market. Then the fund flips a coin each year. It means 90% of the funds are crappy and destined to be crappy (even if they occasionally beat the market sometimes), and 10% of the funds are superstars and are more likely to beat the market every year.
• I think funds are flipping the same biased coin each year, and tail beats the market. That means 90% of funds underperform the market on any given year, and over time every fund underperforms the market thanks to the law of big numbers. Even if you’ve been lucky for 5 consecutive years, good luck with the next five.

All scenarios may be tuned to have same expected aggregate result, matching the stats we have on actively managed funds underperforming the market.

Joe made a good point about asset flow, i.e. people putting money in and getting money out at unfavorable time. That’s the reason why (according to him) good actively managed funds stop outperforming the market: when the market is down investors take money out, and that doesn’t help the recovery phase. At the same time, when the market is good the fund gets more money from investors which doesn’t help performances. Investors are stupid and buy high and sell low. That’s why Joe himself hates actively managed funds (he said).

This is a very good point and something new that I learned today, even though it contradicts what Joe previously said: funds that outperform the market are more likely to keep doing so. On his defense, he also added that without asset flow active managers would be way better than what we’ve seen. Note that ETFs don’t suffer from this problem because investors buy and sell shares among them, and there’s no asset flow for the fund manager to handle. ETFs are similar to (and usually confused with) closed-end funds. So why not let these great active managers run ETFs instead of mutual funds, Joe?

Joe concluded his active management defense with: “I’m not saying you go out and buy this fund, I’m saying if you own this fund right now and you know how this particular manager performs, because it’s like a heartbeat, what do you do? Do you move from this fund right now if you own it?”

Note another fallacy here: why would owning the fund (or not) matter? “I wouldn’t buy the fund, but if I had it I would keep it” is logical nonsense unless the trading costs are significant, and they should never be.

Paula: “I would, yes! I absolutely would!”

Joe: “you have a manager who’s working, why do you fire them?”

Paula: “Because I know that the expected value of any fund is lower than the expected value of an index fund over time!”

This is fun. I’m going to defend a position I didn’t expect to defend. Joe is very good at defending an indefensible position, and Paula is making statistical mistakes. I’m with you Paula, but this is not the way to attack Joe’s position!

Joe: “you’re taking the entire universe and saying it’s all created equal”

Ouch, another punch in the face!

Paula: “if we have an active fund that purchases mid-cap and we have an index fund that represents mid-cap stocks, the index fund is more likely to do better over time and the outperforming active fund is likely to revert to the mean”

No and no Paula 🙁

It is true (pending more data) that an active fund is more likely to underperform the index over time, but you’re saying that the fact that a specific fund consistently outperformed the index in the past N years not only doesn’t imply that the fund will keep outperforming (like Joe said) or that it has a slightly better probability distribution of performing well (like I said) or that it still has the same probability distribution of any other fund (like a new coin flip, a random walk, an ergodic process like you previously said) but that it actually makes the fund more likely to underperform thanks to reversion to the mean! Unless there’s some study that demonstrate reversion to the mean for actively managed funds (and please don’t show them to Warren Buffett) this is a double statistical mistake.

Paula then talks about coin flips and that outperforming for 10 years doesn’t change expectations for year 11, which is the random walk hypothesis and it’s against reversion to the mean!

And finally Joe entered the fallacious side with both feet: “it’s not a coin flip, you have a system at work here! If I go in a classroom and I can put my money with the student who sits in the front row who gets all As, or I can put my money with the student in the back, that sleeps all day and constantly gets Ds and Fs… What you’re saying is that they all going to revert to the mean. Not true. The group as a group will revert to the mean, the individuals don’t have to revert to the mean! Btw, people are going to think that I’m advocating actively managed funds and I’m not. I think you should go passive! I just think that calling all active managers bad is wrong”

A lot of stuff to analyze. First of all you don’t have a system at work. Investing is not that systematic. You can’t have a guaranteed system that works above average, or else that would be arbitraged away. It’s a second order chaotic system.

Second, the students analogy is fallacious. As and Fs students are easy to classify. There’s a wide spread, and student performances are deterministic given hard work and talent. There’s almost no luck involved.

In the world of investing, everyone is an A student. It’s actually the selection of the top students among the A students. B,C,D students are quickly kicked out. Everybody is an A+++ student, now make your bet! Plus, there’s a lot of luck involved. Plus, a fund can change the management style, strategy, and even people. The student analogy is fallacious, I’m here to propose the poker analogy.

Poker champions tend to change all the time, there’s no “Usain Bolt” of poker. That’s because in an individual championship tournament all participants are A students, the talent spread is very narrow, and luck plays a huge role. Am I going to bet on Daniel Negreanu again after he won a tournament? Yes, maybe. He’s a very good player… will he make it to the final table in a 1000 player tournaments because he’s an A student? Not guaranteed! And let’s imagine that the index poker player always ends the tournament in 10th positions. What do you do? I’m better off betting on the IPP and cashing 10th prize 😀

Fun fact: friends say I look like Gus Hansen, who ended up broke after 18M Dollars of total losses. I hope my “system at work” is better than his 🙂

Anyway Joe, you can’t say “By the way, people are going to think that I’m advocating actively managed funds and I’m not. I think you should go passive!” and at the same time defend the predictability of outperforming the market. You can’t. Yes, you’re advocating actively managed funds 🙂

The argument goes on for another 3 minutes with a couple of other bad analogies, Joe coming back to the original point of “understand what you own”, claiming that “cheaper doesn’t mean better”, Paula coming to my point of “F students get fired and all you have is A students”, Joe finally summoning “Ray Dalio never reverted to the mean!”, Paula complaining that “you’re cherrypicking!” (which is ok as a proof of non ergodicity, the problem is that Joe is cherrypicking in hindsight! And that doesn’t guarantee that Ray Dalio is going to outperform the market next year as well!) and a final cool down…

Conclusions

Understand what you’re investing in, deeply understand it. Do not invest in what you don’t understand.

Your first choice should be passive funds.

If you really want to try to beat the market, spend the next N years to study how to become a Value Investor yourself. Mind that the odds are against your success as an active investor even if you’re an A+++ student.

Avoid actively managed funds. Yes, they may outperform (even somehow consistently) the market, but if you don’t have the skills to be a Value Investor yourself, you don’t have the skills to judge if a particular fund manager is the next Warren Buffett.

Avoid having your money managed by an asset manager. If you’re too lazy to study even the basics of diversification and index investing, then use a roboadvisor.

If you still believe your uncle/friend/consultant/advisor/bankster is the next Warren Buffett, and you want to hand them all your money in the hope of beating the market while sipping mojitos on the beach, please take a look at this checklist:

1) understand how your financial advisor gets compensated.

2) demand openness about financial instruments they are investing your money in: always be a click away from knowing exactly what asset every cent of your principal is being invested in. Each financial instrument should come with associated fees, strategy, performance track. Make sure graphs include at least a bear market and a recession.

3) demand openness about your advisor: ask if their own money is invested in the same way yours are. If not, double check that the difference is just related to different risk tolerance and investing goals. Ask for last X years of their performances.

And if you own AffordAnything podcast, you can afford to have Mr RIP on air 🙂

Paula, invite me pleeeeease!

P.S. Dishes are still not done, I had to stop and go write this post (sorry Mrs RIP).