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Indexing and Tulips

Indexing and Tulips

The flowers sure do smelly lovely. Will they lead to an unpleasant financial odor?

Passive investing (i.e. indexing) is all the rage. Academics preach its virtue. They justify their existence by cranking out study after study concluding most managers don’t outperform the indexes all of the time.

Massive mutual fund complexes (we’re lookin’ at you Vanguard) promote the benefits. Think they have a reason to blow the trumpet?!

Governments implore the use of index funds in ERISA plans (e.g. 401(k)s) with the myopic view that lowest cost must mean best choice.

The gold standard of indexes is the S&P 500. It’s performed rather well since bottoming in March 2009. While many explanations exist the amount and timing of fund flows cannot be ignored. As promoters of indexing gain influence more and more money flows out of active strategies in favor of indexed strategies.

It’s a dangerous cycle. Indexes perform well so performance-chasing “investors” put money into them. The increased demand for indexed products pushes up their prices. Higher prices lead to more money chasing this “outperformance” which pushes prices even higher.

To be sure there’s nothing wrong with indexing. It’s a tool that like any other is inherently neutral. It’s in the way that it’s used that makes it a “good” or “bad” investment strategy.

An index is a measure. But to paraphrase Charles Goodhart when a measure becomes the target it ceases to be a measure.

And therein lies the problem. The religion of passivity and its deity indexing no longer serve a purpose. The measurement of performance as represented by an index has been bastardized.

In its wake is a perverted picture of active investing. The 24/7 information cycle when not updating us on the latest mission-critical news about (insert your favorite Kardashian) has reduced active investing to something useless if it cannot outperform an index every minute, hour, day, week, month, quarter and year.

Think of how ridiculous this is. If you can’t lead the race from the starting gun then why run it at all? Because the goal is to cross the finish line first. If your team doesn’t lead throughout the game then why even play it? Because the goal is to have the most points at the end of the game.

Indexing generally outperforms active strategies during bull markets with low volatility. Sound like the market we’re in?

Active investing is not to be commoditized or marginalized. Like passive investing it must be understood. It too is a tool that’s inherently neutral. It too must be used in a way that determines whether it’s “good” or “bad.”

What do active managers try to do? Here are some common approaches:

  • outperform a benchmark on a risk-adjusted basis
  • limit total risk independent of benchmarking performance against an index
  • outperform a benchmark over an extended period of time

Unfortunately these risk-based approaches don’t fit neatly into Big Indexing’s narrative so they are rarely, if ever, discussed. For fiduciaries such as Apollo Wealth Management noting the impact risk places on the investing piece of the total financial puzzle is prudent in the way we work with our clients.

So where’s the danger? Why all the hubbub? Look to the tulips.

The rush into indexing is not unlike the rush into tulip bulbs. The rush to capture 100% of an index return on the way up means a stampede for the door when investors realize they’ll also capture 100% of the loss on the way down.

Not us, right? We’re smarter than that. It’s the other investors marching to the same beat. While many of us will delude ourselves the rest will guard against the herd mentality and its impact on our portfolios.

The internet has allowed financial information and data to be instantly disseminated to the masses. This, in turn, has synchronized behavioral biases making markets more susceptible to major shifts in psychology. When the pendulum swings from today’s excessive optimism to pessimism the resulting move of selling overpriced assets will leave too many people trying to fit through too small a door.

Let’s clarify. This isn’t a sounding of the alarm. This isn’t a panic-inducing provocation. This is a reminder that when we invest money we must truly understand what we are investing in and why. We must understand the ups and downs – the pros and cons. We must always have a Plan B.

Caveat Emptor!

2 Comments

  1. Doug June 12, 2017 at 11:41 am - Reply

    Investing is like politics. Everyone is full of ****.

    • Howard S. Haber, CFP® June 13, 2017 at 7:08 am - Reply

      Interesting take to be sure. Care to expand on why you believe this? Regardless investing is a necessary part of life. If you’re not already doing so you’ll need to and, as such, you’ll need some sort of approach and philosophy.

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