Are You Better Off Buying an Index Fund? | Brandon Averill, Justin Dyer | AWM Insights #103
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Episode Summary
The most recent SPIVA Report for 2021 was just released and once again the same conclusion is reached. “Passive” has beat “Active” and only 15% of active managers that are paid to beat the market, did not.
Passive investing, sometimes referred to as indexing, doesn’t engage active stock picking. Active management attempts to beat “the market” through the fund manager selecting the stocks.
The great news for investors is that this competition between active managers creates efficient markets that are cheap and easy to buy through index funds. All you have to do is listen to the evidence.
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Episode Highlights
(0:32) Brandon and Justin discuss stock picking and marketing timing. Is active or passive investing winning?
(1:44) Active investors are trying to beat a benchmark. The most common benchmark is the S&P 500 Index.
(2:06) An index is a defined collection of stocks. The Dow Jones Industrial Average has been around for over 100 years.
(3:20) Active Management is commonly compared to these indexes to determine if the cost of research and implementation is worth the return.
(3:50) You can’t actually buy an index itself but you can buy funds that very closely track its return. Plus, they have cheap fees.
(5:20) Dispelling the myths of stock picking.
(5:45) Active managers believe they can read the tea leaves and predict what’s going to happen. They also overweight or underweight sectors to “beat the market”.
(6:25) The evidence every year shows it’s impossible to beat the market consistently.
(7:09) SPIVA stands for Standard & Poor Index Versus Active report.
(7:30) The report compares the many S&P benchmarks to the actively managed funds and identifies which ones outperformed and which underperformed.
(8:50) 85% of active managers underperformed the S&P 500 over the last year.
(10:35) Can you find the small percentage of managers that do outperform?
(11:40) You can find better odds of winning than the 10 or 15% chance of picking the next outperforming active manager. You can get close to 50/50 in Vegas.
(12:20) If for some reason you decided to try to identify which fund will outperform in the future, what are the characteristics to identify?
(13:28) Taxes are frictional costs that drag on investor returns, and do not show up in these numbers. These hurdles also hurt investors' gains.
(14:22) The powerful takeaway: If you’re smart enough to take in the data. You can have a perspective change which will help you avoid the silly game of attempting to outperform the S&P 500.
(15:22) The amount of intelligent people with virtually unlimited resources is the reason the indexes are so hard to beat. This competition is what creates this efficient market which is a plus for investors that listen to the data.
(15:53) If stock-picking isn’t the right way to beat markets, should you just buy an index fund or is there another way to find outperformance?
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+ Read the Transcript
Brandon Averill (00:03): Well, Justin, welcome back. We're going to jump into this next little series here, I think, and a hotly contested debate that shouldn't be hotly contested, I think.
Justin Dyer (00:15): Yeah, I was just going to say that, man.
Brandon Averill (00:16): But it still is, nonetheless I think this is the dark underbelly of our industry, unfortunately, because sometimes just what seems intuitive on the surface doesn't necessarily pan its way out. But what are we talking about? We're talking about market timing, active trading, stock picking. What is the most successful way to actually invest your portfolio, indexing?
Brandon Averill (00:40): All these things are so, I think, complicated. We cut through some of the noise previously. Not every mutual fund is actively traded anymore, not every ETF is indexed, or passively indexed, anymore. So there's lots of nuance, but I know that's where we're going to start to today, Justin, by just throwing out some definitions, laying the groundwork.
Brandon Averill (01:03): So I'd love to hear from you just, yeah, maybe you can give some clarity around here to when people refer to active, what does that mean? When they refer to passive, what does that mean? And how can we start to frame our thinking about what successful investing is?
Justin Dyer (01:18): Sure. So we'll start with these black and white definitions with the disclaimer that the world is not black and white, as we all know, there's a spectrum and flavors, and all that stuff, but we have to start somewhere. We always like to think first principles let's go there. And to your point, Brandon, let's start with definitions.
Justin Dyer (01:37): So I think the simplest way of framing this conversation with respect to active investing are those are investors who are trying to beat a benchmark, quite simply. There's probably more you can add to that, but I think at the heart of it is they are trying, through their own intellectual capabilities, through their skill, they're believed skill, to outperform an index.
Justin Dyer (02:05): What is an index? An index is a defined collection of stocks that is there to try and represent a specific component or part of the stock market. So the common indexes or benchmarks out there are the Dow Jones Industrial Average. That index has been around for probably almost a hundred years. It is the top 30 industrial companies that trade on the market. That is it. And there's a definition of around what companies need to fulfill to actually be added to the Dow, or subtracted or eliminated from the Dow.
Justin Dyer (02:51): Another big one, S&P 500. That one's even easier. It's the top 500 largest names in the US stock market. There are some definitions and criteria that you have to meet to get in or out of it but, in general, it's the 500 largest companies.
Justin Dyer (03:05): Another big one you hear about is the NASDAQ, or the NASDAQ 100, more specifically, which are the hundred largest stocks on the NASDAQ stock exchange.
Justin Dyer (03:16): And so, a common actively managed strategy, mutual fund, ETF, or just somebody who's trying to do some investment management on their own, naturally, if you're trying to do something on your own and get a good result you need to compare yourself to something to answer the question, "Hey, am I actually at adding value? Is this a good use of my time? Can I actually buy and sell stocks and outperform the S&P 500, or should I just go buy an index?"
Justin Dyer (03:49): You can't actually buy an index, but you can buy products that are ETFs or mutual funds that are designed to essentially mimic the S&P 500. We'll use that probably as the most common index out there. It's just most commonly quoted, it's very familiar to everybody, and it's easy to define, whereas, so those people who are buying those indexes are just saying, those are passive investors, those are indexed-based investors. They say, "Hey, this rule-based approach to investing makes sense, I just want exposure. I want to hold those top 500 stocks, and then I'm going to go focus my time elsewhere."
Justin Dyer (04:28): We'll get into what the data actually shows as to which route you probably should take, and maybe listening to this podcast you can probably pick up on where this is going, but I'll say this, and then stop here, and we can go deeper as you want, Brandon. It's nuanced. There is some nuance to this, right? Like I said, not everything is black and white.
Justin Dyer (04:53): In order to have conversations and to start the debate and to start to analyze something, you do have to ask some pretty simple questions and that's of what we're trying to do today.
Brandon Averill (05:03): Yeah, no, I think that was a great summary, Justin, and, like I mentioned, we're going to get deeper over the coming weeks, and eventually we'll get to what's the actual evidence saying, where should you invest? But I think, to be able to get there, we need to start to dispel some of the myth or the sales pitches that are out there, for instance, really picking on stock picking.
Brandon Averill (05:27): Let's tear that apart a little bit today. There's a famous report that gets put out regularly called the SPIVA. Really compares the S&P, so that index performance you just referred to, but against these active managers, these people that believe they can read the tea leaves, they know where things are going. They're going to underweight, overweight, pick certain stocks. They're going to really put all that together.
Brandon Averill (05:56): Maybe some market timing to that aspect, but maybe that's where we hone in here, Justin, and I'd love you even just to unpack this SPIVA report a little bit. It pretty consistently shows that there can't be outperformance, yet we continually have people that think they can do it, so I'd love for you to just, yeah, why don't you dig in there a little bit and help us to understand, what is it about stock picking that makes that really difficult to really, if you look at the evidence, impossible to consistently, and that's a key word, consistently beat the market?
Justin Dyer (06:29): Yeah. And it is amazing that such a treasure trove of data is out there and often goes a overlooked. And I shouldn't say overlooked. When the reports come out, I think they come out every six months or so, there's a handful of articles around it, but often it's a single news cycle, and then everyone moves on and we all forget about it, but it's an incredibly robust report, set of data, that there. Just type in S-P-I-V-A into a Google Chrome browser and it will pop right up.
Justin Dyer (07:05): And just to expand on it, SPIVA stands for S&P Index Versus Active report. And essentially, what it does is it goes and takes all the Standard & Poor's indexes, which there's many, it's not just the S&P 500. S&P 500 is the most prominent. It takes all of their benchmarks, their indices, I'll use those terms interchangeably, and it just compares it to the data set of actively managed funds in the marketplace and says, "Okay, how many of these funds, these managed funds, have outperformed, how many have underperformed?"
Justin Dyer (07:43): It looks at various time periods. It looks at the trailing one year, it looks at trailing three, five, 10, and then further to that, Brandon, to your point, it also says, "Okay, well, often there's a little sliver, it's a very small sliver, that does outperform .is same group persistent year in and year out?", meaning, does the same group of people that outperform, do they outperform in subsequent years, two, three, four years down the road? The answer is very, very few do.
Justin Dyer (08:13): And so, just to put some statistics, I'm not going to go too much into it, but the most recent report was to just released for 2021, calendar year 2021, and the headline here, and to your point as well, the general trends apply across the board, whether you're talking about fixed income, you're talking about large-caps, you're talking about small-caps. There are some differences but, in general, these same conclusions can apply.
Justin Dyer (08:43): So within the large-cap stock arena, this is the S&P 500, the 500 largest stocks, there are a lot of managers who are trying to participate and outperform, 85%, 85.07 to be specific, underperformed the S&P 500. 85% of managers underperformed over the last year through December 31st. Over five years, it was 74%, over a 10-year period it was 83%. You do get some anomalies in any one year, but those longer term numbers are incredibly consistent across the board.
Justin Dyer (09:19): One of those anomalies I'll show you, large-cap value last year versus the S&P 500 value, actually better than, almost 40% or, excuse me, 38% underperformed. So a little over 60% outperformed, which is really, really good for a given year. It's almost a coin flip though so I'm giving them the benefit of the doubt here, but the persistence question has to come back into play, and it just isn't there. The numbers revert over the long term to 80% underperforming, and those that outperform don't continuously show up there. So that's the nitty gritty data.
Brandon Averill (10:03): Yeah.
Justin Dyer (10:04): And then, we can get into the why too because I think that's important.
Brandon Averill (10:09): Yeah. I think that's the great question. One thing that I hear when you're reciting those statistics and, I'll be honest, early in my career, I used to think, "Well, shoot, Justin, you just told me 68% in the current year outperformed, and even if I go out 10 years, 87% underperformed, but there's still 13% that outperformed over 10 years".
Brandon Averill (10:34): And so, I used to go through the mental exercise, and I think a lot of people maybe are, if they're listening to this is, that's great, so let's go find the 13%. Let's go find these managers and that's where we should invest. That's ultimately part of why we're paying you, let's go find them it.
Brandon Averill (10:53): But at the end of the day, I think, and you can give some more color to this. I can tell from my experience and really studying the industry beyond that is, unfortunately, what you're saying is the persistence. There are no qualities that allow you to identify those people that do outperform over the 10-year period. And like you said, if you wanted to play the game of trying to pick a manager in the one year, and then you're going to try to flip to the manager the next year, I think we start to get into these reasons why it becomes so difficult, right?
Brandon Averill (11:27): It's the cost of trading, it's the fees, it's the taxes, it's all of those things. So maybe unpack, give me your two cents. Why can't we just go find the 13% that outperform?
Justin Dyer (11:40): Well, I would, first of all, say that those are terrible odds. You can go to Vegas and get better-
Brandon Averill (11:46): I know, but I've got to ask the question.
Justin Dyer (11:46): No, totally. But you can go to Vegas and get better odds of winning, essentially, at the craps table. Now, be careful where you play on the craps table but, anyway, it's a totally valid question. Like you said, it's a good question to ask, but I would say, well, A, I would say that those aren't very good odds but, okay, if you want to really challenge yourself and do it, I think that the next question, and you alluded to it is, okay, what are the discerning characteristics of these individuals, and is that something we can extract from the data>?
Justin Dyer (12:24): And really, time and time again, the data in the public markets, we should have underscored this at the very outset, this is public market investing, the data shows that there is no discerning characteristics that say if you're outperforming in one year, you're likely to outperform in the next year. It's, call it, the hot hands manager, if you will, and those managers are just incredibly fleeting.
Justin Dyer (12:53): And so, if you're playing that game your odds start to diminish even more. So, okay, maybe you say, "I want to find that 13% or the top quartile," and then you're like, "Okay, well, I need to find, of that subset, I need to find those that are going to outperform two, three, four years down the road.
Justin Dyer (13:09): I would argue that's actually a terrible timeframe to play around with. You want to buy something and hold it for 10, 15, 20 years, and that makes the numbers even worse because, to your point, often what doesn't even show up in these numbers are these frictional ancillary costs like taxes.
Justin Dyer (13:29): So these active managers, not only are they bad at picking stocks that outperform the S&P 500, they're doing it in a way that introduces more tax hurdles or tax drags in the portfolio and those don't show up in these statistics. You can back into it roughly, but there's no specific after tax rate of return that's specific to each and every investor. And guess what? Active managers are incredibly tax inefficient, and so there's this huge drag there as well.
Justin Dyer (14:02): Now, I will say this isn't bashing stock pickers. There are incredibly intelligent people that are doing this and that's part of why that this is an efficient, or relatively efficient, market. There are so many intelligent people competing against each other and it makes the market work incredibly well. And guess what? If you're smart enough to just look at the data and take this all in, you actually are benefiting from that, and that's the mental perspective change that we take and that we really want to underscore, and I hope really get through people's heads with this podcast is that markets are incredible. They're powerful.
Justin Dyer (14:47): Long term investing, compound interest, all these cool buzzwords are incredible, but don't play this silly game of trying to chase your tail, outperform the S&P 500 by whatever it is each and every year. You can actually take a step back and invest in a very thoughtful way, which we'll get into, and actually hopefully still outperform the market slightly through being tax aware, controlling what you can control, and actually have a better outcome over the long term.
Justin Dyer (15:20): So it's not to say that there's a bunch of dumb people out there doing this, it's actually the complete opposite. There's a bunch of incredibly intelligent people out there that are doing this but they're all doing it against each other and it makes for this really efficient marketplace overall.
Brandon Averill (15:38): Yeah, I think that's a really good point. And hopefully, we give a good sense today and we're going to, like you said, Justin, we're going to go deeper. We're going to get to, okay, given all of this, I know that picking stocks probably isn't the right way for most. If people want to be successful investors, let's face it, you're not going to go pick stocks. You're probably not going to try to time markets. We didn't get into that too much today, but we're going to in an upcoming episode.
Brandon Averill (16:04): And if you're going to cut to the punchline, if we're going to be successful investors, what we're actually going to look at is the evidence, and the evidence shows that you do want to take an indexed approach. Now, there are certain areas in the market that do outperform over time, and so it's not purely a strict passive play. That's also not the best way to go about investing for most people, but for some, it might be okay, so we'll get into, future episodes, we're going to get into, what does it mean to be a passive investor? What are you accepting when you do that? What if I'm an indexed investor but using the evidence, and what can I expect from that?
Brandon Averill (16:44): So we hope this was helpful, just laying the foundation for this world, these big, broad terms of active, passive, indexed, market timing, stock picker, et cetera. It's a whole alphabet soup we'll try to work through in the next few weeks.
Brandon Averill (17:00): But also, as you know, if you've been listening, before we close out here, shoot me a text. We're building up this database for you guys to be able to communicate back and forth with me. We've had some really good suggestions for episodes. We had the Ukraine episode, we had the NFT, those all came as inbound subjects from the community here, so we'd love for you to join the AWM Insights community.
Brandon Averill (17:27): Shoot me a text. That number is 602-704-5574. Again, it's 602-704-5574. It'll come right to me, I'll respond, I promise. And please, yeah, give us a suggestion for a future episode, at least throw the word insights or the little light bulb emoji in there. We're going to be giving out swag and stuff like that, so come join us in that community and we look forward to staying in touch with you through that. But until next time, own your wealth, make an impact, and always be a pro.