The conventional wisdom on investing has been that the markets are inefficient, and smart people, working diligently can, after the costs of their efforts, persistently exploit mispricings and deliver alpha. However, as Nicolas Chamfort, an 18th-century French writer best known for his wit noted: "There are well-dressed foolish ideas, just as there are well-dressed fools."
Active management is a foolish idea no matter how many people believe it or how fervent their belief. If you haven't been convinced, perhaps the following will help.
In an article in the summer 2010 issue of Journal of Wealth Management, Peter Mladina and Jeffery Coyle of Waterline Partners in Los Angeles analyzed the performance of the successful Yale endowment. They concluded that its returns were largely explained by its exposure to risk-not manager skill. The endowment's exposure to small-cap and value stocks provided excess returns over the Wilshire 5000, the chosen benchmark. A similar result was found internationally.
The authors concluded that any disciplined investor with a high risk tolerance could largely replicate Yale's results using publicly available index funds and some leverage. They added that they saw value in Yale's broad diversification across asset classes with relatively low correlation. If Yale, with all of its resources, can't identify the future alpha generators, what are the odds you can?
Here's what Edward C. Johnson III, chairman of Fidelity Investments, said three decades ago about indexing: "I can't believe that the great mass of investors are going to be satisfied with just receiving average returns. The name of the game is to be the best."
Following is the typical stockbroker's pitch when confronted with an investor who asks about indexing as an investment strategy: "If you index, you will get average rates of return. You don't want to be average, do you? We can help you do better."
Both stockbrokers and Johnson are appealing to what seems to be the all-too-human need to be better than average. As you've learned, they confuse market returns (what indexing delivers) with average returns. As economics Nobel laureate William Sharpe demonstrated, by accepting market returns, passive investors in aggregate must outperform active investors in aggregate.
Listen to Jonathan Clements, the former personal finance columnist at The Wall Street Journal for 18 years: "It's the big lie that, repeated often enough, is eventually accepted as truth. You can beat the market. Trounce the averages. Outpace the index. Beat the Street. An entire industry stokes this fantasy." In a great irony, Fidelity is now one of the world's leading providers of index funds.
Larry Swedroe is principal and director of research at Buckingham Asset Management (www.investmentadvisornow.com) and BAM Advisor Services (www.bamadvisorservices.com) in St. Louis. He is also the author or co-author of 10 books on investing.