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The Index Fund vs. Active Fund Debate

Are Active Funds Obsolete?

Have index funds, the autopilot portfolios that dispense with stock-picking entirely, made fund managers obsolete?

Lately it seems like everyone is asking that question.

Although index funds are not new (the first index fund was created by Vanguard in 1976), they’ve become incredibly popular following the 2008 FInancial Crisis. Index funds now hold a third of the total assets of stock funds, up from less than 20% a decade ago.

However, media outlets have recently been reporting on the comeback of the active fund manager… at least for now. According to research firm Morningstar, actively managed mutual funds are up 2.25% YTD, compared to passively managed funds which are up 2.2% and the S&P 500 which is up 1.9%.

So what’s better: actively or passively managed funds?

Over the long run, low-cost index funds (passively managed funds) are very likely to outgain actively managed funds. This is because any overperformance by the average active fund will not compensate for the higher fees charged by them.

Note that I say the average active fund – the efficient market hypothesis is not actually valid, which means that a skilled active manager can still beat the market.

This is why – as I explained in How To Start Investing Part I and Part II – index funds are great investment vehicles for Defensive Investors, while Enterprising Investors should be sure to conduct careful fundamental analysis and apply the principles set forth in Ben Graham’s The Intelligent Investor.

Jason Zweig (who edited the revised edition of The Intelligent Investor and also has the same recommendations for Defensive and Enterprising Investors) attended a debate concerning index funds versus active funds, between John Bogle – founder of Vanguard Group and father of the retail index fund, and James Grant – editor of Grant’s Interest Rate Observer, a twice-a-month publication widely read by professional portfolio managers.

Zweig scored the debate as a tie.

An audio of the debate is at Grant’s site here and you can read Zweig’s summary of Bogle’s and Grant’s comments – which first appeared in the WSJ – below:

Bogle vs. Grant in the Great Fund Debate

Have index funds, the autopilot portfolios that dispense with stock-picking entirely, made fund managers obsolete?

That question was the subject of a debate that I watched in New York last month between two respected investing experts: John Bogle, founder of Vanguard Group and father of the retail index fund, and James Grant, editor of Grant’s Interest Rate Observer, a twice-a-month publication widely read by professional portfolio managers.

The two friends had already been duking it out for months in a series of letters and issues of the Grant’s journal.

Mr. Grant landed the first blow in November when he warned that index funds had become perilously popular, calling them “a good idea that Mr. Market”—the moody personification of the investing crowd—“has driven into the ground.” Index funds hold a third of the total assets of stock funds, up from less than 20% a decade ago.

Mr. Bogle punched back, accusing Mr. Grant of “a rare lack of understanding” and declaring that index-fund investors, as a group, “would capture about 99.4% of an 8% assumed stock-market annual return,” while investors in the actively managed funds run by stock pickers would earn only about 72% of the market’s expected gains.

In the debate, at an investing conference sponsored by Grant’s, the two men contested whether the cost of investing is the main factor that determines the success of investors. Mr. Bogle argued for it, Mr. Grant against it.

Mr. Bogle came out of his corner and swung a haymaker. He said he had been swarmed at the refreshment break by portfolio managers thanking him for “helping them do well in their own personal portfolios”—which they had all invested in index funds instead of the funds they manage.

The crowd tittered nervously.

Mr. Bogle then argued that investment performance must equal the market’s returns minus the costs of earning them. Between management fees and trading costs, he estimated, active funds cost roughly 2% annually; index funds, as little as 0.05% a year. Therefore, those who invest in index funds “must earn higher net returns,” as a group, than those who don’t.

Nor is indexing a fad, added Mr. Bogle; it is a new technology, much as electricity, the automobile or refrigeration were in decades past.

Mr. Grant counterpunched that indexing may be a superior way for “the average lay investor” to manage money, but that “ought not to be true” for “the accomplished professional investor.”

He pointed out that investing in an S&P 500 index fund means buying stocks picked by the committee at S&P Dow Jones Indices headed by David Blitzer and holding them in a market fueled by low interest rates determined by Janet Yellen’s Federal Reserve.

“When you buy ‘the market,’ you are buying David’s market and Janet Yellen’s,” said Mr. Grant. “Are you quite sure you want it all?”

He said Mr. Bogle “reminds me of a kind of Debbie Downer Little League coach who lines the kids up and says, ‘I don’t mean to sound discouraging, but in the big leagues it comes in at 93 mph…and beyond that, your career’s likely to be short, and most guys wash out in the minors. So I’d play softball.’ ”

When I spoke with them afterward, neither conceded defeat. “I’m not worried about who won,” Mr. Bogle said.

“I think there are many ways to make money or lose money,” said Mr. Grant, “and Jack says there is but one.”

My own view is that index funds are ideal for what the great financial analyst Benjamin Graham called “defensive” investors: people who have neither the time nor the inclination to analyze individual holdings.

Those whom Graham called “enterprising” investors, who are fascinated by the market and determined to test their skills against it, are free to try doing better. Most will fail, but some might have just enough fun to make the attempt worthwhile.


Berk