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Tom Madell

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Is Skill Still Relevant in the Era of the Indexes?

Anyone failing to notice that index funds, along with index-based ETFs are, day-by-day, becoming the preferred investments for investors likely hasn't been paying much attention. So it's more important than ever to consider the question of whether portfolios still managed based on presumably skillful interventions can realistically ever hope to consistently beat portfolios run on autopilot, that is, passively managed and made up of index funds.

More and more, this question seems to be spiraling toward a consensus conclusion: Managers and active investors, it is now said, are almost deluding themselves if they continue to think that they can ever hope to come out ahead long term over the currently most popular index funds that charge so little and, additionally, help to take all the pain and guesswork out of deciding where to invest.

Therefore, as the debate becomes one-sided favoring index funds over managed ones as well as ETFs over ordinary mutual funds, many might think I am trying to defend an almost an indefensible position these days, namely, that actively managing your own portfolio, or using "old-fashioned," managed funds, or both, can result in just as good or even better outcomes than very little activity or just using the most popular broad "total market" index funds or ETFs.

Is there a place for "skill" in investing, or, has that now been shown to be a "mirage," perhaps perpetuated by those who want to continue to make a profit by "managing" our money in spite of evidence suggesting that you will typically do better without them, just by investing in the indexes?

While I am fully aware that just holding broad-based index funds or their nearly identical ETF versions have shown some superiority, especially recently, it turns out that this is far from the whole story.

While one might use other indexes to make passive vs. active comparisons, the funds I choose are three Vanguard funds (or their ETF counterparts) which when combined in a hypothetical portfolio represent to me a near ideal worldwide diversification for "total market" index investing:

Vanguard Total Stock Market Index Inv (MUTF:VTSMX) 65%
Vanguard Developed Markets Idx Admiral (MUTF:VTMGX) 30%
Vanguard Emerging Markets Idx Inv (MUTF:VEIEX) 5%

To make bond portfolio comparisons, I merely use the Barclays Aggregate Bond Index.

Essentially, one's position regarding the debate boils down to how one comes down on the following two questions:

  • a) Is it possible for someone to determine in advance, with any degree of accuracy and consistency, where and in what relative amounts, to position investments to come out ahead of a fixed allocation, index-only, portfolio? Or,
  • b) are such efforts nearly impossible to get correct enough of the time to merit even trying?

If you answer b) yes, you will lean toward indexing and indexed ETFs and your own passive management of your portfolio; if, however, you answer a) yes, you likely will be open to using a variety of types of investments in your portfolio, and possibly, in choosing some degree of active involvement on your part in portfolio decision making.

Down through the years, I myself have been open to using all types of stock and bond investments with the result that, even though over the last two or three years, my overall stock fund choices have somewhat trailed broad market indexes, the opposite is true over a full five years. And my bond fund choices have recently beaten the appropriate indexes regardless of how long held.

Sure, if you want simplicity and to be relieved of making sometimes stressful decisions above all else, even above potential returns, broad, entire-market-encompassing index funds (i.e. "total stock market" funds) or similarly matched ETFs, are the way to go. But if you have any confidence at all that investment results are more predictable than, say, into which slot a rotating roulette ball will land around a spinning wheel, then you may want to consider spreading out your investments, some in such broad index funds, some more narrowly defined index funds (i.e. value or small cap funds), and some in managed ones, while yourself not opting for a completely "hands-off," passive approach year after year.

Broad index funds provide assurance you won't miss out on the returns passive investors have been receiving, which have been outstanding recently. The other types just mentioned give you the opportunity to make use of the acquired knowledge that either skilled managers have presumably accumulated, or you yourself can come to possess, not only in selecting which more specialized stock or bond funds to include, and in what amounts, but in deciding when to initiate, add to, or lighten up on those investments.

While no amount of mere words is likely to resolve the active vs. passive dilemma, investors should at least be aware that not all evidence always point to the superiority of passive management. If a hands-off approach was so clearly the slam-dunk winner that its advocates claim, none of the data which can be seen on my website could have likely turned out the way they did.

For example, over the last five years, both my Model Stock and Bond Portfolios, the former with 14 funds, the latter with 9, beat similarly diversified portfolios of the above top-notch indexes by approximately 1%.

I take for granted that the just mentioned indexes, that is the three Vanguard funds I use to compare my diversified Model Stock Portfolio against, should typically be excellent choices, and generally speaking, among the hardest benchmarks for any similarly diversified investor portfolio to come out ahead of. But, nevertheless, past Model Stock Portfolio results have shown why I persist creating these Portfolios, with a high percentage of previously recommended Portfolios exceeding these benchmarks.

It is certainly one frustrating aspect of investing that no matter how much research you do, nor no matter how knowledgeable you might think you are, you may not succeed as much as you expect, nor even do as well as simply buying and holding a few well-known index funds. Does this mean that index funds are inherently superior? Certainly, they start out with usually a small advantage in terms of being less expensive, which accounts for some of their performance advantage. And active manipulation of a portfolio may subject the portfolio to overreacting to what turn out to be insignificant and passing events.

But skillful investors and fund managers can overcome these pitfalls by focusing on only the most glaring situations to prompt action such as gross ?instances of over- and undervaluation, while ignoring almost all other factors. Of course, unmanaged index funds cannot "react" at all to such occurrences, which is their biggest disadvantage and why skillfully managed portfolios can come out ahead.

 

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