Thursday, June 30, 2011

The "Best of Both Worlds"? - There's No Such Thing!

Every once in awhile I come across a personal finance article that offers up shockingly bad advice which, if followed, would do much greater harm to an investor’s situation than it would to help them. A recent Forbes article does just that in claiming that there is a way to have “the best of both worlds” between actively and passively managed investment strategies.

As a passionate indexing advocate, my interest was piqued. The strategy is presented as follows: rather than invest in international stock funds, simply buy 10-30 foreign stocks according to the weightings of your favorite international mutual fund. The writer sums up the strategy’s “benefits” - “by avoiding the high fees of an actively managed fund, investors who buy a diversified portfolio of individual stocks are getting much of the same low cost advantage as index fund investors.” In reading that, I was speechless. Why recommend a much more difficult and costly strategy when it’s already been stated that your goal is to replicate the low-cost strategy of the index fund? Why not just buy an index fund?

Not only is this bad advice for obvious reasons – assets are being spread too thin and high transaction costs eat away at returns (the strategy is by no means low cost), it goes completely against the tenet that investors should keep investing
simple. How is this strategy “the best of both worlds” when it so obviously involves actively managing your portfolio? After all, the investor is picking both the fund to replicate and the stocks to own when managing their money.

The writer even notes “owners of individual stocks also get the added advantage of being able to reduce their taxes by controlling when and how they sell individual shares. They can sell shares that have dropped in value, buy them back after 30 days, and then use the losses to offset other taxes.” Most of the individual investors I know have neither the time nor the patience to pull off such a bad strategy. Besides, indexing is inherently tax efficient which would negate any positive effect the above tax loss selling strategy would have over the low costs of indexing. Here’s a better idea then the one offered up in the article: buy an index fund and forget about everything else!

Ultimately, the article offers up no rational argument against indexing – the simplest and most efficient way to long-term wealth. Indeed, the article opens up explaining how indexers think:

Since you have no way of knowing which lucky manager will outperform, you're better off just buying the whole market and minimizing your fees with passive index funds. The evidence seems to largely bear this out as studies show that up to 80% of actively managed mutual funds underperform the market and that those that did outperform didn't tend to continue doing so over subsequent periods of time.

The facts are all laid out for the reader. I’m at a loss for why people still try to justify owning actively managed funds – or an investor’s replication of an actively managed fund - provided there’s a passively managed fund that is considered an equal or greater representation of a specific area of the market as compared to the actively managed fund.

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