A Weird Argument for Index Funds

by: Felix Salmon December 04, 2008    
Felix Salmon

Felix Salmon

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Daniel Solin has a column at BloggingStocks extolling the virtues of index funds, which is all well and good. But the argument he uses to get there is odd:

All information about listed companies is public. It is widely and instantly disseminated. This information is studied by millions of investors, who establish the price of a given stock based on this data.

Many of those looking at this data are professional analysts. They are well trained in finance and have access to powerful computer programs that assist them in crunching the numbers.

There is one piece of information they don't know: tomorrow's news.

Future events move stock prices. The market has already discounted for current news.

This is a very strong version of the efficient markets hypothesis, and anybody with an eye on the stock market's massive swings of late know that it's bullshit. Stocks move all over the place on no news at all, every day.

But you don't need to believe in the efficient markets hypothesis to come to the conclusion that investing in index funds is a good idea; you can think that even if you're a strong believer in alpha. Solin himself demonstrates that:

Of the 500 companies that made up the S&P 500 in 1957, only 74 of them were in the index in 1997.

Here is the real kicker: Only twelve of those companies outperformed the S&P 500 index in the period from 1957-1998.

The fact is that the S&P 500 itself outperforms the market, largely thanks to its survivorship bias. If you can buy an index fund and keep track with the S&P 500, you're ahead of the game already. If you think that you can outperform the S&P 500, you're basically saying that you have truly extraordinary alpha-generation abilities. Most people are happy to admit that they don't have those abilities -- and that's a much easier way of getting into index funds than feeling that you need to buy in to the EMH first.

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This article has 3 comments:

  •  
    Dec 04 11:04 PM
    The S&P 500 is really just a very disciplined momentum trading strategy. Think about it. Stocks are overweighted as their market cap goes up; toxic stocks are automatically cut down as their market cap dwindles prior to being dropped from the index. Isn't it rather ironic that the holy grail of fundamental investment is really a technical strategy in disguise?
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  •  
    Dec 05 09:47 AM
    "If you think that you can outperform the S&P 500, you're basically saying that you have truly extraordinary alpha-generation abilities."

    Not really. The indices can be beaten consistently but it takes a some dedication, study, and work over a time period longer than most care to spend on managing their own money. It is far easier to simply throw it all in an index fund. go on vacation, and run up the credit card debt having a good time.

    Beating the indices IS more difficult for professional managers simply because size makes it harder to move a lot of money around quickly enough. The bigger the fund, the more difficult to beat the averages, though there have been a handful who did, usually because they spent a lot of time working at it.

    Individuals usually don't have to worry about having so much money that they can't beat the averages. If you've got that much wealth, you probably don't care. If you don't have that much, you can probably beat the averages if you really put in the effort and don't give up.

    Suggested reading for those who feel like learning a thing or two while the market flails about (in the order shown):

    1) "Stan Weinstein's Secrets For Profiting in Bull and Bear Markets" by Stan Weinstein

    2) "How To Make Money In Stocks: A Winning System in Good Times or Bad, 3rd Edition" by William J. O'Neil (of Investor's Business Daily)

    3a) "How I Made $2,000,000 In The Stock Market" by Nicolas Darvas

    3b) "Reminiscences of a Stock Operator" by Edwin Lefèvre and Roger Lowenstein

    4) "Trade Your Way to Financial Freedom" by Van K. Tharp

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  •  
    Dec 05 02:58 PM
    It has somewhat amazed me that so many fund managers fail to beat the SP 500 index. Whatever it is that the folks at S&P are doing to construct the index is more successful than the vast majority of higher priced experts. I've seen little in the way of research that deconstructs the S&P method to achieve superior performance. Usually it goes something like "I've found a better way based upon this backtest data" without really considering how the benchmark has achieved the performance it has made.
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