Indexing is no panacea for investors

The behavior gap for those don’t know is the difference between a fund’s headline return and the actual dollar-weighted return that investors actually earned. The difference represents less than advantageous timing decisions on the part of investors. While much is made of the benefits of index investing the fact is that behavior matters as much (or more) than the low cost benefits of indexing.

There is no doubt that index investing is on the rise. A quick look at Vanguard’s continued market share gains helps demonstrate this trend. Said another way there is a bull market in passive investing. Adam Zoll at Morningstar writes:

To illustrate investors’ growing use of index funds, consider that on Nov. 1, 2003, 12% of all U.S. open-end mutual fund and ETF assets (not including fund-of-fund or money-market assets) were invested in passively managed products. Today that percentage stands at 27% and rising.

Another way of thinking about the rise of passive investing is put it in terms of the growing trend of automation. The broader trend toward automation is resulting in displaced workers. The same is likely taking place in money management as well. As David Varadi at CSSA writes:

In truth the quant is as much a threat to the classic portfolio manager role as the machine is to human labor. A quant can manufacture investment approaches that are far cheaper, more disciplined, have greater scale, and are more reliable.

Passive investing is just another (simple) quantitative method of managing a portfolio. As computing power has increased while data and trading costs have fallen quantitative asset management has become more attractive. Indeed the rise of ETFs while initially about low-cost indexing has gradually become more the province of various quant strategiess. As Rick Ferri notes:

Strategy index-tracking ETFs have expanded exponentially over the years. New entrants have come to the market with a range of active management strategies that have been mechanized into indexes and launched as products. The marketing of these products has also taken on a life of its own. Phrases such as fundamentally indexing and smart beta have spun out of these special products.

So while index funds and other low cost quantitative methods may be making investing cheaper and easier for investors there still is the problem of investor behavior. One of the selling points of the online investment managers is that by automating your investments they will help you avoid return-reducing behaviors. As Patrick Burns at Betterment writes:

Most online products want to maximize the time you spend using them. We always knew that our mission was different—to build a site you would use less. We minimize the number of decisions you have to make, which de facto reduces how much you interact with your investments, which on average hurts returns.

On average the fewer decisions an investor has to make the better. An investor can also pull the plug on their auto-piloted investments, but that is a far bigger decision than simply tinkering around the edges is what most investors do. This broader trend towards quantitatively run money is therefore likely to be a boon for more investors but it is not a panacea.

Investors almost always retain the ability to change their methods along the way. The challenge for all investors is to find a methodology that they can stick with over time. Doing that is far more advantageous than trying to generate a little additional alpha through clever investing. From Systematic Relative Strength:

Of course, you will construct your rules during a period of calm and contemplation—but that’s never when rules are difficult to apply!  The real test is sticking to your rules during the periods of fear and greed that occur routinely in financial markets.  Devising the rules may be relatively simple, but following them in trying circumstances never is!  As with most things, the harder it is to do, the bigger the potential payoff usually is.

So while indexing may be a great leap forward for most investors it ultimately comes down to each of us to construct and manage over time an investing approach for each one of us. In those difficult decisions made (or not) lies investment success.

*Update: Just saw this piece at Yahoo Finance that talks about this very issue. Phil Pearlman who notes the many emotional challenges for investors and notes:

Paraphrasing Winston Churchill’s famous comment about democracy, Pearlman describes indexing as “the worst form of retirement investing except for all the others.” The big flaw in index investing, he says, is that it does not solve for human nature.

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