Paul Winkler: Welcome to “The Investor Coaching Show.” I’m Paul Winkler, talking money and investing. I believe that if you are educated, it is hard to take advantage of you. If you don’t know anything about it, you just blindly trust, it’s easy to take advantage of you.
I actually had a conversation with a client this week, and she said, “I probably ought to pay more attention to it.” And I said, “There are just a couple of things that you need to pay attention to.”
Benchmarking
The thing that I have people pay attention to is benchmarking. I’m looking at the area of the market that they’re investing in.
When you’re diversified, you’re going to have a lot of different areas, right? You’ll have large companies, you’ll have small companies, and you’ll have value and you’ll have growth, and you’ll have these areas. And what you want to do is make sure that you’re just looking at the different areas that you’re invested in and make sure that the investment vehicles that you’re using are keeping up with those.
So if we look back through history — look at large U.S. companies, and you look at long swaths of time, you look at, for example, 30-year periods in large U.S. stocks have been right around 10% for every 30-year period, look at small companies about 12, and you look at large internationals about 10, so various areas of the market historically — the returns are more consistent long run. Short run it’s all over the place because you might have a good profit year, you might have a bad profit year; it’s going to be back and forth.
But long run, the returns of these various areas of the market have been consistent historically. And we look at that and go, “Hey, that’s good enough. If professional managers can’t do better than that return, then I’m going to be okay with the return of that area of the market.”
So if the S&P, let’s say, I’m going to use this for an example, goes up 30% — if my fund that’s investing in large U.S. stocks goes up 30%, then I can look at that and go, “Okay, good. All right, I match market returns.”
If the S&P goes down 10, that fund ought to go down 10. Now, that’s where people get a little bit confused because they go, “Well, if a market goes down 10, don’t I want to miss that downturn?”
That’d be great if you could do it, but what do we know? Professionals, managers can’t do it, so hence, trying is a huge waste of time because what happens is you may get out just before it goes down — let’s say you get lucky and get out before the market goes down — when do you get back in? Are you going to get back in and it goes down even further and then get scared again, pull back out, and then it goes up and then you’ve missed it?
The number of different alternative scenarios is infinite, but what we know is if professionals don’t get it right, what’s the likelihood of you getting it right? Probably somewhere between slim and none.
When I invest, I want to make sure that those various funds that I’m using are matching or getting in the ballpark of the benchmark.
Now, that leads us to the benchmark because some people have come to this conclusion when they hear me talk: Don’t stock pick, don’t market time, don’t use active management. I believe stock picking and market timing are basically gambling, so yes, you would’ve come to the right conclusion.
Investing in Indexes
So how do we do this? Well, let’s just index the portfolio. And you’ll see huge fund companies investing in indexes like the total stock market index, maybe mirroring the CRSP one through 10, that’s an index, or maybe matching the S&P 500 or maybe matching the Russell 2000 and the Russell 1000 or whatever.
You have various indexes. And the question that you have to ask is, “Which indexes should I be investing in?”
Now, if you look at what fund companies typically do, they just typically invest in the indexes that are most recognizable. Is that the best thing for you? Maybe after I talk a little bit, you’ll start to question that.
Are they really low-cost? Well, you might start to question that as I talk a little bit because a lot of what people think about investing and what is actually the truth or what the case is — quite often those things are at odds with each other.
So I was sitting through a workshop this week just listening to a guy talking a little bit about this topic, and it was fascinating because he talked about the number of indexes out there, and I quizzed the folks in my office. I said to just the guys who were around, “Hey, guys, how many indexes do you think there are?”
And one of the guys, Michael, he steps out and he goes, “How about maybe 3000?” And I said, “Wow, that’s pretty good. You got the three right. It’s 3 million.”
3 million different indexes. Now, what is an index? Well, it’s a grouping of stocks. If you look at the Dow, that is an index of 30 companies, right?
Now, back when it first started, it was like 11 companies, then it went to 12 and then it went to 30 later on. But they were just 30 companies that were important in the economy.
Now, if we look at the S&P 500, that’d be another index, the Russell 2000, another index — you’ll have a grouping of stocks that generally meet a criteria that is desired and you have no end to the number of people that want their own index. Why?
Companies make money licensing their index.
Now, if you run an index fund that tracks the S&P 500, you have to pay standard fees for the rights to use that name because it is going to attract business because people recognize it. So you got 3 million different indexes out there and they track all kinds of crazy things really.
Making Investing Decisions
You’ll have different decisions you make as an investor. And of those decisions, the number one is, “How much in stocks do I own versus how much in bonds should I have?”
Then maybe if you’re a little bit more sophisticated, now you’re starting to get into, “Which asset classes or maybe which factors do I get exposure to?” Then you have to decide when you’re going to tell whether you’re doing well or not, “What do I benchmark against?”
And it’s interesting because if you look at various benchmarks for small company stocks, you think, “Well, small company is a small company is a small company.” Right? No, it’s not the case at all.
If you take the S&P SmallCap 600 index — that’s an index that tracks small companies — and you look at it versus the Russell 2000 — which is an index that tracks small companies — and then you compare that against the CRSP — which is an acronym for the Center for Research in Security Prices — U.S. Small Cap Index, and you look at the average difference in returns of those three indexes from 2004 through 2023, guess how much the difference in return is on average per year? Average is 4.9% difference. That’s huge.
There’s almost 5% difference, which could be the difference in return between small companies and large companies. That’s a pretty big difference. Well, which index should we be tracking? Go figure.
Now, that’s a little bit beyond what I’m going to talk about right now, but you look at that and go, “Well, wait a minute.”
So when you own a small company index fund, which market segment is it actually tracking? Do you even know?
So what sometimes people do is they just go, “Well, I just want to invest in index funds because it’s cheap.” And I’m all about keeping expenses low, by the way, because we don’t get paid by the fund companies so it doesn’t matter to me, but cheap is almost never a criteria that you use in any other area of your life. I could get the cheapest heart surgeon or get the cheapest airline from one place to another, and it may be a good idea, or it may not be such a good idea to fly a Piper Cub from one place to another.
Expenses in the Investing Process
You look at that and go, “Well, why do we do that?” Because we think that’s the only expense. But the reality of it is there are a lot more expenses in the investing process than meet the eye. So when you invest, there are things that drive returns.
Expenses are just one thing that drive returns.
Which market am I exposed to? That’s going to be one thing.
When I look at an index, what is excluded and what’s not excluded? For example, when you put together an index that covers an entire area of the market called small companies, well, are you including real estate investment trusts in there?
Are you including IPOs — initial public offerings? And we know that IPOs typically lose money, last I saw the data, in the first nine months that they’re out there.
Are you including bankrupt companies? Are you including things in that portfolio that are not necessarily things you might want to be including?
Maybe you have things in there that are not good, but they meet the criteria for the index. Do you even know that?
Remember, that was a real revelation for me 20-plus years ago because I’m looking at it and saying, “Don’t actively stock pick, don’t market time. Okay, index.” And then after I did a lot of research, because I’m pretty analytical, I came to the conclusion, “No, I did not want to index clients’ money in most areas of the market, that didn’t make any sense.
Does the funding use securities lending? Do they make money off of securities lending revenue? Do they look at corporate actions? Are they looking at short-term return drivers, which can help offset some of the costs in the portfolio?
What is the rebalancing strategy? You can just rebalance a portfolio if you have 10% of your money in one asset class and 10 in another and it gets off. You sell the overage in the one asset category that’s overrepresented, maybe it’s taking up 15% of your portfolio and the other one’s only taking up five, and just sell the five and buy five in the other area and rebalance.
Well, I’ve got a lot of trading costs when I do that — am I taking that into account? So sometimes you’ll hear me talk about rebalancing based on deviations from a target or rebalancing, better yet, based on cash flows. Whatever is underrepresented, have new cash flows go into that category to rebalance the portfolio.
But when you ignore the trading costs in an index fund, you could have style drift. The fund drifts into a different area. And I’ll talk about that. It can be really interesting when you get into the data, and I’ll talk about that in a second.
Trading Costs
You have opportunity costs for missing the returns of stocks that shouldn’t be in the portfolio anymore, maybe because they’re too large and then they end up doing poorly, but you don’t change the portfolio to get rid of them when they should be abandoned or they should be gotten rid of in the portfolio. So with trading costs, you’ll have bid off or spread costs.
Every time a stock is bought or sold, it is bought and that price that is paid is a markup over what the market maker paid for it.
Just like when you go buy eggs from a grocery store, they buy the eggs, they mark it up, and they sell it to you — the same thing happens. Now, when you have an index, a lot of them are only reconstituted annually. In English, what that means is that if you have, let’s say, the Russell 2000 Index and it’s decided that certain companies don’t belong in there anymore and they need to be moved out and new ones need to be moved in, an index fund that doesn’t want to have tracking error against that index has to sell all those stocks that no longer belong in there.
Well, what can happen is you announce to the world, “Hey, guys, we’re going to be selling this stock because it doesn’t belong in our index. We’re going to be selling these stocks, and we’re going to be buying these ones in their place.”
If you have any kind of sense about you whatsoever, what are you going to do? You’re going to go, “I’m going to buy those stocks before they buy them because they’re going to be throwing a ton of money at those stocks and they’re going to drive the price up, or they’re going to be selling these stocks over here and when they sell them, they’re going to be putting a lot of inventory out there and those stocks are going to drop.”
Front-Running
Well, you can front-run it. Somebody asked the question, “Is that ethical? Is that ethical to do it?”
And the guy doing the workshop goes, “Well, it’s kind of like you’re on a bus or a train and somebody drops their wallet. Is it ethical for you to tell them, ‘Hey, bud, you dropped your wallet’? It might be ethical for you to do that, versus somebody that jumps on the train and starts throwing $20 bills all over the place knowing full well what they’re doing.”
Well, you’d be probably crazy not to pick up the money because they’re sitting there going, “Well, it’s no big deal that I’m losing this money.”
Well, that’s what index funds are doing.
They’re literally throwing money around in that way through the reconstitution effect because they know that people are front-running them.
They know it. They’re fully aware of it, but for them from a marketing standpoint, it is better for them to be tracking the Russell 2000 and using that name, or the S&P 500 and using that name, or the Europe, Australasia, and Far East Index and using that name, because it attracts investor money.
And you know what? Most investors are clueless about this stuff.
If they don’t know about it, then it’s probably not a big deal. So ignorance is bliss. So that’s basically what happens is you’ll have this style drift, small companies become medium-sized, and they don’t make any changes in the portfolio.
And I was just thinking about the whole idea about investors in general and something that we do. Well, I don’t do it, but a lot of people do this. And this makes it so hard to do well as an investor, quite frankly.
I’ve said this before: When you diversify, you’re all over the place. You have a lot of different things all over the place.
Watching Investors Win
I was thinking about it in this way: What if you went on Facebook and you saw all the fun that people were having? You saw this person having fun, you saw that person. And I was thinking, “Well, wait, this kind of really happens.”
This is what people do now. They call it Facebook depression. Why? Because you go out there and you see all the fun this friend is having, and then this person posts when they’re having fun, and then this person over here posts when they’re having fun.
And I thought, “Isn’t that just what Wall Street does to us?” They will show you the top market segment at any point in time, you’ll see it in the news, and then the media will be talking about which area the market’s having the highest returns, which area is hitting record returns, and they’ll be parading that in front of you, and then all of a sudden you look at your investment portfolio and go, “Man, I’m pathetic. My portfolio’s pathetic.”
When in reality, the only thing you are seeing is the winner.
It’s just like being on social media: All you ever see is when somebody’s winning at life and it makes you feel that your life is pathetic.
Why do they do this? Because it sells investments. Is it good for you? No, it’s terrible for you.
But that is what the investment industry does. Why? Because it’s about making money for the investment industry.
Now, there’s nothing wrong with making a profit. There’s no issue with that. I don’t have a problem with that. Capitalism is great and everything, but at whose expense?
That’s why I believe that for you to be an educated investor is such a huge deal. And what I’m going to do is I’m going to take a quick break.
And typically, when we look at indexes, we go, “Well, what is the problem with the S&P 500? Are they really the 500 biggest companies in the US?”
Well, in general, but there’s more to the story, and I’m going to talk a little bit about the more to the story right after this because there may be some things that you find really surprising. For example, when certain companies got added to the index, what was the criteria and what did you not know about those companies that caused some performance to not necessarily be as good as it could have been based on what criteria was used to add the company?
I’ll give you a couple of things that I think you’ll just find really interesting, and it’s not isolated. You’re listening to “The Investor Coaching Show.” I am Paul Winkler, educating investors one at a time — hopefully many at a time — on this show.
Episode 2
Paul Winkler: All right, we’re back here on “The Investor Coaching Show.” I’m Paul Winkler.
Oversimplifying Investing
So we’re talking a little bit about indexing. The idea behind an index fund is you’re generally tracking an area of the market. I often talk about how when you try to figure out which stocks are going to do better than others, it’s a huge waste of time.
And I see these videos out there: “You only need three funds as an investor.” And a lot of times they’re just talking about three index funds, and typically the information’s horrible because of the index funds that they’re recommending. I’ve seen these videos out there on YouTube saying, “You only need three funds, four funds,” or whatever.
They have all of these problems that I’m talking about, but they go even deeper than I typically talk about. So I’m going to walk through that a little bit.
But it’s simple. And there is a bias that we have as humans, and that bias is that we want things to be super, super simple.
We often oversimplify to the point where the information ends up being fairly useless or very low quality.
We want to make it so simple that we don’t have to think much. But can you imagine? There’s a case for that.
You go to a doctor and say, “Hey, give me an idea of what you’re going to do.” If they told you every detail of the surgery that they were going to provide on you, your mind would probably blow up.
The same thing can be the case for investing. But I think you deserve to know a little bit more. And sometimes I’ve taught workshops like this, and people go, “Oh my goodness, Paul.”
And I go, “But isn’t it nice that we know this stuff?” And they’re like, “Yes.” But I want you to have an appreciation for the complexity in investing when you really start to get into the details and dig into the details because it can make a big difference.
The S&P 500
So let’s say we take the S&P 500. Generally, you’ll hear me say it that way when talking about the 500 biggest companies in the U.S.
Now, why is it that I just say generally, and I don’t say it is the 500 biggest companies? Well, because you could have a company like Tesla, and when they were the 60th largest company in the U.S., they weren’t in the S&P 500.
You’re going, “Well, wait a minute, how could that be?”
The reason was because they didn’t have four quarters of positive net income, and that is one of the criteria to be included in the S&P 500.
One of the requirements is that you have to have that. What happened is that there was this period of time between when S&P said they were going to add Tesla versus when it was actually added that the stock went from 130 to 230. That’s a pretty big jump. It’s a pretty big jump in value.
And what happened is that it then became like the sixth largest company. So it made a big jump just because it was going to be added to the S&P 500.
Now, is that unusual? Well, on average, I saw this one statistic that said it took 33 months after a company fell into the top 500 of companies for it to be actually added to the S&P.
And that was over the last year. That was 12 stocks, 33 months. If you look at who decides what’s in the S&P 500, it’s really a secret committee that makes that decision.
So we don’t really necessarily know. Google didn’t get added because it had done so well, and that was just a different story right there. It didn’t get added because it had done so well as a stock.
And you go, “Well, why didn’t it get added?” Because you’ve got humans determining which stocks are going to be in this index.
As a human, you look at that and go, “Well, wait a minute. If this thing is skyrocketing, do we want to add it to the index because the horse is already out of the barn?”
And they say, “Well, maybe not. We’ll wait for it to do what? We’ll wait for it to drop.” Well, there’s only one problem: It didn’t drop.
So as an investor, you would have missed out on most of Google’s run if you were following the S&P 500, which the reason I bring that up is because you often hear me say you watch these videos and what are they telling you to do? Invest in these big cap index funds.
Why? Because they’re well known. The vast majority of money invested is invested in these huge companies, which is where I would expect the least return, long run. It’s a problem.
Small Value Stocks
Now, if you look at small value stocks — let’s just use that as another area of the market — where would I expect the greatest amount of return historically? Small in value.
Why? They’re small companies. They’ve got a lot of room for growth, a lot of potential for growth.
And then value, those are companies that have lower prices compared to book value and earnings, possibly. But how do we determine if something is small value or not? And you look at them and go, “Well, what metrics do I use to determine whether it is small value?”
If you look at Russell, Russell is an index provider. They use three metrics. If you look at MSCI, they use eight.
Well, which one? Personally, I’m going to tell you, fewer metrics than that.
And the reason being, and I’m not going to get into this but in my book, “Confident Investing,” I get into a little bit of talking about how the denominator needs to be more stable, but there’s a reason. I’m not going to get into that right now. I’m really tempted, but I’m not.
But if you look at when it’s reconstituted, like I was talking about earlier, an index fund buys a bunch of stocks that it says, “These are small value stocks,” let’s say.
As time goes on, they decide to change which stocks are in there because maybe they drift out and they’re no longer small or value stocks anymore.
And by George, I wanted to have a small value index. So what I do as the index manager is I reconstitute it. I go, “I’m going to change this and make sure that I’m really back to small value again because some of these companies aren’t small in value anymore.”
Well, if you look at, I think it was last year, the companies that were in the Russell 2000 value index, one year later, 20% of those stocks are now growth companies. You’ve got 20% of your portfolio that’s not even small in value anymore. That’s a lot.
And if you look at that and say, “Is that extreme?” No, it’s not.
That style drift is the norm in index funds. You look at overlap between the Russell 1000, that’s typically, in general, the thousand biggest companies, and the Russell 2000, which is the next 2000 below that — how much overlap is there?
Well, in the best-case scenario in the past year, 15%, but it ranged all the way to 35% of the portfolio because of this style drift.
Indexes Breaking the Rules of Investing
You look at that and go, “Well, what rule of investing is that breaking?” This is why this is important. You always hear me say that there are rules of investing that we generally know are true, and maybe we ought to be following what we generally believe to be true.
When you invest in indexes like this and you have that much overlap, you’re breaking the rule of investing, which is diversification.
Because if you have that 35% of the portfolio, and those particular stocks go down in value, you don’t just have one fund that goes down, you have both of those funds that go down due to that performance. So that’s an issue.
And you go, “Well, they do reconstitute it. They do that once a year.”
Yeah, great. Can you imagine if you just went up to your boss, let’s say, and said, “Hey boss, I’m only going to go to work one day a week,” or even worse, “I’m going to only go to work one day a year.”
That’s what they’re doing with the index funds. They’re reconstituting it one day a year. Now, maybe if your boss only paid you for that one day, they might save money, but how much money do they lose because you’re not doing anything the other 364 days of the year?
You look at that and go, “Well, there are costs to this laziness.” And I’ve only just scratched the surface.
I’m going to talk a little bit more about it because people ask me about it all the time, these guys, and I’ve heard financial advisors say, “Well, Winkler, those guys just index portfolios.”
No, no. This is why I tell people, “No, this is not my mode of software because there are problems with indexing, but there are a lot of problems with active stock picking and market timing, and that is typically what you find in the rest of the industry.”
So I’m going to continue on this. I want to continue to educate, because I believe the more that you understand this stuff, the less you get taken advantage of. But here’s the thing, if let’s say you’re a client of ours and you’re going, “Wow, I had no idea you guys were doing all this stuff, it’s cool to know that.”
The Risks of Indexing
A lot of times people think that when I talk about investing, I’m just talking about market efficiency — so you stock pick and market time. No.
You buy and hang on to things; you don’t do a lot of trading. Now, it doesn’t mean that nothing’s going on when you’re managing a portfolio. There’s a lot going on. But it’s just not picking stocks based on which companies you think are going to do better than others.
Because what do we know about that? We know that there’s somebody on the other side of the trade that says, “Hey, you’re getting rid of that stock? I’ll take it.” Or when you’re wanting to buy something, there’s somebody on the other side of the trade says, “I’ll take that,” because they think it’s going to go up.
Now, when you index, you’re just buying and hanging on to things, and that may sound good, it may sound like it’s inexpensive, but it can be expensive in other ways. You can end up with risks that you didn’t even know you had.
You look at the NASDAQ, for example, and this is my pet peeve: If you listen to the media, they talk about what the Dow is doing today, the S&P 500 and the NASDAQ, and then generally, you’re hearing what large U.S. stocks did three times — S&P 500, large stocks, Dow, large stocks, NASDAQ, in general, large stocks.
Now, why do I say that? Well, NASDAQ is a trading platform, but if you look at the concentration in the NASDAQ, it is going to be more of the bigger companies. And it can get really extreme.
At one point, the Magnificent Seven, everybody was talking about these seven companies, Nvidia and Microsoft and so on, and these companies that were really, really doing great. They were very tech-oriented companies, and AI was going to be very, very beneficial.
Now, they’ve decided that they’re down to the Fab Four. That’s their new name for them.
But anyway, the Magnificent Seven at one point, recently, 55% of the NASDAQ 100 were these seven companies. You just think about that. Seven companies, 55%.
So when something goes wrong with those companies and you have that index, and all of a sudden it comes down, that’s 55% of your portfolio.
That’s a problem. Now, if you look at what happened when they decided that they were going to change it, the funds that track that index had to have 23% turnover. That’s a lot of buying and selling.
And what you’re doing when you’re turning it over, that’s how many of the stocks have changed in the portfolio. So you’ve got to sell these companies and you’ve got to buy these companies, and you have trading costs.
Now, is that part of your expense ratio? Your management fee? The answer is no. In fact, the cost to do that was double the expense ratio of the fund, of the ETF that actually tracks that area of the market.
People Don’t Pay Attention
Now, the question may be for you, for those of you that are listening, you may ask this: “Why, Paul, does this stuff not get fixed? Why is it that nobody comes in and says, ‘Man, we need to fix this problem. This is a problem.’”
I would submit that the reason is that most of you are asleep at the wheel. You’re not paying attention to any of this stuff.
You look at it and go, “Man, everybody ought to just at least have enough interest to pay attention to some of this stuff.” “Well, no, I don’t need to pay attention. My financial advisor is.”
No, I’m telling you, I got a buddy of mine, he’s been training financial advisors for, oh gosh, I guess over 30 years. I had to think about that for a second. I had a conversation with him one time.
I was actually signed up to go through a financial doctoral program, and they closed down the program. The long and short of it was they didn’t have enough people that teach the program. And I was really disappointed.
And he said, “Paul, why do you want to do that?” And I said, “Well, typically, unless you have doctor in front of your name, a lot of times people don’t pay much attention, and teaching isn’t necessarily something that you get to do.” What he said, I’ll never forget it.
He said, “Forget it, Paul. I’ve been trying to do that for 30 years. They’ll never listen. They’ll never learn.”
And he just said, “Don’t bother.” And I was just like, “Well, that’s kind of frustrating.”
He said, “I’m telling you, it is beating your head against the wall often to get financial advisors to do it, because they are subject to the same biases that investors are. They’re human, and it is so hard to get them to follow the academic research.”
He’s one of these guys, he’s kind of like me — get us to change our beliefs on things. I’ve been doing this radio show, and there are a lot of people out there that have been listening to this show for the 22 years that I’ve been doing this.
Because I ask people, “How long have you been listening?” They’re like, “Almost 20 years.”
Yeah, there are people that kind of get that I have not changed this message in 22 years. You won’t shake me. And it’s because I’m absolutely convinced, and I understand this and I get it, and I think it is critical.
Selling Based on Past Performance
So why doesn’t the industry change it? Number one, a lot of these biases are hardwired into people’s brains.
But another is, there’s no incentive. When it gets down to it, what is the incentive when the public and the investing world are ignoring the academic research because it’s easier to sell based on past performance?
It’s easier to sell the idea that we have a hot hand and we know which stocks are going to be best.
It’s easier to sell that we can look at the tea leaves, we can look at the evidence out there, and we can look at, let’s say, what’s going on in the economy or what’s going on politically, and we can tell you where markets are going to go, because, hey, if something’s bad happening over here in the economy, that means the stock market’s going to go down. And those two things, it seems to make sense.
But then I come out there and I tell you, “Do you know that a lot of the biggest upturns in the stock market are during recessions?” And people sit there and go, “What? That doesn’t make sense. That doesn’t seem reasonable.”
But it’s true. Do you know a lot of market downturns occur during expansions? That doesn’t seem real.
So what happens is it’s a lot easier to sell people on what seems to make sense to them. It’s a lot easier to get them to invest in a mutual fund that just recently had good past performance because it seems likely that it will continue to have past performance.
Why? Because we think it is because of skill that it had great returns.
We don’t ever consider that it might’ve been luck. Or it might’ve had nothing to do with the investment manager at all, but just a movement in that area of the market or some technological breakthrough that happened to affect that area of the market.
Another thing is this. Well, I’m going to save this until after the break, because this may come as a surprise to you.
Whose interest is served? Really, really important. Really key.
Beating the Index
So I’ve been talking a lot about indexes. You look at market segments, large companies, small companies, value, and growth.
And when we look at professional managers and how often they beat the index, it’s pretty bad. SPIVA, they have this data on how often professionals do better over 15 years. They have it over five, 10, 15 years, how often they do better.
For large companies, it’s like 93% of the time the index does better than the professional manager for large companies. And it’s like 97% for small companies. It’s different for different areas of the market and based on different time periods as well.
So you look at that and you say, “Well, if the professional managers can’t tell you which stocks are better than others, then just buy the index fund.” And you think, “Well, that’s cheap because it’s really inexpensive to manage the index fund.”
But part of the reason it’s so inexpensive to manage is there’s nothing really going on, so you end up with expenses that you’re not thinking about.
Like when an index has securities lending that they do, where they lend securities to people trying to short the market, hoping that they can actually beat the market by buying or selling something, and then re-buying it at a lower price, that is what is called shorting. You can lend those securities.
And what a lot of the index funds do is they will actually make money doing that and keep the money for themselves. Well, I like the idea of the fund giving that money back to the investor.
I think that’s what’s right. But what I think is right doesn’t necessarily tell you what an index fund manager’s going to do.
Now, the other thing that they’ll do is they will be subject to somebody else coming in and front-running them. When they’ve got to sell a stock and get rid of it, somebody will sell it in advance of them selling it. Or when they’ve got to buy a stock, they’ll buy it before the index fund buys it.
So they’ll front-run them and take advantage of the index manager. And I think a lot of you’d probably go, “Man, I don’t really like the idea I’m being taken advantage of.” And that’s what’s happening with index funds.
Hurting Bias
The other thing that you’ll find is that there are a lot of different indexes out there. I talked about it earlier, there’s three million. Which index do I track?
Then you’ll have indexes that are investing in small U.S. stocks, but they can have huge differences in returns in the same exact area of the market. And then you’ll have the funds that aren’t necessarily tracking that area of the market because there’s been drift out of that area.
Small companies become medium-sized companies. Well, I wasn’t trying to track medium-sized companies with my small index. That’s another thing that you run into.
Now, the other thing that you want to understand is that the index provider is not a fiduciary. They don’t have to keep your best interest first. It’s not part of their job description.
Their job description is to put together an index that somebody will maybe license and track using an index fund or an ETF. That’s what they want. They want you tracking their index.
So that’s why you have more S&P 500 index funds than any other market that I can think of. I can’t think of any other index that is tracked more often than the S&P 500. Why? Huge name recognition.
Now, because it’s a well-known name, does that make it a good thing to do? Well, no.
Your mom probably said to you, “Just because everybody else is out there jumping off a bridge, does it make sense for you to go jump off a bridge?” No, it doesn’t.
But hurting bias is a real thing. We do tend to follow other people.
We’re hardwired to follow other people, whether it’s right or wrong. We think there’s safety in numbers, but there’s not.
This is why I think it is so critical that you become an educated investor. At paulwinkler.com, we educate, but you have to know everything that we know. But I think it’s critical you know some things because it’s hard to take advantage of you when you’re educated.
As a matter of fact, you can even ask a question on the website, paulwinkler.com, if you want me to cover it. And that’d be something I can cover right here on this show.
Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.
