Indexes: Why the Critics are Wrong

Buying and holding the hundreds of stocks making up the broad stock market averages is likely to be the most sensible investment strategy for both individual and institutional investors. I've argued this for nearly 30 years, since even before index funds existed. The way I put it in 1973, when the first edition of "A Random Walk Down Wall Street" was published, was that a blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts. In practice, the recommended strategy is to throw a towel over the stock pages and buy and passively hold their entire market portfolio, as can now be done through several broad-based index funds.

Time has been very kind to my thesis. The broad capitalization-weighted indexes regularly outperform about two-thirds of the actively managed mutual funds, and the fund managers who beat the index in one period are unlikely to do so in the next. In most years, a Standard & Poor's 500 index fund has a rate of return about two percentage points better than the average manager's; for the 10 years ending in 1998, the index outperformed the average manager by 3.5 percentage points, and did better than more than nine out of 10 active managers. Over the past 30 years, a $30,000 investment in the index would have grown to $311,000 (after expenses); in the average general equity fund, the same investment would have grown to $171,950.

A very few active managers have managed to beat the index over long periods. But there is no way to tell in advance who they will be, and the past record of a fund is no help in predicting how it will do in the future. The top funds of the 1980s have, as a group, under performed in the '90s.

Why does indexing out maneuver the best minds on Wall Street? Paradoxically, it is because the best and brightest in the financial community have made the stock market very efficient. When information arises about individual stocks or the market as a whole, it gets reflected in stock prices without delay, making one stock as reasonably priced as another. Active managers who frequently shift from security to security actually detract from performance by incurring transaction costs amounting to 0.75% to 1% of assists. Moreover, the average active fund manager pockets about 1.5% of assets to pay for marketing, research, and manager compensation. Index funds typically charge less than 0.2%.

For all the attractions of indexing, it has elicited a chorus of criticism from the financial community. Let's examine the arguments.

• Indexing only works in rising markets. It is true that the advantages of index funds are likely to be somewhat diminished during down markets, because they hold no cash while the typical active manager has between 5% and 10% of his portfolio in cash, thus cushioning the decline. But records show that index funds continue to outperform active ones in most down markets, thanks to their substantial expense- and transaction-cost advantage. And don't hold out hope that your actively managed fund will wisely increase its cash position before a market decline. Market timing is more likely to hurt performance, for the typical fund lowers its cash position during market peaks and increases it at market troughs.

• Indexing is self-fulfilling and ultimately self-defeating. With the popularity in recent years of mimicking the S&P average, the argument goes, the inflow of funds has boosted the prices of S&P stocks and has led to the self-fulfilling result that index funds have widely outperformed active managers. The result, according to critics, is that the S&P is now bloated with vastly overpriced stocks and will ultimately come crashing down much like the "nifty fifty" stocks of an earlier decade.

In truth, despite the increased popularity of indexing, its impact is still small relative to the general flow of funds into the equity market. Indexed funds currently comprise only 9% of all equity mutual funds. Even during 1998, a year of enormously increased popularity of indexed equity funds, less than one-quarter of the net cash flow went into index funds, and only 16% went into S&P 500 funds. In addition, careful empirical work finds no relationship between changes in the relative flow of money into index funds and the amount by which the index outperforms active managers.

• If everyone indexes, there will be no professionals left to ensure that the market is efficiently priced. This worry is misplaced. Most investment money is actively managed; professional security analysts ands money managers are nowhere near extinction.

• Indexing doesn't work in less efficient markets. Some professionals grudgingly admit that indexing probably works for big companies, but they argue that it cannot work in less efficient parts of the market such as smaller company stocks, and certainly not in the notoriously inefficient emerging markets. In fact, indexing can have greater advantages in less efficient markets. Small-cap markets and especially emerging markets tend to be illiquid. Bid-asked spreads are large, and it is impossible to buy or sell blocks of stock without considerable market impact. Hence the transaction costs of actively trading in these markets tend to be far larger than big-company stocks. Moreover, management costs are substantially higher for funds that invest in small companies and in emerging markets. The evidence is clear that when active equity managers are compared with indexes of stock with equivalent market capitalizations and with appropriate country benchmarks, index fund investors come out well ahead.

• Indexing won't work when large-cap stocks under perform. More than three out of four index funds simply replicate the S&P 500 index. The large-cap domestic stocks that dominate the index have enjoyed unusually superior performance in recent years. One dangerous feature of indexing is that the investor automatically increases the portfolio weighting of stocks that have been increasing in price and thus constitute a bigger share of the index. If the new "nifty fifty" begin to under perform, the advantage of S&P 500 indexing will sharply narrow.

This is an argument for which I have considerable sympathy. It may well be that better values in the market today can be found in small-cap stocks, in real estate equities, in bonds and even in the stocks of the battered emerging markets. But this is not an argument against indexing. Investors today have available to them index funds that invest in a wide variety of domestic and international securities. Moreover, there are "total stock market" index funds that replicate indexes of several thousand securities. The argument that large-cap stocks are pricey relative to the rest of the market is not an argument against indexing, but rather a call to investors to use care in deciding which index fund or combination of funds they should select for their particular needs.

In addition to the cost advantages, indexing provides enormous tax benefits for taxable investors. An actively managed fund trades, and thus realizes capital gains, much more frequently than an index fund does. Even with long-term capital gains tax rates reduced to 20%, an active manager would need significant over performance relative to the index to make up for the deadweight loss of taxes.

Indexing allows investors to buy securities of all types with no effort, minimal expense and considerable tax savings. Indexing is a winning investment strategy whose recent growth reflects a realistic adjustment of individual investors to a not-so-well-kept secret of the investment business: Professional portfolio managers are unable to beat the market consistently. All intelligent individual investors should have index funds at the core of their portfolios.

By Burton G. Malkiel, author of "A Random Walk Down Wall Street," the updated seventh edition of which has just been published by W. W. Norton.
Wall Street Journal Interactive Edition
May 24, 1999

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