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Rupert Hargreaves
Rupert Hargreaves
Articles (660)  | Author's Website |

Benjamin Graham: Index Funds Are Better Than Active Managers

The father of value investing explained his position in an interview

March 12, 2018

Benjamin Graham is best known for his work on value investing, particularly establishing a basic framework for every investor to be able to follow to find the cheapest stocks and achieve market-beating returns over the long term.

While Graham did what he could to make it easier for investors to find cheap stocks, he also acknowledged this approach was not going to be appropriate for everyone. He, therefore, also recommended it might be sensible for some investors to invest in index funds as an easy, cost-effective method of producing market returns without running the risk of paying high performance fees that do not justify the returns.

The best method

Graham reiterated this point in an interview with the Financial Analyst Journal shortly before his death. Published in 1976, the interview was titled "A Conversation with Benjamin Graham." Today, his advice is still highly relevant and informative.

The interviewer asked Graham if it was possible the average manager of institutional funds could obtain better results than the Dow Jones Industrial Average or Standard & Poor's 500 index over the years, to which Graham replied:

"No. In effect, that would mean that the stock market experts as a whole could beat themselves--a logical contradiction."

The interviewer then asked if the average institutional client should be content with achieving an average market return. Graham replied:

"Yes. Not only that, but I think they should require approximately such results over, say, a moving five-year average period as a condition for paying standard management fees to advisors and the like."

Essentially, what Graham is saying here is the average manager cannot outperform the index consistently. Therefore, investors should be content with market average returns at an attractive cost as the likelihood of being able to achieve market-beating returns consistently is slim.

What about index funds?

The interviewer then went on to ask Graham what he thought about index funds and the argument that index funds should be ignored because they do not take into account each investors' different requirements, an argument Graham believed was entirely without merit:

"At bottom that is only a convenient cliche or ability to justify the mediocre record of the past. All investors want good results from their investments, and are entitled to them to the extent that they are actually obtainable. I see no reason why they should be content with results inferior to those of an indexed fund or pay standard fees for such inferior results."

Put simply, what Graham is saying here is investors should always demand index average returns, no matter what the situation. Some fund managers might try to charge higher fees for more tailored solutions, but ultimately these solutions are inferior to the offering provided by an index fund, which will offer positive returns over the long term at a higher rate than most managers, whose fees absorb a great deal of the returns generated over a five or 10-year period. Fees will only exacerbate the underperformance if these managers do not manage to match the market.

Finally, Graham has some advice for individual investors who want to try and beat the market. He believes they have a tremendous advantage over institutions because they are flexible in regard to where they can invest and how much they can invest in specific situations:

"Institutions have a relatively small field of common stocks to choose from--say 300 to 400 huge corporations--and they are constrained more or less to concentrate their research and decisions on this much over analyzed group. By contrast, most individuals can choose at any time among some 3000 issues listed in the Standard & Poor's Monthly Stock Guide. Following a wide variety of approaches and preferences, the individual investor should at all times be able to locate at least one per cent of the total list--say, 30 issues or more--that offer attractive buying opportunities."

About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website

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