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Robert Abbott
Robert Abbott
Articles (502)  | Author's Website |

Indexing for Dummies: Seduced by Big Promises

Too many loud voices guarantee too much to active investors—and we're too ready to listen

May 09, 2019

A rant about the misleading claims of active investing proponents makes up the bulk of chapter four of “Index Investing for Dummies,” a book by Russell Wild. To make his point, the author offered a bevy of reasons why well-intentioned investors get caught up in these promises.

He began with a screed against what he calls “Worshipping Wall Street” and argued that the big firms such as Smith Barney and Merrill Lynch (this book was published in 2009) do not make money for clients. They make money by skimming fees from clients.

Wild wrote, “In total, we find a huge industry — both mutual funds and brokerage houses that actively trade securities — that is built in good measure on the lay public's ignorance.” That is, ignorance about the benefits of index investing. To keep those fees coming in, the Wall Street giants have “developed some very slick tricks over the years.” Collectively, we’ve been willing to go along with them.

Hidden fees

In his capacity as a financial advisor, Wild reported he had seen many new clients arrive at his office with the “feeling” their portfolios managed by Wall Street firms were not doing well but didn’t know why. Looking at the fancy reports, he found a lot of meaningless information—and lack of some important details.

“In other words, what they give you is a lot of useless and practically meaningless crap.

I'm not exaggerating.

In the small print of an actual Smith Barney quarterly review report that is sitting on my lap as I type, it says the following: All rates of return on this page are presented before the deduction of management fees.

There was no information on the rate of return after paying the firm’s fees, which is critical. Knowing only the gross return is essentially knowing nothing. And, to compound the misleading nature of the report, Smith Barney listed “Contributions/Withdrawals/Fees” as a single line item.

Churning and pumping

Churning refers to the brokerage practice of unnecessarily buying and selling client stocks “with the only apparent benefits going to the churner (and perhaps to Uncle Sam)—very rarely to the churnee.”

A second complaint in this section refers to a mutual fund advertising tactic: Comparing a fund to the wrong benchmark. For example, comparing a large-cap fund with an international stock index.

Third, big mutual fund companies run funds made up of different asset classes and often their “success” is due to an asset class having its turn in the sun, rather than good stock picking. As the old saying goes, “Even a broken clock is correct twice a day.” This is what Wild means by “pumping.”

The television circuses

To illustrate his case against the television experts, Wild focused on Jim Cramer of “Mad Money,” the over-the-top advice program for wanna-be stock pickers. At the time Wild’s book was published, Cramer’s record was “pretty miserable.”

And it hasn’t improved in the bull market that’s gone on since then. According to a Wharton-based research study, Cramer’s Action Alerts PLUS portfolio, from 2001 through 2017, averaged just 4.08% per year and significantly trailed the S&P 500, which averaged 7.07% per year.

Cramer, of course, is just the tip of the iceberg. Many others do the same, in print, on air and online. In any case, check their credentials before you jump into their stock tips.

Attractive cover stories

It’s not that Wild wanted a blanket condemnation of all media coverage of investment ideas. In discussing investment publications, he encouraged readers to skip cover story recommendations, but look at non-cover articles. In his words, “It’s usually the cover pieces — designed to sell magazines off the news racks — that truly stink. My advice: If you want to read about money in a magazine, just ignore the cover story!”

Self-congratulation running amok

How honest are those other pundits who tout their stock picking? Wild warned of a couple of issues they may not tell you when patting themselves on their backs:

  • Even if you had ignored them, you likely would have made money anyway, and perhaps even more. For example, Cramer once bragged his mad-money method had earned 16.2% one year. What he did not tell his viewers was that index funds invested in the same asset classes would have generated 21.8%.
  • Costs are quietly ignored. Wild cited the Value Line organization, which claimed to have beaten the S&P 500 by a ratio of almost 15 to 1 for the period January 1965 to December 2007. Yet, Morningstar reported (for the years leading up to 2009) that the Value Line mutual fund had underperformed the S&P 500 on both a 10-year and 15-year basis (according to Morningstar, the fund continues to lag the benchmark and its category in May 2019).
  • Purposeful amnesia. Many pundits and organizations have conveniently forgotten their past mistakes. Among them was a certain ladies’ investment club of Beardstown, Illinois. They claimed to have outperformed the market and their stock-picking book became a huge best-seller. Independent analysts determined they had actually underperformed the benchmarks, yet they went on to publish another four books about picking stocks.

Overconfidence in our own abilities

Wild reported being at a workshop in which participants were asked to rate themselves as average, above average or below average on their driving skills. Some 70% considered themselves to be above average, which roughly corresponds to what academic research has shown: We are overconfident in our own abilities (men are more guilty of this than women).

Wild wrote, “Here lies perhaps the biggest reason that everyone doesn't index: It isn't the way we are manipulated and fooled by Wall Street or the media; rather, it is the way we manipulate and fool ourselves.”

So many hurdles

If you decide to be an active stock picker, you must clear many hurdles:

  • Risk management.
  • Cover all costs.
  • Time entries and exits.
  • Spend time doing research or spend money for advice.
  • Pay taxes (if investing outside a registered vehicle).

In other words, you must get many things right and you must earn returns above index funds just to match their performance.

Tracking

To paraphrase the late management guru Peter Drucker, if you don’t measure it, you can’t improve it. Wild wrote of clients coming to his office for a review of results they’d achieved with Wall Street firms, and in many cases they had not done as well as they thought they had.

As he also noted, it’s very hard to accurately measure a portfolio’s performance. However, it should be done, and clients who did so sometimes found out they would have done better with index funds.

There are many ways managers and promoters of actively managed funds may mislead us about the results we’re getting. At the same time, though, we may also be fooling ourselves to some extent. Whether you believe in the superiority of index funds or not, these are all issues that should concern serious value investors.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution." In his book, "Big Macs & Our Pensions: Who Gets McDonald's Profits?" he looks at the ownership of McDonald’s and what it means for middle-class retirement income.

Visit Robert Abbott's Website


Rating: 5.0/5 (3 votes)

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Comments

Thomas Macpherson
Thomas Macpherson premium member - 2 weeks ago

Thanks Bob for another insightful article. As an active money manager myself, I obviously have an inherent bias that one can beat an index with a proper methodology, emotional balance, and unlimited patience. I have a couple of comments about Mr. Wild's thoughts. First, I find that when reporting results it's best to measure your performance against the S&P500TR no matter what category you might fall into (I generally show up as small to mid-cap growth) as well as a customized index-based portfolio that matches your holdings including cash. (Something like 15% cash, 25% Vanguard US Small Cap Growth, 45% Vanguard US Mid Cap Growth, and 15% Vanguard International Stock) I think many see the S&P500 as a proxy for the stock market while the second gives my clients a pretty close comparison less my my management fees and other costs (such as trading and bid/ask differences). Second, there ARE a lot of investment managers with truly atrocious records. Ron Muhlenkamp's (Dr. Paul Price's favorite money manager!) MUHLX has underperformed for 3, 5, 10, 15, 20, 25, and 30 year periods and yet not once will you see that mentioned in his materials or quarterly reports (with the exception of some very hard to read charts). Rather you hear about macro-economic events that are showcased as to why you need an active money manager.....like him I was recently discussing performnce with a senior Fidelity executive who said they estimate that less than 5% of fundholders will read their monthly statements or prospectuses. 5%! So there is plenty of blame to go around. All I can advise is that money managers see their investors as partners - there to be treated with respect and have their capital invested in the most diligent manner to meet their investment needs. Reporting should be detailed, with a clear explanation of investment methodology, business cases, valuation calculations, and detailed peformance tracking. I believe my investment partners deserve nothing less. Equally important, investors need to make sure their investment managers meet those requirements. If they did, I can assure you there would be less active managers and an even greater move to indexing in general. I'll get off my soapbox now. Thanks for a great summation as always. Best - Tom

Robert Abbott
Robert Abbott premium member - 2 weeks ago

Thanks for your helpful thoughts, Tom!

I've occasionally wondered if performance below the S&P 500 should be considered an "opportunity cost".

If it is, then, as you say, a lot of fund managers are leaving a lot of money on the table that should have gone to clients. If I recall correctly from my analysis of gurus with available results, only 28 of 72 had beaten the S&P 500 over the 10 years ending in 2015 or 2016. Congratulations on being among that elite group!

Thomas Macpherson
Thomas Macpherson premium member - 2 weeks ago

Thank you Bob. It has as much to do with luck as it does skill. Your article got me thinking and I completely tore up my draft article and wrote a new one building on my comment. So thank for lighting a spark! Have a great weekend. Best - Tom

batbeer2
Batbeer2 premium member - 2 weeks ago

@Tom

.... and hopefully reasonably on topic.

You say:

>> As an active money manager myself, I obviously have an inherent bias that one can beat an index with a proper methodology, emotional balance, and unlimited patience.

This makes me wonder.... why would it be easier for someone to select a good investment manager than a good stock? Is the ratio of good investment managers to bad investment managers higher than the ratio of good stocks to bad stocks?

I can think of a number of (subjective) reasons why a given investor should have a preference for one of those problems but I can't see an objective reason why one of those selection processes would be inherently easier to do than the other.

Any thoughts?

Thomas Macpherson
Thomas Macpherson premium member - 1 week ago

Hi Batbeer: I'm sorry I didn't get back to you earlier. I was banned from using the computer over the weekend! In regards to your first paragraph, I think it would be easier to pick a good stock than a good manager (I apologize if this misrepresents what you meant, but I'm defining "good" as "market beating" I'm also assuming we are discussing "active" money managers). From a pure numbers perspective, roughly 90% of all active managers will underperform or be merged away (likely due to underperformance) over a 25-30 year period. Equally - from a numbers perspective - it's hard to conceive of a stock picking model where 90% of all your stocks underperform the general markets for a 30 year period. (It's possible, but I think it would be harder) So I think its easier to pick bad managers than bad stocks and I think the ratio of good managers to bad managers is worse than good stocks to bad stocks. In regards to your second paragraph, I think your thesis is correct - meaning subjective versus objective. I haven't had my morning tea an caffeine, so hopefully this addresses your question/thoughts. Best - Tom

batbeer2
Batbeer2 premium member - 1 week ago

Thanks! your point is glaringly obvious/clear but I never thought about it that way; you've clarified something I've wondered about for a long time.

Some (most?) money managers probably have a tough time beating the market because their clients pull out at exactly the wrong time. The idea of dollar cost averaging works against them.

Attracting the right clients (and avoiding the wrong ones) is probably part of doing a successful job. At least if you define success as beating the market which is not the same as maximizing fees.

just some thoughts.

Robert Abbott
Robert Abbott premium member - 1 week ago

Hello Batbeer - I think your question for Tom caught the need to buy at discounted prices in a nutshell. You cannot predict how a stock or active manager will perform because whatever happens will happen in the future. But, if you buy fundamentally good stocks at a solid discount, or if you find a manager who does that at a reasonable cost, you've tipped the odds in your favor.

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