Why proponents of passive investing make false claims.
Indexing’s roots are in the staid, respected halls of academia, places where truth, precision, and candor are valued supposedly above all else. Why then do so many indexing adherents perpetually insist on overstating their case, moving from a true and accurate statement that indexing is a good and simple way to ensure above-average results to a patently false claim that anything other than indexing is inherently bad, a morally suspect act of folly?
The math of indexing is straightforward. Lower costs ensure that over most time periods an index will better most managers’ returns. A low-cost index fund generally will beat around two thirds of its competitors and trail the other third. However, if one makes two simple adjustments in picking active managers and selects only from funds with below-average costs and where managers have significant investments in their own funds, the odds improve much closer to 50/50 or even better. Of course, one might well still argue that indexing remains the wiser choice because of tax or predictability advantages, but how in the world do these preferences or marginal benefits generate the utter contempt that so many index adherents express for active managers?
The disparagement of active management simply isn’t a rational response to the facts. Cynics will attribute this position to academic hubris or envy, professors wanting to show their clan’s superiority over all those better-paid Wall Street types. Others will cite the huge fortunes or scholarly fame that early index proponents have won. Such riches will swell the egos and alter the ethics of even the most honest practitioners.
But these explanations can’t justify fully the systematic dishonesty of the index community, many of whose members, like Jack Bogle, are neither greedy nor arrogant. Why do so many smart, otherwise honest people perpetuate a position so overstated that it is effectively a lie?
I’ve wrestled with this question for many years and have come finally to believe the answer lies in Plato’s The Republic. In this famous dialogue, Socrates, an otherwise honest man, conceives of the noble lie. The leaders of the republic Socrates envisions must tell the citizens that they are born of the earth and are composed of different metals that indicate their role in society. The purpose of this lie is to engender loyalty to the republic and to encourage the behavior necessary to produce a well-run state. I think that Bogle, surely our modern financial Socrates, sees the same need with indexing and like Socrates, an essentially truthful man, chooses to perpetuate an overstatement in order to produce a better investor outcome.
Indexing is a great tool, but it is not a panacea for all investment problems. Index funds can be easily misused, as seen in the euphoria around the QQQs in the 1990s or the flood of hot money that went into Vanguard’s large-cap growth index fund in 1999. More recently, several passive emerging-markets funds have seen similarly unfortunate asset flows. To use index funds wisely, one needs to be either highly disciplined or extremely inattentive. The temptation to tinker often undermines one’s results. “Don’t just do something, sit there,” Bogle counsels. But, as financial advisors can’t ignore the market, they must acquire discipline somehow, and one proven means to do so is through the cultlike overstatement of the righteousness of one’s cause. The belief that you follow the morally pure approach will keep followers on the proper path during the dark hours of doubt.
Of course, such discipline is helpful to all investors. With active funds, this discipline might come from devotion to a star manager (the noble lie of active management), but with passive, it must come from devotion to the philosophy behind the approach. That, I believe, is the only favorable light in which one can justify the ritual overstatement of the case for indexing. This noble lie is especially important to users of cap-weighted index funds, which by definition have maximum exposure to the most overheated parts of the markets at their absolute peaks, something emerging-markets index investors have been reminded of this summer as China shares have imploded. Indeed, if one is to harness the China story, either through active or passive funds, one needs desperately the discipline engendered by a noble lie to help stay the course.
Those who lose faith during moments of crisis will undermine their results at a cost that no amount of expense or tax efficiency can offset. Without its noble lie, indexing is only a partial solution to investors’ core challenges.