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Rekenthaler Report

Me Active, You Index

Finance experts don't necessarily invest as they advise.


Do as I Say
Richard Thaler, the 2015 president of the American Economic Association, agrees with Nobel laureate Eugene Fama that retail investors are best off owning index funds. Warren Buffett gives similar advice, as does David Swensen, Yale's chief investment officer. Harvard professor Andre Perold serves as a director for the bastion of indexing, Vanguard.

Yet, while advocating indexing, four of those five are unquestionably active investment managers. Thaler is a principal of Fuller & Thaler Asset Management, which runs institutional monies in addition to subadvising on a mutual fund. Buffett, of course, runs  Berkshire Hathaway's (BRK.B) stock portfolio. For their part, Swensen and Perold both allocate their assets actively (Swensen for Yale's endowment fund, Perold for his advisory firm's clients), frequently by using actively managed funds.

The fifth, Fama, is not fully an active manager, but he's more of one than you would think, given that he's the person dubbed by Wikipedia as "the father of the efficient-markets hypothesis." Fama is a consultant and director for Dimensional Fund Advisors--a company that describes itself as active. True, DFA creates indexes for its funds, but these indexes reflect DFA's beliefs. And DFA portfolio managers make active decisions. For example, they may bypass a stock that joins their fund's index, if they believe that issue to be distressed.

Then there's Roger Ibbotson, Yale finance professor and founder of the company (since purchased by Morningstar) that popularized the use of long-term financial markets data. He runs a hedge fund. Or Nobel laureate Myron Scholes, who co-founded the hedge fund Long-Term Capital Management. Or Josef Lakonishok, chief executive officer of LSV Asset Management and Illinois finance professor. Or Andrew Lo, at MIT and AlphaSimplex Group.

You get the idea--academic literature, MBA classes, and the media encourage investors to index. Meanwhile, many of the most informed, influential researchers, the very people who have been most associated with the boom in indexing, run actively managed portfolios. What gives?

Temptations, Temptations
For one, there are egos. Although none of these experts will admit it, they each believe that they are smarter than the rest of the market's schmoes (and the schmo who wrote this column, and you schmoes who are reading it). Their confidence is understandable. They are very bright. They have had tremendous professional success. And, for many of them, their belief in their own abilities has been vindicated by the investment results.

The danger lies in overconfidence. In the 1970s, when behavioral researchers begin to study in earnest how people make decisions, they were surprised to learn that highly trained experts were even worse at the task than were novices. To be sure, the experts knew more about their subjects than the novices knew about much of anything, no question about that. But the experts' self-belief soared even higher, making them more likely than the mopes to be overconfident in their answers. In knowing more, they also knew less.

That lesson would certainly seem to apply to Scholes, who jumped from comanaging the bankruptcy of Long-Term Capital Management to consulting with their risk management prior to the 2008 financial crisis. (Nassim Taleb's acerbic response: "This guy should be in a retirement home doing sudoku.") But several others have also struggled, leading one academic to quip that finance professors are "the world's smartest bad investors." (He exaggerates, but entertainingly so.)

For another, there are profits to be made.

In the cases of Buffett and Swensen, the motivation is obvious. They are paid to allocate capital. If they can do so better through active management than by indexing--which has indeed been the case--then that is how they will do their jobs. For the others, investment management is a night job. But potentially, a highly lucrative night job. Although finance professors are atop the academic money ladder, and they can supplement those salaries with consulting gigs, that's not money like winning investment management is money. The one affords a nice wine cellar; the other affords a winery.

Almost Efficient
In addition to the twin temptations of ego and lucre, the financial experts have some genuine beliefs to support their efforts. Even avid advocates of market efficiency, and thus of indexing, lack complete faith. Yes, the financial markets are typically ruthlessly efficient at absorbing investors' aggregate knowledge and incorporating those insights into stock prices, but they have all seen strange things occur. Take momentum--the notion that stocks that have relatively outperformed during the past few months are likely to do so over the next few months. That seems to have been the case. Why so remains unanswered.

So, too, are the reasons for the 1987 market crash--no news during the weekend before Monday, Oct. 19 that could possibly account for that day's 22% decline--or some of the stock quotes during the technology-stock mania of the late '90s (including child companies that were owned by a parent and being valued at more than the parent, even as the rest of the parent was profitable and held more cash than debt). Head scratchers don't often occur; most of the time, when a stock's price strikes an observer as being obviously wrong, it is the observer who needs fixing, not the stock. But they do happen often enough to give pause to any notions of full market efficiency.

And then there are factors, such as DFA's tilt toward smaller, value-priced companies. Those attributes may bring extra risk, but in theory--or at least, in observation--they are accompanied by extra return. To form portfolios that hold companies with exposure to those factors, while excluding others, may not be active management in the traditional sense. But it is active management in some sense. Implicitly, by his involvement with DFA, Eugene Fama advocates being on one side of a stock trade and letting others take the opposing side.

In short, it makes sense for financial experts to recommend indexing to outsiders, and it makes sense--psychologically, financially, and intellectually--for them to behave otherwise. The conflict exists, but so do the reasons behind it.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler has a position in the following securities mentioned above: BRK.B. Find out about Morningstar’s editorial policies.