Market Efficiency, Indexing, and Low Cost Investing vs Active Management

Part of the reason I write is to articulate various frameworks and positions that are in my head. Many people ask me similar questions too, so hopefully I can just refer them to the blog in the future. That being said, I’m going to kick-off a multi-post series on the oft-misunderstood concepts of market efficiency, low-cost investing, index investing and passive management.

Despite the growing popularity of index investing (which I highlighted last week):

  • Active managers still manage the majority of assets under management (AUM).
  • Many investors’ think that they or someone they hire can beat the market.

On the flip side:

  • Many investors’ conflate market efficiency, indexing, low-cost investing, and a host of other concepts.
  • Many passive investors overstate the case for market efficiency and/or index funds.
  • Some investors have a blind faith in market efficiency and/or passive management.

Adding to (or abetting) the confusion is a financial services industry that markets and promotes a wide range of approaches. It can be difficult to find unbiased answers and construct a framework without researching these topics yourself. My goal for the next few posts is to provide some answers in a concise way.

Watching the Migration to Index Funds

Fund flow data consistently shows that dollars have been moving from actively-managed funds to passively-managed funds over the past decade. Beyond seeing the data every quarter, the shift has been evident in the conversations that I have.

Ten years ago, most of the clients that I spoke to were skeptical of index mutual funds and ETFs. I’d have to explain the rationale and evidence supporting index funds.

Five years ago, it was a toss-up whether new client conversations would be spent explaining why we primarily used index funds or explaining why we also had exposure to some higher cost active funds.

These days, new clients are often quick to understand and accept the indexed parts of portfolio recommendations, but I have to explain why specific active funds make more sense for parts of a portfolio.

Although index funds are not always best and certainly not for all parts of a portfolio, they often are the best choice and rarely a terrible choice. Thus, I think greater investor awareness and acceptance of index funds is generally a good thing. It’s been interesting to watch the migration.

Peter Thiel on Competition

Over the past few weeks, I have seen and heard evidence of increased competition in both public and private credit markets. As valuations rise and prospective returns decline, I think it wise to remember Thiel’s mantra of avoiding competition. Just as businesses do best in the absence of competitors, investors perform best when they do not have to compete for opportunities.

“Competition means no profits for anybody, no meaningful differentiation, and a struggle for survival. So why do people believe that competition is healthy? The answer is that competition is not just an economic concept or a simple inconvenience that individuals and companies must deal with in the marketplace. More than anything else, competition is an ideology—the ideology—that pervades our society and distorts our thinking. We preach competition, internalize its necessity, and enact its commandments; and as a result, we trap ourselves within it—even though the more we compete, the less we gain… If you can recognize competition as a destructive force instead of a sign of value, you’re already more sane than most.

-Peter Thiel, Zero to One

Brilliance vs Rationality

Just now catching up on highlights from last week’s Berkshire Hathaway annual meeting, which is always full of wit and wisdom from Buffett and Munger. The above quote is my favorite from this year’s meeting and is pretty consistent with what Munger and Buffett have been saying for years about the importance of intelligence versus sober thinking.

On IQ:

“You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.” -Warren Buffett (via Wiley)


“Success in investing doesn’t correlate with I.Q. once you’re above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” -Warren Buffett (via Pensions & Investments Online)

On Rationality:

“It is remarkable how much long-term advantage people like [Warren Buffett and myself] have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” – Charlie Munger (via 25iq)

Lastly, one of my favorite Munger stories (via WSJ):

“In the late 1980s, [Munger] recalled in a magazine interview, a guest at a dinner party asked him, “Tell me, what one quality accounts for your enormous success?”

Mr. Munger’s reply: “I’m rational. That’s the answer. I’m rational.”