18 August 2017

Are index investors better behaved?

Broadly, there are two things that prevent most people having a successful investment experience: costs and behaviour. As more and more investors are coming to realise, using index funds dramatically reduces the fees and charges you pay; compounded over decades of investing, it amounts to a huge sum of money. But does using index funds also improve investor behaviour?

All investors, regardless of the type of investment vehicle they use, are prone to bad behaviour. Typically, they buy when markets are rising and sell when they’re falling, and generally they trade far too often; by tinkering with their portfolios they incur additional ‘friction’ costs, which eat away at their returns. But there is evidence that those who invest via index funds do behave better than investors in actively-managed funds.

To quote a recent article by Nir Kaissar, “index investors have been uncharacteristically disciplined about sticking with their investments”. Kaissar quotes Morningstar data showing that, over the 10-year period ending July 31st 2017, investors in US equity index mutual funds captured on average 96% of their funds’ returns, whereas investors in actively-managed US equity funds captured just 71% of their funds’ returns.

The difference, Kaissar points out, was even more pronounced in overseas markets. Investors in emerging-market equity index funds captured 85% of their funds’ returns compared with 33% for those in active funds.

That indexers have generally stayed the course is all the more remarkable when you consider everything that’s happened since 2007. To quote Kaissar again:

“The fact that index investors were able to hang on over the last 10 years is no small feat because markets handed them plenty of opportunities to make bad choices. Remember that the last decade includes the 2008 financial crisis. And overseas markets doled out other hairy moments. The MSCI Emerging Markets Index, for example, dropped 26% from May to September 2011, including dividends. It also plunged 29% from September 2014 to February 2016”.

Assuming that these figures are more than just a coincidence, why is it that indexers, in the US at least, have shown considerably more discipline than active investors? There are probably two main reasons.

First, index investors generally have a better understanding of how markets actually work than active investors. Indexing is counter-intuitive; to decide to index, you have to make a conscious choice not to act on your natural instincts, and to disregard what most investment professionals and commentators are encouraging you to do. Often indexers have come to that decision themselves; others have done so with the help of an adviser. Either way, if you genuinely understand and accept that volatility is part and parcel of equity investing and that, over time, markets almost always reward patient investors, you are far less inclined to change your course when, inevitably, markets tumble.

The second reason why US indexers have been more likely to stay the course than active investors in recent years is the rise of what could be called the evidence-based fiduciary. A big trend in the US over the last 20 years has been the rising number of registered investment advisers who, instead of commission, rely for their income purely on fees. Most, though not all, of those advisers have an investment philosophy which is grounded, to some degree or other, in academic evidence. Central to that philosophy is not just the use of low-cost index funds, but also the importance of behaviour. Because an evidence-based adviser doesn’t need to keep monitoring (or apologising for) the performance of actively-managed funds, they often have more time to spend with clients — reminding them of the rationale for indexing, reassuring them that markets will eventually start rising again, and encouraging them to block out the noise and focus instead on what really matters and what they can control.

No, indexers aren’t immune to self-destructive thoughts. But there are good reasons why they’re more likely than active investors to keep them in check. As we say at Carbon, investing is a long-term discipline. Anything else is speculation.

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