Two compelling reasons for indexing
- Robin Powell
- Jan 23
- 3 min read
Active fund managers use a range of arguments to justify their higher fees. But the evidence clearly points in a different direction.
There are two particularly strong reasons to steer clear of active funds and both are hard to ignore.
The first relates to cost. The second is about risk. Both factors should matter to every investor.
KEY TAKEAWAYS
1. Costs reduce your net return
According to VICTOR HAGHANI, when you combine all actively managed portfolios, they effectively make up the market. But unlike low-cost index funds, active portfolios incur higher charges. So the average active investor earns the market return minus those costs and is therefore likely to underperform.
2. Active investors take on more risk
Even if fees were eliminated, active funds often involve greater risk. On a risk-adjusted basis, this makes their performance even less attractive. The more rational approach is to aim for the best return for the level of risk taken.
3. Indexing is the more rational choice
Both cost and risk matter. Index funds offer a simple, effective way to achieve broad market exposure while keeping both of those critical factors under control.
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TRANSCRIPT
Robin Powell: Proponents of active fund management suggest all sorts of arguments for using active funds.
But there are two compelling reasons why you shouldn’t.
The first is what’s been called the Cost Markets Hypothesis.
Victor Haghani: If you take everybody's portfolio, where they have active, stock picking portfolios that they don't own, the market cap weighted index, you take all of these active portfolios, all of these active investors, and you put all of their holdings into a big pot. That pot is going to look exactly like an index fund.
It has to. So therefore we know that the average dollar of all these active investors everywhere, of all the stock pickers, everywhere that the average dollar is going to earn the return of the market portfolio.
But it's going to earn that minus whatever fees are associated with all this active investing.
RP: So the average passive investor HAS to outperform the average active investor, net of costs.
But, aside from cost, there’s another very good reason for avoiding active funds.
Victor Haghani calls it the Risk Matters Hypothesis.
VH: The risk matters hypothesis says that the average investor dollar, that's in actively managed portfolios, that's doing stock picking either in a mutual fund or just doing your own stock picking that the average dollar among all these stock pickers and active mutual funds is going to get the market return minus costs, but let's say costs have now gone to zero.
But the average risk of all of those portfolios is higher than the market risk. And so the risk adjusted return on the average dollar will be lower than the risk adjusted return of the market portfolio. And this is inescapable.
RP: Perhaps because it’s easier to understand, the cost-related argument for indexing tends to receive the most attention.
Although it’s also very important, the risk-related case is often overlooked.
VH: A lot of people, they just don't. They think they don't care about risk. But we all have to care about risk. It's kind of inescapable.
But, you know, some people might say, all I care about is how much money I'm making. But no, you could always make more money.
If you can make more money for taking the same amount of risk, you should always want to do that.
That's always a rational thing to do. So it's always better to make more money for a given amount of risk, and that we always. And that risk is a real cost. It's the cost that we bear to make expected returns.
RP: In short, cost is a crucial factor, but so is risk.
Investors shouldn’t just focus on their net returns alone, but on their net returns adjusted for the level of risk they take.
The best way to maximise your expected, risk-adjusted net returns is by indexing.
