Ferri: Total-Market Investors Not Dumb

If you can't catch the really big fish, why not cast as wide a net as possible, Rick Ferri asks investors.

When you own all the fish in the ocean, you don’t have to worry about where the fish are. Total market index funds are managed to track the return of all securities in the market. It doesn’t matter which part of the market is up or down because you own it all.

Can you do better? Sure, but most people aren’t good fishermen. Finding fish isn’t easy and there’s always a cost. There are winners and there are losers in the active management game, and everyone pays higher fees whether they win or lose.

Nobel laureate William Sharpe shows that the net result of active management in aggregate is a return that’s below a total market index fund. It’s simple arithmetic. He pointed this out more the 20 years ago in his timeless article, The Arithmetic of Active Management, and more recently, The Arithmetic of Investment Expenses.

There’s been a lot of media coverage of so-called smart beta strategies because the sellers of these products claim the strategies have outperformed the market based on hypothetical back-testing. These quantitative strategies employ a variety of security screening and weighting methods in an effort to carve out a portfolio that’s supposed to deliver higher returns than the total market.

It’s questionable whether these actively managed funds will deliver better results than total market index funds, especially after adjusting for risk. One thing can be said: there won’t be any excess return to investors until the higher costs are covered.

The expectation of higher returns from smart beta strategies implies there must be dumb beta out there. How else would investors in smart beta outperform if there were no dumb beta investors?

The marketing material of some smart beta providers infers that total market index fund investors are the dumb beta side of the equation. That’s not correct. The expected higher return proposed by smart beta providers doesn’t come from total market index fund investors – it can’t.

The flip side of smart beta is dumb active management. This is pure Bill Sharpe arithmetic. If one active strategy outperforms, then another active strategy must underperform, and both are before fees. This holds true for every active strategy. For every smart investor who wins, there must be a dumb investor who loses.

Where does this put the total market index fund investor? They are neutral in the smart-dumb active management tug-of-war. Beta is neither smart nor dumb – it just is.

There are a variety of low-cost total market index funds and exchange-traded funds (ETFs) covering different asset classes: US equity, foreign equity, US investment grade bonds, etc. They are offered by a variety of fund providers, including Vanguard, Schwab, Fidelity and iShares.

The ocean only has a finite amount of fish that can be caught each year. A total market index fund gives you your fair share of all the fish caught. If some fishermen catch more fish and others catch less, it has no effect on your share of the overall catch. That sounds like smart investing to me!

This blog, which first appeared on Rick Ferri’s blog, is part of a regular series of articles on ETF.com featuring some of the most influential voices in the world of index and passive investment. Ferri is the founder of Portfolio Solutions, a Michigan-based registered investment advisor with about $1.2 billion in assets under management.