Trying To Beat The Market With Index ETFs Is Alive & Well

Jared Dillian is editor and publisher of The Daily Dirtnap, a market newsletter for investment professionals, and the author of “Street Freak: Money and Madness at Lehman Brothers.” and “All the Evil of This World.”

Unless you have been trapped under something heavy, you know by now about the rise of indexing. You’ve heard about the assets fleeing actively managed funds for index funds, under the idea that you can’t be the market, so why try?

The thing is—people are still trying the beat the market.

Imagine this scenario: Retail Investor A goes in to meet Financial Advisor B. Financial Advisor B is a convert to indexing, and wants to act in the best interests of his client—so he wants funds with low fees. ETFs!

So what ETFs does Financial Advisor B pick?

• He likes utilities, so he picks the Utilities Select Sector SPDR Fund (XLU).
• He likes health care, so he picks the Health Care Select Sector SPDR Fund (XLV).
• For a little international exposure, he picks Germany, via the iShares MSCI Germany ETF (EWG).
• For a little emerging market exposure, he picks India, via the WisdomTree India Earnings Fund (EPI).
• For a little fixed-income exposure, he picks the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD).
• And finally, he likes defense stocks under Trump, so he picks the iShares U.S. Aerospace & Defense ETF (ITA).

He then constructs the following portfolio:

20% XLU

20% XLV

10% EWG

10% EPI

20% LQD

20% ITA

You Won’t Be Getting Market Returns

It goes without saying that the return of this portfolio is going to be very different than “the market.” It could be higher, it could be lower, but this portfolio of index ETFs looks nothing like the market.

Well, how do we define “the market?” If you really want to be a true indexer—you want to own a perfect slice of every asset in the world. U.S. stocks, international stocks, emerging and frontier stocks, U.S. bonds, international bonds, corporate, municipal, mortgage—everything. And that’s just tradable assets. Theoretically, you would also want to own real estate and commodities.

You would earn:

Economic growth + a risk premium.

That is indexing.

Indexing Is Total Market Stock & Bond ETFs

From a practical standpoint, investing internationally can be difficult/expensive, and commodities and real estate can be very hard, so let’s just say you pick a total stock market ETF and a total bond market ETF and you’re done.

Any deviation from that—and you are not indexing, you are stock picking.

You may not think you are stock picking, because you are picking passively managed ETFs, but you are deviating—sometimes significantly—from total market investing.

There is a lot of this that goes on. I don’t hear many stories of financial advisors who have their clients in a total stock market ETF and a total bond market ETF only. There is a Dilbert cartoon about this phenomenon—“Those index funds don’t pick themselves, you know!”

Substituting Index Funds For Stocks

So if you really believe in indexing (which I don’t), then you have to call into question this type of behavior where an advisor picks a half dozen to a dozen narrow-based ETFs. The client would almost be better served with a dozen large-cap stocks.

It is one thing to play the style box game—it is another altogether to construct a portfolio full of very narrow, specialty ETFs and think that you are indexing.

If we’re going to index, let’s take it to its logical conclusion: Everyone invests in one fund that owns everything. But I doubt we’ll get there, because it is human nature to want to outperform. Now we’re just doing it with funds, instead of stocks.

Speculation In The Veneer Of Indexing

This discussion, of course, hasn’t even touched on the smart-beta craze, where people try to build indexes that outperform indexes.

Why don’t we just be honest with ourselves: It is human nature not to be satisfied with the certainty equivalent—even though the certainty equivalent is very good. People exhibit risk aversion when it comes to most things, except when it comes to trying to beat the market.

Now, there are valid reasons why you might want a portfolio that is not the market. Maybe you want less volatility than the market (a laudable goal). Maybe you want more income than the market provides. But that is not what many advisors are doing—there isn’t a conscious effort to build a portfolio with certain risk characteristics—it is just rank speculation.

Rank speculation is OK! Let’s just be honest about what we’re doing. Right now, we’re not being honest—we’re wrapping speculation in the veneer of indexing.I challenge any advisor reading this to put all their clients in two funds: a total stock market fund and a total bond market fund. But then, how would you add value?

Exactly.

At the time of writing, Jared Dillian held none of the securities mentioned. He can be reached at [email protected].