15
An Invitation to Winning

Would you, like most investors, be glad to know—in advance—that your investment fund will be comfortably in the Top Quartile over the long term? Here, based on the evidence, is a sensible, confident way to get there. And it's easy!

Accepting reality is not always easy. And when acceptance would oblige giving up on a long-held set of beliefs, particularly when many others are apparently holding onto those same beliefs, accepting reality can be hard—very hard.

While Darwinian evolution enjoys extensive scientific confirmation, over 40% of Americans still profess belief in creationism. And over 40% doubt global warming. Although serious students of reality may find it hard to understand why so many resist indexing and exchange-traded funds (ETFs) or somehow believe in creationism or disbelieve in global warming, we should not be surprised. As Thomas Kuhn explained in his classic, Scientific Revolutions, change can be hard for those who have built their careers on developing the particulars of a theory to change to a new concept.

So it is with global warming skeptics who seized on major snowfalls in Washington last winter as “proof” against global warming without checking to see if the data might actually confirm rather than deny global warming. (The snow was, in fact, strong confirmation of global warming.) As biology probes ever more deeply into the way life really works, Darwinian evolution gets more and more confirmation. And so it is with indexing and ETFs. But “old school” skeptics persist.

Study after study adds to the accumulation of evidence that, with rare exceptions and very rare exceptions that could have been discovered in advance, active management costs more than it produces in value added. And no systematic studies support an alternate view. So what can we sensibly expect of the way people with strong economic or social or emotional interests in continuing to favor active management will behave?

The pattern by which innovations win acceptance is well known. The short description is simple: slowly, but inevitably. The process is one of resistance being overcome one person at a time. Resistance to innovation—or the viscosity of acceptance—differs by society: farmers were slow to accept the innovation of hybrid seed for corn; doctors were less slow to accept new kinds of pharmaceuticals; and teenage girls are quick to take up the new, new anything.

Two groups are key players in the diffusion of innovation:

• Innovators are always trying new things: Their experiments often fail, but they delight in the newness and little mind the failures because they do not overinvest in their experiments and they don't take it personally if the new thing fails.
• Influentials are widely respected for their ability to pick new ways with high rates of success and almost never fail. That's why many, many people watch what they do and follow them with confidence. Interestingly, Influentials monitor Innovators closely, and when they see an experiment succeed with Investors, they will then try it too. Because the Influentials only try what has worked for the Innovators, their success rates are very high. And this explains why so many others will follow them and why they are Influentials.

Use of ETFs and indexing are—albeit at a remarkably slow pace—moving up the familiar curve of innovation and are doing so at a slowly accelerating rate. Why? Because more and more investors are realizing that ETFs and indexing have been more successful—after fees and after adjusting for risk—than active management.

Is this a slam on active managers? No! Certainly not! In fact, it is only because active managers are so talented, hard-working, and well-armed with databases, computers, Bloomberg terminals, CFAs, and other advances, and so clearly dominate stock market activity.

Fifty years ago, professional investors' trading was less than 10% of the market; today, professional trading is well over 95% and derivatives are even larger in value traded and are 100% professional. (And trading volume is over 2,000 times greater.)

In reality, the supreme compliment to active management is ironic: Only because so many are so good is their market—while certainly not “perfect”—so efficient due to so much talent working so hard and so skillfully to get it right that almost no active managers are able to do better than the expert consensus—particularly after fees and costs of opportunities. Active manager fees may be 1% of assets, but they are about 15% of returns and over 100% of incremental returns when restated as incremental fees as a percent of incremental returns over the widely available indexing alternative. Increasingly, the unhappy results of active management are causing clients to have serious questions about the cost:benefit value of active investment management.

Given the persistent accumulation of evidence, there should be no wonder that individuals and institutions now using ETFs and indexing are steadily increasing their allocations. The real wonder is why the two rates of increase are not even greater.

As all grandparents and most parents know—and as most grandchildren will come to know—the real test of a good driver is simple: No serious accidents. And as all flyers know, safe, dull—even boring—is the essence of a good flight. The secret to success in investing is not in beating the market any more than success in driving is going 20 MPH over the posted speed limit. Success in driving starts with being on the right road. And success in investing comes from having clearly defined objectives and the right asset mix and staying with it.

ETFs and indexing make it easier for investors to focus on what really matters: setting the right goals on risk, designing the portfolio most likely to achieve sensible objectives, rebalancing as appropriate, and staying the course. Indexing and ETFs simplify implementation (while improving results versus active management) freeing the investor to focus on the really important work of getting it right on investment policy. That's why ETFs and indexing are increasingly important for individuals and institutions that are correctly interested in winning the Winner's Game and not losing the Loser's Game.