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Abstract

why it’s becoming increasingly difficult for any investment manager to outperform the market.Put simply, there are too many skilled investors in the market today.The bulk of stocks are owned by institutional investors, think Vanguard, BlackRock, pension funds, and endowments.These institutions hire brilliant people to manage their portfolios. This means that Anytime a stock is bought or sold, there is a good chance that the person on either side of that trade is highly skilled.Remember, when you buy a stock, it means someone else was selling it.They are selling it because they have the opposite prediction about where the price of that stock is going. You are buying because you think the price is going up, and the other person is selling because they believe the price is going down.If the bulk of the stock market involved trades between amateurs, it would be much easier for skilled investment managers to find inefficiencies and generate alpha.But when the Harvard endowment investment manager chooses to sell a stock to a hedge fund manager, these two managers are more equally matched. This means the more trades between skilled managers, the more even the split will be between who wins those trades.As more and more money assets are controlled by large institutional investors who hire the most brilliant managers, there is paradoxically less chance that these bril

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liant managers can generate alpha because they are squaring off against equally brilliant managers.To be fair, this study was completed before the rise of Robinhood and the meme stock craze, so there is probably more “dumb money” for professional investors to take advantage of in the past few years.But I haven’t seen any data to indicate that active investors are performing any better than they have in the past. The fact is, the meme stock investors control a drop of water in the ocean that is the stock market.Either way, the best you can reasonably expect from most active funds is to earn the average market return — before fees.This leads us to the obvious conclusion that the most important investment factor in our control is investment fees.Which is the real super-power of index funds; by their very nature, they will always have lower fees than active investment funds.<h2 id="b3c7">Calling Financial Bull $hit</h2>Each week I publish a new article reviewing popular financial advice and comparing it to the evidence to determine if it’s legit advice or a financial bull$ hit.<h2 id="d4e4">Subscribe to my Substack to read more</h2>This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.</article></body>

A Counterintuitive Reason Index Funds Outperform Professional Stock Pickers

There are too many good investors to compete against

Over the past 15 years, 93.4% of comparable actively managed investment funds have underperformed the S&P 500.

Even the skeptics of passive index investing must admit that is an overwhelming number. If you are a long-term investor and your goal is to maximize your investment returns net of taxes and fees — Index funds are the rational choice.

There are many explanations for why index funds are so effective — In fact, I wrote an entire book about it — But here is one explanation you may find surprising:

“There are too many smart investment managers in the market today, which means there aren’t enough bad managers to take advantage of.”

The crowding out of skilled active managers

A 2014 paper published in the Journal of Financial Economics explains in simple terms why it’s becoming increasingly difficult for any investment manager to outperform the market.

Put simply, there are too many skilled investors in the market today.

The bulk of stocks are owned by institutional investors, think Vanguard, BlackRock, pension funds, and endowments.

These institutions hire brilliant people to manage their portfolios. This means that Anytime a stock is bought or sold, there is a good chance that the person on either side of that trade is highly skilled.

Remember, when you buy a stock, it means someone else was selling it.

They are selling it because they have the opposite prediction about where the price of that stock is going. You are buying because you think the price is going up, and the other person is selling because they believe the price is going down.

If the bulk of the stock market involved trades between amateurs, it would be much easier for skilled investment managers to find inefficiencies and generate alpha.

But when the Harvard endowment investment manager chooses to sell a stock to a hedge fund manager, these two managers are more equally matched. This means the more trades between skilled managers, the more even the split will be between who wins those trades.

As more and more money assets are controlled by large institutional investors who hire the most brilliant managers, there is paradoxically less chance that these brilliant managers can generate alpha because they are squaring off against equally brilliant managers.

To be fair, this study was completed before the rise of Robinhood and the meme stock craze, so there is probably more “dumb money” for professional investors to take advantage of in the past few years.

But I haven’t seen any data to indicate that active investors are performing any better than they have in the past. The fact is, the meme stock investors control a drop of water in the ocean that is the stock market.

Either way, the best you can reasonably expect from most active funds is to earn the average market return — before fees.

This leads us to the obvious conclusion that the most important investment factor in our control is investment fees.

Which is the real super-power of index funds; by their very nature, they will always have lower fees than active investment funds.

Calling Financial Bull$hit

Each week I publish a new article reviewing popular financial advice and comparing it to the evidence to determine if it’s legit advice or a financial bull$hit.

Subscribe to my Substack to read more

This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.