Many people I encounter challenge my assertion that indexing is the only rational approach for investing by pointing to “investing geniuses” like Warren Buffett. Ironically Buffett and his mentor Benjamin Graham have recommended index investing as the best strategy for most investors.
Buffett did so once again at the annual meeting of Berkshire Hathaway as reported by cbs marketwatch:
Chairman Warren Buffett reiterated his view that for most small investors who don't have time to research individual companies, cheap index funds are the best way to invest in the stock market.
"The best way in my view is to just buy a low-cost index fund and keep buying it regularly over time, because you'll be buying into a wonderful industry, which in effect is all of American industry," Buffett told CNBC anchor Liz Claman.
"If you buy it over time, you won't buy at the bottom, but you won't buy it all at the top either," the billionaire investor said.
…"If you have 2% a year of your funds being eaten up by fees you're going to have a hard time matching an index fund in my view," Buffett said. "People ought to sit back and relax and keep accumulating over time."
Then there is the supposed controversy over exchange traded funds vs index mutual funds. In fact the debate is not over etfs vs index funds but over investor behavior. It has two main elements.
1. The first part of the “controversy” is over the active trading of mutual funds. Yes one can trade etfs throughout the trading day, but no one requires that an investor do so. The problem is that too many people go ahead and trade the etfs on a short term basis. But that has nothing to do with the etf structure. Individuals trade in and out of individual stocks and actively traded mutual funds as well. The other difference is that you can’t trade mutual funds intraday.
Buffet himself realizes this:
"I have nothing against ETFs, but I really think an index fund that just charges a few basis points for management is pretty hard to beat," Buffett said. "You put it away, you have nobody encouraging you to trade it next week or next month ... your broker isn't going to be on you."
The CBS marketwatch report correctly points out that
Numerous academic studies have shown that individual investors have a bad track record at timing stock-market moves, often because they chase recent performance to their detriment, essentially buying high and selling low.
The father of index mutual funds John Bogle has also criticized etfs as encouraging trading:
"If long-term investing was the paradigm for the classic index fund, trading ETFs can only be described as short-term speculation," he wrote. He also criticized ETFs' movement to narrower market segments and warned that brokerage commissions and taxes can ratchet up investors' overall fees when they trade ETFs a lot.
But most of the press misinterpreted Bogle’s message as well. The fault lies in the investors’ behavior not in the financial instrument:
Bogle said( in a recent wsj piece) that if they are not traded, they can often match regular index funds. "In this format, used in that way, ETFs are solid competitors to their classic forebears,".
2. The second part of the controversy is related to the mass proliferation of etfs targeted at extremely small sectors of the market. For instance there are 3 “water” etfs others devoted to medical equipment, nanotechnology, individual countries, apartment reits etc etc. Imo no one can totally fault the etf companies for trying to make a buck and marketing new financial products.
The real problem is again investor behavior. Etfs are a a great instrument for creating a portfolio diversified among major asset classes (US and International Stocks, fixed income, reits and commodities), But when investors jump in and out of small sectors of the market using etfs they are taking the loaded gun handed to them by the etf industry with its etfs targeted towards speculative sectors of the market and shooting themselves. It is no more likely that individual investors will be successful trading in and out of sectors of the market than they were trading in and out of individual stocks.
But don’t leave it to CNBC reporters to point that out to you. The other day CNBCs Erin Burnett
interviewed a very intelligent advisor who uses etfs in constructing client portfolios, holding long term positions in the etfs that represent the major asset classes. When asked about the “etf controversy” he replied that several years ago enough etfs had been created to cover the major asset classes. To which crack cnbc reporter Burnet replied
“Do you only invest in etfs of asset classes like the S+P 500 or healthcare, do you have to be that broad to make it work “
No, Ms. Burnett, as any book on investing and asset allocation will tell you, healthcare stocks are not an asset class.