July 22, 2017 1:02 a.m. ET
Jack Bogle, the legendary founder of Vanguard, has won the argument. Time and experience have demonstrated that for most investors, low-cost indexing is the most efficient way to invest. Over the past five years, indexers have outperformed the vast majority of active managers, causing even more investors to realize the now-obvious answer to the question of what they should do with their money: index.
Can this go on forever? Highly doubtful. While indexation is efficient and effective, there has never been a really good idea on Wall Street that hasn’t been taken to a foolish extreme (mortgage-backed securities, triple-levered exchange-traded funds, or smart beta). The situation is reminiscent of the old tale about the poker-game host who admonishes his friends, saying, “Let’s all play our cards carefully and maybe we can all make some money tonight.”
Just as only 10% of investors can be in the top decile, so inevitably the continuing rise in passive investing will create both winners and losers.
A MAJOR DETERMINANT of investment performance over time is cost. Thus, passive investing has been a net benefit to most investors, and it’s widely understood that index investing should reduce three major costs: the management fees that investors pay to money managers to manage their accounts; the cost of managing the individual companies that make up their portfolios; and—last but not least—taxes.
Compensation of corporate managers is another cost—substantial but less publicized—borne by shareholders. Institutional investors have been reluctant to speak up about excessive executive pay for fear of losing access to the managements of the companies whose stocks they own.
Big index investors are increasingly finding themselves in a position to affect corporate governance by demanding a connection between pay and performance. It would seem obvious to most people that money managers have a fiduciary duty to maximize the long-term value of the shares held by their clients. They certainly have a duty to prevent corporate managements from ripping off their clients.
Far less turnover means less taxes. Buy and hold is an easy concept to understand but hard to put into practice. A very successful active value investor I know constantly cautions his troops, “Do not show me how hard you are working by running through a bunch of trades.”
THE CLEAR LOSERS of the indexing argument are high-cost, poor-performing portfolio managers. The days of 2% management fees and 20% of annual profits are out the window, leaving befuddled investors moaning, “What was I thinking?”
That isn’t to say all active managers have lost. In fact, as the pendulum continues to swing in favor of indexing, it should create an enormous opportunity for stockpickers. As costs go down, the attractiveness of the stock market investment game goes up. This should lift prices of stocks in general.
So where do we go from here? What’s coming next? Indexing seems to presume that all companies are equal, and most assuredly are not. As indexing becomes even more popular, the valuation spread between great and mediocre companies will continue to narrow. This development ought to bode well for long-term stockpickers, particularly those who focus on quality.
Perversely, this is happening at a time when social commentators lament how the world is becoming more and more bifurcated between the “haves” and the “have-nots.”
I believe many investors will gradually begin to recognize and embrace a few great companies, in effect creating supercurrencies. Global, world-class, cash-generating companies will be able to use their shares to acquire anything they want, accumulating more wealth than ever before for their shareholders. (To some extent, this is similar to what Warren Buffett’s Berkshire Hathaway (ticker: BRK.A) has done with its cash.)
It is often said there is nothing new under the sun. There is certainly nothing new on Wall Street. The stockpickers’ market that I foresee resembles a rebirth of the Nifty 50 idea of the 1960s and early 1970s, where a few great companies sold at enormous valuations. “OK, fine,” you say. “Weren’t the 1960s followed by the 1970s, a terrible period for the stock market?”
Of course. Trees do not grow to the sky, and the stock market will always face cycles and volatility, but investors who minimize costs and pick decent stocks will give themselves the best possible chance to both compound and outperform over time. This has been true throughout my career, even in this world of indexation. In the next world, it will prove to be even more effective and important than ever.
SINCE INDEXING has become broadly accepted, it seems that we are closer to the end of a cycle than to the beginning. Indexing has brought great benefits, enabling investors to play in a much more attractive arena. But the lack of distinction between great and mediocre companies isn’t going to last forever, so investors who seek quality growth will be well served eventually.
As with anything on Wall Street, the odds are high that indexing, too, will be taken to extremes. But I believe that we are at the end of the beginning, not the beginning of the end. We can sit back with our index funds, leavened with quality growth stocks, and enjoy what could be a very long-lasting bull market.
FREDERICK E. “SHAD” ROWE is the founder and managing partner of Dallas-based Greenbrier Partners Capital Management.
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