(PUB) Investing 2016

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Richard Thaler, the 2015 president of the American
Economic Association, says that retail investors are
best off owning index funds. Warren Buffett gives
similar advice, as does David Swensen, Yale’s chief
investment officer. Harvard professor Andre Perold
serves as a director for the bastion of indexing,
Vanguard. Yet, while advocating indexing, all four
are unquestionably active investment managers.
Thaler is a principal of Fuller & Thaler Asset Manage-
ment, which runs institutional monies in addition
to subadvising on a mutual fund. Buffett, of course,
runs Berkshire Hathaway’s BRK.B stock portfolio.
For their part, Swensen and Perold both allocate
their assets actively (Swensen for Yale’s endow-
ment fund, Perold for his advisory firm’s clients),
frequently by using actively managed funds.
Then there’s Roger Ibbotson, Yale finance professor
and founder of the company (since purchased by
Morningstar) that popularized the use of long-term
financial markets data. He runs a hedge fund. Or
Nobel laureate Myron Scholes, who co-founded the
hedge fund Long-Term Capital Management. Or
Josef Lakonishok, chief executive officer of LSV
Asset Management and Illinois finance professor.
Or Andrew Lo, at MIT and AlphaSimplex Group.
You get the idea—academic literature, MBA classes,
and the media encourage investors to index.
Meanwhile, many of the most informed, influential
researchers, the very people who have been
most associated with the boom in indexing, run
actively managed portfolios. What gives?
Temptations, Temptations
For one, there are egos. Although none of these
experts will admit it, they each believe that they
are smarter than the rest of the market’s schmoes
(and the schmo who wrote this column, and you
schmoes who are reading it). Their confidence is
understandable. They are very bright. They have had
tremendous professional success. And, for many
of them, their belief in their own abilities has been
vindicated by the investment results.
In the cases of Buffett and Swensen, the motivation
is obvious. They are paid to allocate capital. If they
can do so better through active management than by
indexing—which has indeed been the case—then
that is how they will do their jobs. For the others,
investment management is a night job—a highly
lucrative night job that pays better than a day job.
Almost Efficient
In addition to the twin temptations of ego and lucre,
the financial experts have some genuine beliefs to
support their efforts. Even avid advocates of market
efficiency, and thus of indexing, lack complete faith.
Yes, the financial markets are typically ruthlessly effi-
cient at absorbing investors’ aggregate knowledge
and incorporating those insights into stock prices,
but they have all seen strange things occur. Take
momentum—the notion that stocks that have rela-
tively outperformed during the past few months
are likely to do so over the next few months. That
seems to have been the case. Why so remains
unanswered. So, too, are the reasons for the 1987
market crash—no news during the weekend
before Monday, Oct. 19 that could possibly account
for that day’s 22% decline—or some of the stock
quotes during the technology mania of the late ‘90s
(including child companies that were owned by
a parent and being valued at more than the parent,
even as the rest of the parent was profitable and
held more cash than debt). Head scratchers don’t
often occur; most of the time, when a stock’s
price strikes an observer as being obviously wrong,
it is the observer who needs fixing, not the stock.
But they do happen often enough to give pause to
any notions of full market efficiency.
In short, it makes sense for financial experts to
recommend indexing to outsiders, and it makes
sense—psychologically, financially, and intellectu-
ally—for them to behave otherwise. The conflict
exists, but so do the reasons behind it. K
Contact John Rekenthaler at
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