(PUB) Investing 2016

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You Index, Me Active The Contrarian | John Rekenthaler

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 ‘ 90 s (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 john.rekenthaler@morningstar.com

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

Our Contrarian Approach I go against the grain to find overlooked funds that may be ready to rally.