In the spirit of modern day discourse, I wish it to be known that so-called passive investing – the use of index funds and/or ETFs – as a long-term investment strategy is not just less than optimal, it is morally irreprehensible and frankly the root of all evil in the universe.

Okay, maybe that is a little over the top. (I have been told I should jazz up my writing style in order to keep up with the edgy blogosphere.) However, it is my position that “passive index investing” as a long-term strategy is not just a poor way to invest, but is actually wrong. A note of caution: I am not saying ETFs and index funds do not have some uses. We often use them to gain exposure to the markets while looking for better long-term opportunities, but they should not be the core of any long-term strategy.

There are a lot of very smart people who disagree with this position, so I don’t make this argument lightly. They will claim that active investment managers don’t beat the index, and even if a few do, they cannot be identified ahead of time. I will argue that they are wrong about that, but even if they were not, indexing is still wrong. Indexing is wrong because of how it distorts the free flow of capital in the market, and the way the concept is abused in actual practice makes this distortion even worse.

Before we get to that, let’s address the usual arguments for indexing. Argument 1: The average active investment manager never beats the market. This is absolutely true; you get no argument from me. It is also true that the average college basketball coach never gets to coach in a Final Four game, let alone win a championship. I have not seen a study, but I would wager a guess that the average college basketball coach will end his career with a losing record. It doesn’t have to stop there. The average touring golf pro never wins a tournament, let alone a major. I could fill a book of examples where average isn’t very good.

Fortunately for basketball fans, John Wooden wasn’t average, neither were Adolph Rupp, Dean Smith or (as much as it pains me to admit) Mike Krzyzewski. Arnold Palmer, Jack Nicklaus, Phil Mickelson and yes, the philandering Tiger Woods, aren’t exactly average either. Talent exists. It exists in every human endeavor, so why in the world would anyone believe that the management of investment portfolios is any different.

Of course this leads us to the next big argument. Argument 2: You cannot pick a winning manager by using past performance. Again, true, you get no argument from me. However, contrary to what most believe, this is not the same as saying you can’t pick a winning manager. John Wooden defined success as “peace of mind which is a direct result of self-satisfaction in knowing you made the effort to become the best which you are capable.” John Wooden led the UCLA Bruins to ten NCAA championships, seven in a row. But winning championships was not his definition of success; it was a byproduct of his definition of success. In my experience this is true for just about every truly successful person I have ever known or known about, including consistently successful investment managers.

In the investment world it is about process, process, process. Investment managers form a process that is intellectually sound and consistent, and they are always trying to improve upon it. Results are a byproduct; it is the process they want to talk about. By focusing on the process ourselves, we have consistently been able to identify superior managers, as well as beat the market. (For more on process leading to long term out-performance I recommend reading “The Superinvestors of Graham and Doddsville,” an essay by Warren Buffett, which can be found on-line at no cost.)

So the two big arguments for passive index investing do not hold up. However, even if they did, indexing is still wrong because of what it does to the market. This goes to the very purpose of capitalism and free financial markets. The free market exists for the purpose of allocating capital throughout society. The marketplace allows investors to sell stock in a company whose future no longer seems bright – at least to that investor – and to purchase stock in another company that has a brighter future. In other words, the market allocates capital to its best possible use, maximizing the growth of the whole economy. The market’s ability to do this has been questioned over the last few years, largely because of the misunderstanding of risk that led to distortions, but also because too many investors are no longer actively seeking to allocate their money across what they really believe are the best companies. Too many are passively investing in index products that place the most capital where the most capital already exists, instead of where it needs to be going. In other words, companies are rewarded with fresh capital not because they are deserving but because they are big and already in the index.

To use the language of the anti-market people, the rich get richer. This is the byproduct of widespread use of passive index investment instruments. This is how we get Enron, WorldCom, Tyco, Lehman Brothers, etc. Sure, I know active managers that may have been fooled by one or two of these bad stories, but the only fund I know that had them all is the index fund. Passive investing is also a mindset that impacts things like how proxies are voted. If one is passively investing in an index, then he probably does not care what the CEO of one of the 500 companies whose stock he indirectly owns is getting paid. The passive attitude of too many shareholders has allowed many of the scandals of the last decade to occur, and I personally believe the concept of passive index investing has played a big part in that.

There is another major flaw in the index investing theory: it cannot actually be done. The index is not real. Read the index disclaimer sometime, it often says so right there. One cannot invest in the index. The index itself is a collection of securities, usually chosen by a committee or a formula, whose prices are tracked and combined to produce a proxy for the market’s return. There are no transaction costs in the actual index, and the real world does not work that way. Index products have relatively low price tags, but there is no such thing as free investing.

Index funds have costs, and those costs are higher than most people realize. If you purchase an index mutual fund you will pay a management fee. Your returns also will be net of internal transaction costs. The index fund seeks to mimic the returns of the actual index, usually by purchasing all the securities in the index. Let’s use the most popular S&P 500 as our example. The fund goes out and purchases the stocks of the 500 companies in the S&P 500 index in proper proportion. Index funds use sophisticated trading strategies to minimize this cost, but it is still there.

If, instead of a mutual fund you decide to purchase an ETF, the ride gets even better. ETFs have commissions and dealer spreads associated with them, so they are more expensive to purchase and they compensate with lower management fees. Because they can be traded during the day, they also have the disadvantage of not always selling at NAV (the market value of the actual stocks owned by the ETF). In a rising market the typical S&P 500 ETF will sell at a premium, because there are more buyers than sellers. When the market heads south, it sells at a discount, and this time there are more sellers than buyers. Investors lose in both directions.

A few years ago one of our newer analysts suggested we should place all the index options in our institutional clients’ plans on the watch list. Her reason was that they all had a reverse upside, downside capture. Yet index funds and ETFs will always underperform their index. They will go up less in up markets, and they will go down more in down markets. We typically do not like managers with that kind of record, but our analyst did not realize that all index funds will always do this.

Let me say this again, because it is worth repeating: the next time some index-hugger tells you whatever percentage of active managers don’t beat the index (over the last ten years, it is about 40%, but the index believer is likely to exaggerate), remind him that 100% of all index funds and ETFs never beat their indexes. The index investor is settling for known failure.

Indexing also impacts many “active” managers. I once had a portfolio manager in my conference room talk for twenty minutes about all the reasons he did not like Exxon as an investment. It’s not relevant to the story whether he was correct; what does matter is that Exxon was in his top five holdings. I asked him about that, and his response was that it was the largest holding in the index to which he was benchmarked. To him this was a significant underweight. This manager was not trying to deliver adequate returns to his clients, he was trying to protect his job by never being too far off from the index.

In the institutional world many managers talk about risk as being tracking error, or the amount their portfolios differ from the index. To me this is one of the more hideous evils of indexing, and consequently why so many “active” managers fail to beat their indexes. One cannot beat the index by looking like the index. If one’s goal is to not stray too far from their benchmark, instead of being the best he can be, then one shouldn’t be surprised when they fail both to beat the index and to be the best they could be.

The last major problem with index investing in practice is that there is no such thing as an intellectually consistent methodology for passive investing. Almost all passive index investors have been sold by someone who claims to be a superior asset allocator. In other words, they use passive index instruments as tools to make active asset allocation decisions. According to the “Crosscurrents” newsletter, the average holding period for U.S. stocks has gone from two years in the 1980s to just 2.8 months today. There are several reasons for this but among the top three is the explosion of ETFs. A large contingent of so-called passive investors are using these instruments to be more active than anyone would have even dreamed possible 20 years ago, and they are contributing to the massive volatility of the market in the process.

Worse yet, many have been convinced that passive is the way to go for “traditional” investments, but “alternative” investments are different, warranting huge hedge fund fund-of-fund management fees. Stay tuned until next quarter’s newsletter for that discussion.

In the meantime, know what you own and own it deliberately. Life is too important and too short to go through passively. We need the free flow of capital in our society to bring back growth and prosperity. We need capital to go to those who are deserving, not to those who just happen to be in an index. We need shareholders once again to act like owners.

Charles E. Osborne, CFA, Managing Director