Index over Active Management Still Requires Discipline

The inevitable periods of underperformance often suffered by active managers—coupled with their relatively high fees—make index investing a more attractive option for many investors. This according to a recent Globe and Mail article by Validea CEO John Reese.

Reese writes, “By Mr. Buffett’s reckoning, investors have lost out on $100 billion in fees and underperformance over the years.” The movement to index investing, he argues, is “up-ending the asset management industry.” Still, according to Reese, investors should exercise discipline when choosing index funds, as such funds can also suffer long periods of low returns.

Investors can find good active managers, the article contends, but they are often hindered by their tendency to look at only 3-5 years’ worth of performance. Instead, Reese says, they should evaluate process over performance. He outlines the following pertinent questions to address:

  • Do you understand the investment process, and does it make sense to you?
  • Is the manager exploiting some type of market inefficiency?
  • What is the manager’s long-term (at least 15-year) track record?
  • Is the investment and decision process consistent, repeatable and can the manager explain why he/she bought or sold a stock?
  • Are the fees reasonable?
  • In what types of environment(s) did the manager underperform?

Reese cites the investment strategy of guru James O’Shaughnessy, which underscores the danger in emotional investing. Even in index funds, argues O’Shaughnessy, many investors will make the mistake of panicking and selling when the market falls.