A Case for Indexing – The Quest for Alpha

The active versus passive investing debate has been raging for decades, and author Larry Swedroe is certainly not shy about what side of the argument he defends.  In his book, The Quest for Alpha, Swedroe likens the Holy Grail of Christian mythology to alpha in financial management – the ability of money managers to deliver returns above their appropriate risk-adjusted benchmark.  Swedroe goes on to explain how stock selection and market timing combine forces to form an art of active financial management and how this artwork, for the most part, is far too risky for individual investors.  This is because any effort to exploit the market for a mispriced stock is a futile exercise.   The market knows more than any individual investor will ever know on their own.  The Quest for Alpha goes on to provide numerous examples to support this claim:

  • A study by Marlena Lee of Dimensional Fund Advisors about the performance of over 2,300 bond funds from 1991-2008 revealed:
  • “Actively managed bond funds underperformed by an amount roughly equal to fees.”
  • “Collectively, investors in active bond funds lose about 90 basis points per year, or about $1.4 billion in 2008, in underperformance.”
  • Successful streaks associated with great, active money management occur much longer than folks would typically believe, but these “hot hands” eventually get very cold:  “For each of the 11 years 1974-1984, the Lindner Large-Cap Fund outperformed the S&P 500 Index.  However, over the next 18 years, the S&P 500 Index returned 12.6 percent per annum.   Believers in past performance as a prologue to future performance were awarded for their faith in the Fund…returns of just 4.1 percent, an underperformance of 8.5 percent per year for 18 years.”
  • “By the end of 2005, Bill Miller’s streak of outperforming the S&P 500 Index had reached 15 years.  Unfortunately for investors, that steak was broken in 2006 when the fund underperformed the S&P 500 Index by about 10 percent.”  The book goes on to describe Miller’s underperformance in subsequent years:  2007 down by 12%; 2008 down by 18%.

Clearly in The Quest for Alpha, Swedroe defends passive money management.  He also uses colleagues, industry experts and admissions from the financial industry to drive his point home:

  • David F. Swensen who has been the chief investment officer of the Yale Endowment Fund since 1985, had this to say about mutual fund fees and performance:  “Overwhelmingly, mutual funds extract enormous sums from investors in exchange for providing a shocking disservice.  That is, mutual funds charge their investors big fees and usually fail to deliver returns that beat the market.”
  • Warren Buffett (no explanation necessary) in his 1993 Annual Report:  “By periodically investing in an index fund the know-nothing investor can actually outperform most investment professionals.”
  • John Rekenthaler, the VP of research and product development at Morningstar, about identifying alpha:  “We should have more answers.”  “To be fair, I don’t think that you’d want to pay much attention to Morningstar’s star rating either.”  This quote is quite the admission.

Swedroe goes on to discuss pension plans, and how they are slowly moving towards indexing equity assets.  He also leverages wisdom from Nobel Prize winners who state “I make my money writing about the market, not participating in it.”

All of Swedroe’s writing is very compelling and makes for an interesting read for those who have ever questioned passive investing as a viable investment strategy.  I’m personally convinced after fees, transaction costs, not to mention the laws of survivorship, even the most determined mutual fund picker over the long-term has no hope of alpha – they will never escape the inevitability of loses when compared to their benchmark index.

However, what had me a bit perplexed in Larry’s book was the minimal evidence of direct stock ownership, and long-term ownership at that, and its success rate over active fund management.  Surely owning many blue-chip stocks directly for 30 years would have been more profitable than owning most mutual funds?  I get that smart people makes mistakes.  I also get most investors do not learn from their investing blunders and fail to see their investing bias.  My point being, I read little in Swedroe’s book that alarmed me enough to immediately halt the other part of my retirement strategy, dividend investing.   Swedroe highlights two very important factors throughout his book when it comes to losing the market-game:  trading costs and taxes.   What if I owned a few stocks whereby I could reinvest dividends that didn’t cost me a dime to do so?  What if I owned these stocks in my Tax-Free Savings Account (TFSA) to avoid any tax on dividends paid or reinvested?  What if owning these stocks, I received a (Canadian dividend) tax-credit for owning them even if they were not held in my TFSA or RRSP?   Larry has a point, fees and taxes are a burden when it comes to active investing but this doesn’t mean companies that have paid shareholders for generations need to be discredited.

I liked Swedroe’s book.  He reinforced many existing investing concepts and threw some new ones at me as well.  His book was well written, full of examples and provided readers with some excellent ingredients to make a sound portfolio.  However, in closing, I’m not sure if I need to have an all-indexed investment approach just yet.  Swedroe told me “prudent investors don’t take more risk than they have the ability, willingness or need to take.”  For now, I’m not.

Have you read Larry Swedroe’s The Quest for Alpha book yet?  If so, what are your thoughts on it?

42 Responses to "A Case for Indexing – The Quest for Alpha"

  1. Mark
    Glad you found comments helpful

    I would be very careful about the belief that 50 stocks is enough to have reliable cash flow. That type thinking is what is called Triumph of the Optimists, meaning it relies on recent data and/or one data set. Think about what would have happened if you relied on that approach using dividend paying stocks instead of safe bonds and it was the Great Depression. Dividends were cut sharply, and stock prices fell as much as 90%. And think Japan for last 25 years, if you had lived there. There is nothing that says this cannot happen here or wherever one lives. A common mistake is treating the unlikely as impossible, and the likely as if it’s certain. Since most DGI investors or dividend investors in general limit the holders to their domestic economy that fails to benefit of the one free lunch in investing, diversification which reduces risk without lowering expected returns.

    Hope that helps

    1. The experience in Japan shouldn’t necessarily happen in North America for 25 years, but never say never. Your point is a great one when it comes to diversification, taking that “free lunch” as much as you can.

      I will likely index invest more, I’m already starting to do that but I won’t be stopping the dividend reinvestment plans (DRIPs) for my stocks anytime soon.

      Your comments are always welcome and appreciated on this site Larry.

  2. Mark
    Like I said, a there are far worse strategies than a DGI approach, but there are also superior ones. Owning individual stocks, even 50, just isn’t enough diversification,.While 50 stocks is about enough for LARGE caps, it isn’t anywhere near enough for adding small and value stocks and other asset classes like REITs if you want more diversification across asset classes. And then you have international. No real way to do that without mutual funds in efficient manner. Which is why we use them. Just imagine a Japanese investor who bought 50 DGI stocks in 1990 in the leading country in the world at the time. Think how they did. For a strategy to make sense it should work anywhere because we don’t know what the future holds.
    Also dividends I would note are less tax efficient, paying taxes on the full amount, while if use a total return approach and even have to sell some assets to create your cash flow the tax is due only on the gain, not the full amount.
    And note DGI returns are well explained by factor models, as theory predicts, so no benefit from concentrating your risk on relatively small number of stocks.

    The only benefit of dividend strategies/cash flow approach IMO is that there might be psychological benefit to some in bear markets. But education can overcome psychological errors. I know we have been successful now for 20 years, through two major bear markets in keeping investors disciplined without the benefit of a cash flow approach

    Hope that is helpful

    1. I think where we agree Larry, is total return is the best return. This comes with indexing and keeping your trading costs dirt-low and money management fees as cheap as possible while getting the most diversification available.

      50 stocks for a total return approach is not enough diversification but it is good enough for some dependable cash flow; which is part of my investment strategy. I do hold REITs as well.

      I do intend to index more, I’m all but done buying a number of new companies that exist in Canada for my portfolio but it will be interesting to see how I can stick to this. I suppose there is something very much psychological about the dividends coming in, at a higher yield than VTI for example, being reinvested in my account for new purchases. I suppose this is a behavioural bias.

      I do intend to sell some of my indexed products for living expenses in another 15 years, which are in tax-deferred accounts, I just hope the indexed returns over that time are favourable. Time will tell.

      Thanks for your detailed and thoughtful comments Larry. I enjoy your books and I’m about to read the next one: Think, Act, and Invest like Warren Buffett.

  3. Amman
    I think you overstate the case “against” Rick Ferri.
    Just because one doesn’t index everything, doesn’t mean one uses or believes in active management. In fact, my firm doesn’t use ANY index funds yet we use only passively managed/structured funds run by such firms as DFA, Bridgeway and AQR. And for bonds we build individual bond ladders and don’t try to time interest rate movements either.
    Well structured passively managed or engineered portfolios take the benefits of indexing (low cost, relatively low turnover, broad diversification within the asset class, relative tax efficiency) and maximize them and take the negatives (such as forced turnover, realization of ST gains, transparent trading that can be exploited, etc.) and minimize or eliminate them.
    Best wishes

    1. Passive investing is effective when simplicity is maximized and human emotion is minimized. Unfortunately as humans, we’re wired to “tweak” things and a lot of the time can’t get out of our own way either by straying from the financial plan or piling on methodologies that can give us analysis paralysis. It’s a tough battle especially for those embarking on a Do-It-Yourself journey and in a world where information is a tweet away. Given these dynamics, it becomes even more critical as investors to question, and scrutinize those who are challenging these tenants. When I see/hear people in positions of influence preaching one discipline (simplicity) and practicing another (complexity), I need to call it and with the work I do with individual investors to identify and filter out the noise/complexity, I hope more will be empowered to do so. If you and your firm can keep investors focussed and disciplined on these core pillars of passive investing then more power to you sir.


      1. Aman, I agree there is a great benefit and beauty in simplicity. With the new All world ex Canada ETF (VXC), adding VCN for Canada and VAB for bonds, you can now have a simple, low cost, globally diversified portfolio that essentially covers all the bases.

  4. There are many people out there who are pounding the table that passive investing is the sole path to investment success. One such person is Mr. Rick Ferri, who is a champion of passive investing, penning such books as The Power of Passive Investing: More Wealth with Less Work, which (from his web site) claims that “Attempting to earn above-market returns with a portfolio of actively managed funds is both a waste of time and money. A well-designed, passive investment approach that utilizes index funds and ETFs has the highest probability of meeting your financial goals and is the most prudent choice for your money. The Power of Passive Investing will show you why this is true as well as how this approach can work for you.”

    Mr. Ferri has also posted numerous blogs (http://www.rickferri.com/blog/), again pounding the table about the virtues of passive investing. Here’s a few below:

    Busting The Stock Picker’s Market Myth
    Watching The Market Is Not Investing
    3-to-1 Odds Favor Index Investors
    Beat the S&P 500 with the S&P 500
    Too Much Indexing Is Not A Bad Thing
    Coin Flipping Outdoes Active Fund Managers
    Another Reason To Buy Index Funds

    Just recently Mr. Ferri penned a blog entitled, “Confessions of an Index Investor” http://www.etf.com/sections/index-investor-corner/22803-ferri-confessions-of-an-index-investor.html where he admits that, “The problem with being “The Indexer” is that I don’t invest in all index funds. Truth be told, my portfolio is a combination of funds that follow indexes, quantitative funds that don’t follow indexes and actively managed funds. I don’t even consider following an index as being paramount in portfolio management as long as you’re capturing the risk premiums you’re seeking in a low-cost and efficient manner.”

    Mr. Ferri’s goes on to comment that in order to be successful, one needs to undertake essentially:
    • Fundamental analysis
    • Determine risk analysis and assess value premiums that maybe a handful of people can understand
    • It really is about outperforming the market.

    Isn’t the whole beauty of index/passive investing is to just gain exposure to a set of securities at a low price and earning a market rate of return or close to a similar return without worrying about the day-to-day neuroticism of market volatility? Sounds like index investing is more complicated than what it has been marketed to be. What is the average investor to make of this?

    With the proliferation of ETF based products that are being marketed as a low maintenance/low-cost/turn-key solution, I worry that they appear to be evolving away from its puritan origins. The new generation of ETF products have a more active management component while some are constructed to make illiquid assets more liquid via use of derivatives, which is another discussion in itself. I would say they are becoming more like closet mutual funds and we know how they have performed. Unless you read prospectuses to look for the fine print, one wouldn’t understand or be aware of the nuances of how these products, which have been marketed as passive portfolios are constructed and are traded. How many investors are going to do that?

    To me, there is no single product that will be the Holy Grail for gaining super-sized investment returns. Active and pure passive investing have a place, however what is constant is undertaking the appropriate due diligence in evaluating investments and to me this applies even more so now with ETF’s. It is also just as important to understand and be aware of where the message is coming from and their agenda is about. Mr. Ferri has profited from selling average investors about passive investing yet as he as admitted, he doesn’t practice it 100 percent. I spend just as much time teaching people about understanding the players and psychology of investing as teaching people how to analyze and interpret financial statements and ratios. While I appreciate Mr. Ferri coming clean about his true ideology, the fact he has sold books to hard working people about the virtues of an investment strategy he doesn’t fully practice, strikes me as a disservice to average investors who are having a hard enough time figuring this whole investing thing out.

    I strongly believe that whatever investment decisions and whatever products you chose to take, you need to be mindful that those securities, specifically index funds and stock ETF’s consist of companies that have people behind them. These companies are run and created by people who are trying to sell products and services that they think society will want and your decision making will revolve understanding and analyzing how successful and effective they will be in managing scarce capital to earn returns on that capital that are greater than the cost to obtain that capital.


    1. Heckuva comment Aman! Where do I begin?

      I’m aware of Rick Ferri’s advocacy of indexing, and he makes some great points about the virtues of this approach.

      I would disagree investors need to know those details to be a successful indexer…it shouldn’t be complicated whatsoever! ETFs products and using them should be all the things you wrote about: low maintenance/low-cost/a turn-key solution.

      I actually wrote about how some ETFs seem like mutual funds to me:

      For me as well, there is no Holy Grail for investing, which I guess is partly why I have a two-pronged approach – investing in stocks that only pay dividends and indexing. This way, I get the benefits of both worlds.

      The fact that Rick Ferri doesn’t practice indexing 100% is rather disappointing. I prefer cooks that always eat their own cooking 🙂

      1. I guess I’m a bit old school that passive investing should be well…passive! Simplicity is at it’s core, but I lament that the marketing departments in these financial companies are now clouding the waters of ETF’s/index funds with products that are more actively managed but are presented as passive products. As someone who’s worked in the fund industry, it’s all about assets under management and not about performance, so I worry many people who don’t know what the difference is, could get stuck with under performing, higher cost investment products. That’s why the work you do is important to give people the perspective to enable them to make a better investment decision.


        1. Old school is just fine Aman. I personally don’t like the tricked-up ETFs, the inversed products and the like. I don’t see any reason for them other than to make money off people. I avoid those products personally.

          Marketing will always do what it needs to do, which is entice people to buy stuff they don’t need. It’s the consumer that must beware, buyer must always beware. The problem is, you don’t know what you don’t know and the financial industry is the best marketing machine in action there is.

          Thanks for the kind words about the site and I appreciate your insight.

  5. Mark
    A common mistake investors make is to take a cash flow approach to investing. IMO the best approach is to use a total return approach. First, you aren’t going to live forever. As extreme example, ask yourself why a 95 year old should limit their withdrawals to interest and dividends, say 3% of the portfolio, or something like that?
    A cash flow approach also leads people to take on more risk, inappropriately, whenever interest rates, div yields are low, they extend term risk, they take credit risk or buy dividend paying stocks instead of safe bonds.



    1. Hey Larry,

      Great to hear from you again, I appreciate the time you take to read my articles and comments, including those from readers.

      So potentially I do have a bias then – I am using about 50% of my portfolio to spin off cash/income from dividend stocks and the other 50% for index investing, using products in Canada like XIU and from the U.S., like VTI. The former is for cash flow/income so I don’t have to touch the capital. The latter is a total return approach where I must withdraw the capital at some point.

      I’m hoping for an early retirement which means I’ll need to replace my working income in my late-40s and early 50s. Given some income is required in 10-15 years, do you believe I should avoid taking on some equity risk in this 50 dividend stock/50 ETF approach of mine? I’m hesitant to invest in bonds or bond ETFs anymore since I believe they will not provide any inflation protection going-forward and may not again for years to come.


      I would be interested to know and see if you wish to write about my perspective, in support or to challenge it in any of your MarketWatch articles – articles I enjoy. If you’ve written about such an approach already I would be interested to read that as well.

      I did read this one:

      Thanks Larry,

  6. Mark, I’ve read “The Quest for Alpha”. It’s an excellent read. Chapter 5, “The individual Investor – the evidence” shows the evidence that individuals picking stocks underperform the market as well.This means dividend stocks, too. DGI investing is not a bad strategy, and people do well with it, but the evidence shows you are better off with index investing. I’ve also read all of Larry’s articles mentioned above, which present more very interesting evidence.

    1. Thanks for the comment Grant. You sound like a few buddies of mine in Ottawa, and Preet Banerjee, who says I should index more. I probably will actually. The evidence (and success) of this approach is overwhelming. The thing is though, I’m planning on retiring early so I need cash flow. Do you think I can get cash flow from broad market indexed products? Thoughts?

      I need to read the rest of the links Larry sent me.

  7. Hi: I checked the Vanguard web site and there’s no actual performance data for VXC. Here’s the info: •Inception date: 30-06-2014, •Benchmark: FTSE All-World ex Canada Index, •Net assets: $2.5 million. At this stage it’s a very tiny asset base. Would this not be a concern to invest in this, compared to one of the peer/comparable etfs?

    1. Not too much of a concern Helen, for some investors, but I share your hesitation. I’m the same with new ETFs, I don’t jump right in. VXC seems to be a good product. You basically get all your equity exposure around the world with 2 Vanguard ETFs: VCE or VCN and VXC.

  8. Hi Mark, I’m with you – when it comes to mutual funds/ETFs – the evidence is clear that a passive investing approach is superior to an active approach. Fees alone make the difference. Why hold TD’s dividend fund at 2.03% MER when you can hold something like CDZ at 0.66%? Look at the performance of each fund and it’s clear that fees matter.

    Things are less clear when talking about individual stock portfolios. I believe you can build a portfolio of dividend growth stocks that can equal or outperform the index. However, the amount of work that goes into building, researching, and maintaining that portfolio may not be worth the extra percentage.

    That’s why, as ETFs like VXC are introduced, I’m leaning more and more toward a two-or-three fund portfolio just to keep things simple.

    1. “Why hold TD’s dividend fund at 2.03% MER when you can hold something like CDZ at 0.66%?”

      Exactly. Even then, with CDZ, there are better ETFs based on their methodologies. Fees kill portfolios, there is no more convincing needed just that many Canadians don’t really know how badly and by how much.

      I believe my portfolio of dividend growth stocks is just as good as the benchmark index it tracks (XIU). I own >20 of the 60 companies within XIU, so I pretty much have my own index. I don’t have any desire to buy more/new companies at this time. The rest of my portfolio outside these CDN and some US stocks in my RRSP I will index and probably always will.

      For me there is very little research that goes into buying and holding the companies I own. Most of the companies I own have paid dividends for 40+ years so I’m betting this is not going to stop anytime soon.

      VXC looks like an interesting product. Ex-Canada right? This might make a good fit for my RRSP or TFSA.

      Do you think most Canadian investors (say 99% of them) could get away with a 3-fund portfolio now Robb:

      XIC or VCN + VXC + CDN bond ETF? or GIC-ladder?


      1. Hey Mark, I think most investors (99%) could do better with a portfolio of e-Series funds (three or four), and for the more sophisticated DIYers out there, a portfolio with a Canadian equity index fund plus the Vanguard All World ex-Canada fund (give or take a bond fund).

        1. Robb,

          Most investors do not want to be DIY investors. They either don’t understand or want to understand investment strategies. Those in that boat could do better with an TD e-Series portfolio of mutual funds. They could do even better by 1-2%, based on long term performance numbers, with a one stop low fee fund – “Mawer Balanced Fund – A”.


Post Comment