Index funds and the retail investment products paradox

Written on: July, 12 2019

This note argues that a long-term return of an investment strategy is necessarily limited by the amount of effort put in by the investor. Hence a long-term return of an index fund should be driven by the level of effort put into managing it and be similar to the return of a savings account. The only three sources of premium returns for the index fund are (i) accepted short/mid-term volatility and (ii) potential advantages in tax treatment. The only way for a retail investor to improve the returns further is to put additional thoughtful effort into the capital allocation activities. There is no other way despite the promises of the retail investment product promoters.

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Let’s start by suggesting something odd. I believe index funds [1] are not a great solution for retail investors and long term will produce returns similar to best savings accounts and US Treasuries. All “smart” ETFs and similar products will face a similar fate (see (i)-(ii) caveats above).

I’ll explain my thesis in a minute. But first, we need to discuss two concepts: Risk/Reward Principle and expected return.

Let’s start with the Risk/Reward Principle. The principle states that the more return is sought, the more risk that must be undertaken. If you aim for close to 100% certainty the only choice is to open a savings account or invest in US Treasuries, and receive a lower yield. If you want a higher yield — you must embark on some risky business, such as speculation in tulip bulbs. [2] To achieve a higher return, your only option is to accept more risk — there is no other way.

However, defined this way, the Risk/Reward Principle is misleading. One indeed can achieve higher return without taking on more risk. In managing investments, there is a third variable, which we can define as “thoughtful effort” — effort one puts into managing the investments. I.e., one can buy and sell stocks without any research, just randomly picking tickers. While some effort goes into this process (clicking buttons on a computer these days), this is a zero-thoughtful-effort strategy. On the opposite end of the spectrum is an investor who has domain expertise in the industry and companies s/he is investing into.

Here is how the combined Risk/Reward/Effort principle works. (Going forward I’ll call “thoughtful effort” just “effort” for conciseness).

Case 1: If you apply a lot of effort, you can find investments that will produce higher yield with the same amount of risk. For example, by doing a lot of research, a real estate investor can find an underpriced property that will produce higher rental income yield.

Case 2: by applying a lot of effort, you can find an investment that will provide the same return, but with lower risk. As an example, a bond investor can find corporate bonds with the same yield but a much lower default risk.

Now let’s define expected return. This is the return at some future point in time multiplied by the probability of its occurrence. As an illustration, if we assume that $1 dollar invested in a saving account will produce 2 cents in gains with close to 100% probability, our expected return is roughly 2 cents. Now if we assume that $1 invested in a risky asset, say a tulip bulb, will produce $5 in gains with 0.4% probability we arrive at the same 2 cents in expected return. [3]

Let’s now look at the risk/reward/effort principle once again. What unites the two cases above (Cases 1 & 2)? In both cases, applied effort increases your expected return. Either by reducing risk or by increasing yield. We can now summarize the Risk/Reward/Effort principle as “the larger the effort applied, the higher the expected return.” We can call it “effort-return” principle.

Two notes.

  1. We should always remember that we are talking about averages. There are always outliers in both directions. Investors who got rich by applying little effort (lucky gamblers) and investors who put a lot of work and still ended up with low returns. But in the long run, these outcomes average out.
  2. The risk/reward/effort principle predicts the dynamics of the expected returns for any given amount of effort only in the long term. One can serendipitously catch a new trend early and benefit from riding it without applying any effort. But over the long term, lucrative fields tend to get overcrowded, and the trends tend to reverse themselves.

There is a corollary. There is no way you can apply little effort and still end up with a superior return long-term. It doesn’t matter if you invest in stocks, bonds, commodities, start-ups, or tulips. Your level of effort will determine your ceiling for the expected long-term return [4].

Also your expected return is defined not by the instrument, but rather by the amount of effort you put into managing the investments. [5]

So here’s a rule of thumb: If you’d like to predict a long-term expected return for an investor, don’t focus on the instruments in the portfolio but rather pay attention to how much effort the investor puts into working with the portfolio.

Now it’s time to get back to the index funds. How can one estimate the expected return here? To do so we need two things. First, we need to know the amount of effort. Second, we should find a benchmark: the expected return for that amount of effort. Let’s start with the effort. How much energy goes into managing index funds investments by most people? Very little. Is there another instrument that has a comparable amount of work applied in managing? Yes, these instruments are savings accounts, CDs, and US Treasury notes. Now according to the effort-return principle, a given amount of effort will cap the expected return regardless of the instrument. This is why we should expect returns from the index funds investments at best to be similar to those of savings accounts, CDs, and Treasury notes. [6]

There is another important point here. Since it’s not the instrument that predicts returns, but the amount of effort, any instrument with the amount of effort in managing it similar to savings accounts will produce expected returns of a savings account (or worse).

We can come up with all those “smart beta” ETFs, Sector & Industry ETFs and so on, but as long as the individual investor spends little effort managing the portfolio and picking managers, the expected long-term return will be capped at the savings account benchmark. There is no free lunch [7].

So why everyone including Warren Buffet himself is promoting index funds? They follow the lesser of the two evils approach. It is impossible to achieve brilliant investment results with the broad-based index funds (and Buffet talked only about those), but it is also impossible to make a disastrous bet on one company or one manager. Your underperformance is the price you pay to insure yourself from your ignorance.

What does it all mean for the index funds industry? Do we need the whole industry of passive investment instruments, even with the rock-bottom fees [8] when their long-term expected returns should approximate those of the US Treasuries? This is a worthy question for a different post.

But what does it mean for the individual investors, seeking to achieve expected returns higher than those of the US Treasuries? If index funds isn’t the answer, what is?

The answer is — we should follow the “efforts-return” principle. We should stop looking for the shortcuts. Stop trying to achieve superior returns while doing little work. The situation, where we spend more time on thinking about how to remodel the kitchen than on how to manage our investments is not sustainable.

The only way to get higher expected returns is to roll-up one’s sleeves and start investing thoughtfully. Since it’s not the instrument that matters, but the effort, one can find the instruments that make the most sense for them and excel at applying those. It can be real estate, art, wine, startups, public stocks or picking the money managers who are great at investing on your behalf.

Paradoxically, the instruments we should avoid are the ones that by design do not allow thoughtful effort to be applied (such as broad-based index funds). [9]

Thanks to David Weisburd for commenting on the drafts of this.

Notes:

[1] Here we are primarily concerned with the funds tracking the most broad-based indexes. Below we discuss narrow funds too. Read more about index funds at https://en.wikipedia.org/wiki/Index_fund

[2] More about this way of investing here: https://en.wikipedia.org/wiki/Tulip_mania

[3] This is a bit of oversimplification, but gets the point across. More on the “expected value” concept here: https://en.wikipedia.org/wiki/Expected_value

[4] The effort can be put in real-time or can be accumulated in a form of experience, brand, network, or any other advantage that emerges from deliberate and consistent effort over the long time. The accumulated effort often allows an investor to spend less real-time effort to achieve higher expected returns.

[5] There might be instruments that will not produce a superior result no matter the thoughtful effort. But in those cases we should make sure the effort applied is thoughtful. I.e., when one is trying to gain from predicting perfectly random events, no amount of effort will help, but can we call that effort “thoughtful”?

[6] Again, we are talking about long-term timeframes and averages for the whole investor population. Historically 10-year US treasuries yields fluctuated between 1.3% and 15.8% and most recently hovered around 2%. Savings accounts tend to trace the treasuries over time. An argument can be made that putting your money into the index funds requires somewhat more effort than savings accounts/CDs/Treasuries. Thus the expected returns should be somewhat higher. The author agrees in principle. However index funds get more and more mainstream and we have a strong push from the governments around the world to embrace public stocks as a way to build wealth over time, essentially incentivizing public to invest via tax breaks.

[7] It also applies to the actively managed funds as long as the individual investors don’t put much effort into selecting the fund managers and instead follow “the advice from the industry experts.”

[8] But still, don’t lower fees contribute to higher expected return? Generally, there is no causation. It is only valid for the index funds themselves. By design, there is not much else one can tweak to achieve a higher expected return of a given index fund, as the rest of things happens automatically and passively. So if you invest in index funds spending time on selecting the fund with the lowest fees makes sense. It is a thoughtful effort. It will produce some corresponding increase in expected returns. That said, excessive fees do come from the investor capital and thus should be watched closely in all cases. It is an important factor, but not the only one.

[9] We should avoid the “effort trap” here. One can spend a lot of time on “managing investments,” feel busy, even tired, but with little results. It happens when the effort applied isn’t thoughtful and appropriate. Think about someone who will try to fix a jet engine without any training or guidance. The chances of success are slim. In many cases activity is the enemy of success, and thoughtful effort means less activity. Like not selling your interest in a great business just because the stock price went significantly down because of some irrelevant news.

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Artem Burachenok

Builder & venture/angel investor in tech | AI, Energy, Startups, Investing | Posts include investments | https://twitter.com/Burachenok