What would you say if I told you that everyday investors, people like you and me, are just throwing away billions and billions of dollars?
Kenneth FRENCH: It’s not something that just started today. It’s been going on for the last 20 or 30 years.
Is it some kind of a tax?
Barry RITHOLTZ: It’s a tax on smart people who don’t realize their propensity for doing stupid things.
Just how stupid is this stupid thing?
Eugene FAMA: Basically, we were saying, “You’re charging people for stuff you can’t deliver.”
But in recent years, there has been a backlash. Some would even say it’s become a revolution.
John BOGLE: It’s definitely a revolution.
RITHOLTZ: We are in the middle of the Copernican Revolution about the proper way to invest or at least the rational way to invest.
Today on Freakonomics Radio: the revolution in low-cost index investing — also known as Wall Street’s worst nightmare.
RITHOLTZ: There’s too much B.S. on Wall Street.
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It’s hard to think of any other realm where empiricism — or at least what’s dressed up to look like empiricism — clashes so directly with delusion. I’m talking about investing; the stock markets, primarily. The alleged empiricism comes in the form of sales-pitch data:
FRENCH: It’s easy to think — by seeing the ads and reading newspaper articles and stuff — that if you’re just clever enough, you’re going to win.
The delusion comes in the form of how the stock markets actually work.
FRENCH: We don’t understand the negative-sum nature of active investing. Whatever you win, I lose. Whatever I win, you lose, and we both paid to play that game.
That’s Ken French.
FRENCH: I am the Roth family distinguished professor of finance at the Tuck School of Business at Dartmouth.
So the negative-sum nature of investing is one problem that’s often overlooked.
FRENCH: And then the second problem we have [is] most people suffer from overconfidence, particularly in noisy environments where the feedback is weak. That describes the stock market. It’s incredibly noisy and it’s really easy to misinterpret what the return on your portfolio means.
But wait a minute — we know how to interpret our portfolio returns, don’t we? Those big money-management firms and mutual fund firms and investment advisors, they’re so helpful in telling us how much our hard-earned money is growing. Right? Okay, it can be kinda hard to keep track of all the fees they’re deducting. But still — isn’t it amazing that the firm you chose — no matter which one you chose — just happens to be better than everybody else at picking the best stocks and funds?
RITHOLTZ: There’s too much B.S. on Wall Street and being able to say, “Here’s what the data show” is really a useful skill.
That’s Barry Ritholtz.
RITHOLTZ: I run an asset-management firm called Ritholtz Wealth Management.
DUBNER: All right. Explain how you, Barry Ritholtz, actually make money. Who is paying you to do what?
RITHOLTZ: We get paid a percentage of assets. I haven’t looked at it this quarter but it’s somewhere under 1 percent, about .88 or .89. Somewhere in that range. The more assets we gather and the better those assets perform, the more revenue the firm sees.
That’s a pretty typical setup. Many investors pay firms to manage their money — sometimes a percentage of assets, sometimes a flat fee. In return, you may get a variety of services — including advice about insurance or taxes. And, of course, investment advice: how best to save for a house, or your kids’ tuition, or retirement, whatever. Why pay someone for that advice? Because, let’s face it, investing can be confusing, and intimidating. All that terminology; all those options. So you hire someone to navigate that for you — and they, in turn, use their expertise to pick the very best investments for your needs. This is called active management. They actively select, let’s say, the best mutual funds for your needs. And you pay them for their expertise. You also pay those mutual funds, by the way — sometimes there’s what’s called a sales load when you buy it; and an expense ratio, a recurring fee the fund deducts from your account. So, between the mutual fund fees and the investment fees, that’s usually at least a couple percent off the top — and that’s whether your funds go up or down, by the way. So hopefully they go up. Hopefully the active management you’re paying for is at least covering the costs?
FRENCH: What we actually found was the top 2 to 3 percent had enough skill to cover their costs. And the other 97 or 98 percent didn’t even have that.
In 2010, Ken French and Eugene Fama published a study in The Journal of Finance called “Luck Versus Skill in the Cross-Section of Mutual Fund Returns.”
FRENCH: So what Fama and I were doing in that paper is trying to figure out when a fund does really well, should we attribute that to a manager that is incredibly talented and really beating the market? Or are we just looking at the result of luck?
That is, did their funds rise in value because of their stock-picking skill — or, perhaps, simply because the market was rising? And, again, the Fama-French finding:
FRENCH: So the top 2 to 3 percent [have] enough skill to cover their costs. Everybody else: down below that.
Ouch. It’s enough to make you think that maybe it’s not worth paying those investment experts for their expertise. If only there were some simple, cheap way to avoid all that active investing that often doesn’t pay off and just passively own, say, a small piece of the entire stock market. Well, as you may know, there is. They’re called index funds and E.T.F.s, for exchange-traded funds. They can be bought very cheap. And in recent years, a lot of people have been buying them.
RITHOLTZ: When we look at the fund flows over the past few years, there is a massive outflow from active fund management.
BOGLE: The number comes out to around a trillion and a half flowing into index funds and a half a trillion flowing out of active funds, which is a $2 trillion shift in investor preferences. It is definitely a revolution.
That is John Bogle …
BOGLE: … often called Jack, and I’m the founder of Vanguard and the founder of the world’s first index fund.
How big a deal is Jack Bogle? Here’s what Barry Ritholtz thinks:
RITHOLTZ: Jack Bogle is one of the unsung heroes of the American middle class. He has allowed people to invest over the long haul very inexpensively with excellent results in a way that they probably wouldn’t have been able to do without him and without Vanguard.
Warren Buffett, the most famous investor in the world, had this to say recently: “If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle.”
RITHOLTZ: Vanguard is clearly the leaders in low-cost indexing. They’re now $4 trillion, right? That’s an astonishing number.
How astonishing? Four trillion dollars could buy you every major sports league in America; and Apple — the company, all of it; and put 8 million kids through college. And you’d still have a trillion left over. That’s how much money we have collectively given to Vanguard. Why? Because they were the first to offer an alternative to the old-school, expert-driven, high-fee investing model. Let’s get back to Jack Bogle.
DUBNER: You said recently, “What’s clear is we’re in the middle of a revolution caused by indexing. It’s reshaping Wall Street, it’s reshaping the mutual fund industry.” Now, for the man who really can claim way more credit than anyone else for starting the revolution, does it seem like a revolution or more of an evolution? In other words, it’s been a long time coming.
BOGLE: It is a revolution, still going on. It started in the last few years. It’s actually accelerated and I don’t think that acceleration can continue. But I do think the dominance of the index fund will continue simply because we’re in an industry where cost is everything and no one wants to compete on cost. Managers don’t want to compete on cost. They want to make money for themselves. It didn’t bother me that it took a long time. It takes time for people to understand, keep up. I did my best to help.
One way Bogle helped was by setting up Vanguard as a cooperative. It’s owned by the fund’s shareholders; rather than distributing profits, it lowers its fees.
DUBNER: As the founder of Vanguard, as the father of index-fund investing — how have you turned out financially? Are you worth billions and billions and billions?
BOGLE: No, I’m not even worth a billion. They laugh at me. I’m not even worth $100 million. But I was never in this business to make a lot of money for myself. I’ve been nicely paid, particularly in the days when I was running the company, and I am not a spender. I buy a new sweater every once in awhile or a new shirt from L.L. Bean. My wife is the same way. We’re just not interested in things, toys. We’re very happy with our standard of living. We have a nice small house that we love. We have a wonderful family. At 88 years old, I might be the most blessed man in the United States of America.
Bogle created Vanguard in 1975, when things weren’t going so well for him.
BOGLE: It was a way for me to get back in the business, to get back at my old company, which I’d been fired from.
The old company was Wellington Management, where Bogle had spent more than two decades. In 1970, had become CEO; in 1974, he was fired, for making what he admits was an “extremely unwise” merger decision. When he started Vanguard, it was just another traditional, actively-managed money firm — and that part of the business still exists — but Bogle had long questioned the wisdom of picking stocks.
BOGLE: In Princeton University in 1951, when I was choosing a topic for my senior thesis, I chose the mutual fund industry. “The Economic Role of the Investment Company” was the title of my thesis. I examined the records of some funds — we didn’t have what we have today in records — but I looked at half a dozen funds anecdotally. I said in my thesis, this is a virtually a direct quote: “Mutual funds can make no claim to superiority over the market averages.” That’s the harbinger of the index fund.
A harbinger, maybe, but Bogle spent his first couple decades in the business dancing the same dance as everyone else. Then, in 1974, the same year Bogle was fired from Wellington, The Journal of Portfolio Management published a paper by the economist Paul Samuelson called “Challenge to Judgment.”
BOGLE: I was inspired by his article.
Samuelson was a Nobel winner and an extremely influential thinker.
BOGLE: I’m trying to think whether to say he was a thousand times smarter than I was or a hundred times, but it was something like that.
Samuelson’s paper challenged the performance of active managers and suggested that, “at the least, some large foundation should set up an in-house portfolio that tracks the S&P 500 Index — if only for the purpose of setting up a naïve model against which their in-house gunslingers can measure their prowess.” Bogle, who was in the midst of launching Vanguard, took it to heart. Others had been thinking through the idea, but Bogle, and Vanguard, were the first real players to take the plunge. The notion was brutally simple: most stock pickers think they are better than the market — and they aren’t; therefore, investors should just buy the whole market. And, since you’re not paying the big salaries, and all the other costs that go along with those stock pickers — the fund would be much cheaper to buy.
DUBNER: When you founded it, it was treated as heresy, even laughable, by most people on Wall Street. Talk about what it was like to experience that reception.
BOGLE: Well, I don’t cave in very easily. You may have sensed that. In a certain way, the more dissent I got the more confident I was that I was right. I’m that kind of contrarian person. People laughed. There was this great poster that said “Stamp Out Index Funds.” There’s Uncle Sam with a cancellation stamp all over it, all over the poster. “Index Funds are un-American.”
DUBNER: They were considered “un-American”— that argument was what?
BOGLE: The argument is, “In America, we don’t settle for average. We’re all above average.” But, of course, we’re not all above average. But basically, the poster was put out by a brokerage firm. The thing about the index fund — no sales loads, no portfolio turnover. You don’t buy and sell every day like these active managers do. It’s Wall Street’s nightmare and it still is! That kind of reception didn’t bother me. The fund was known as “Bogle’s Folly.” The original underwriting was supposed to be $150 million. This is the original underwriting of the index fund. The underwriters sheepishly, on the day the underwriting was completed, came in with $11 million instead of $150 million.
DUBNER: Did you lose a little confidence then or no?
BOGLE: No! They said, “Why don’t we just drop the whole thing?” It was probably the worst underwriting in the history of Wall Street. I said, “No, we’re not going to drop it. We have the world’s first index fund. That’s good enough for me.” We went ahead and started to run it. It took a long time for people to get the idea.
But, increasingly, people are getting the idea. That rather than spending, let’s say, $10,000 to buy five different mutual funds, each made up of a basket of hand-selected stocks, you spend all $10,000 on one fund that simply tracks an entire stock index — the S&P 500, maybe. It’s going to be a lot cheaper than buying those separate, actively-managed funds — and, as the data have shown again and again — it will likely perform better as well. Over the past decade, according to The Wall Street Journal, “between 71 and 93 percent of U.S. stock mutual funds either closed or failed to beat their closest index funds.”
BOGLE: If we go back to 1970, we find that there were approximately 400 funds in business and basically 330 or 340 have gone out of business. It turns out, in that period, there were two mutual funds who beat the market by more than 2 percent per year. Two! That’s half of 1 percent of all the funds that started in the business. Those are your odds.
Those may be the odds, but the perception is different. Warren Buffett, a stock picker who does beat the market, is a national hero. In schools all across America, when kids are introduced to the concept of investing, they’re often encouraged to become little Buffetts — playing stock-market games where they pick individual stocks. Rather than being taught the sensible route of dollar-cost-averaging their way into low-fee index funds. It’s a bit like learning to drive on a Formula One circuit.
FRENCH: The notion that we can all get rich by trading actively just doesn’t make any sense whatsoever.
BOGLE: You have to understand one important thing about the market and that is for every buyer, there is a seller. And every seller, there is a buyer.
FRENCH: Every time somebody wins, somebody loses even more.
BOGLE: So when transactions take place, the only winner net is the man in the middle. The croupier in the gambling casino.
FRENCH: You have to believe you really are superior to the other folks that you’re trading against.
RITHOLTZ: I draw the parallel between being an outstanding market-beating manager, trader, whatever, with being an all-star in any professional sports league. It’s such a tiny percentage!
FRENCH: If you don’t think that you’re really one of the best people out there doing this, you probably shouldn’t even start.
RITHOLTZ: But every kid who ever picked up a baseball bat, a basketball, a football, dreams of winning the championship, hitting the bottom-of-the-ninth home run. The problem is if you invest based on those fantasies, the odds are strong that you’re going to be disappointed.
BOGLE: This is actually simple wisdom.
Simple, perhaps, but elusive. In part because the alternative — the gamble of picking stocks — is so seductive. Which may explain why it took so long for index funds to really catch on. The index fund is more predictable, and boring — which, as Jack Bogle sees things, is its virtue.
BOGLE: It diversifies away the risk of individual investments. It diversifies away the risk of picking a hot manager and diversifies away the idea that you can pick market sectors like health care, technology, or wherever it might be.
And then there’s the cost comparison. We’ll start with the typical mutual fund:
BOGLE: They charge a lot for this service. We estimate the average expense ratio is almost 1 percent for an actively managed fund. Then these active funds, all of them have sales loads. The index funds do not. The active funds further turn over their portfolios at a very high rate and that’s costly. You add that all up and the cost of owning a mutual fund on average is 2 percent.
And how does that compare to an index fund?
BOGLE: You can buy an index fund of, an S&P 500 Index Fund, let’s say, for as little as 4 basis points, four one-hundredths of 1 percent. In a 7 percent market, you’re going to get 6.96 percent.
That difference — 2 percent versus four one-hundredths of 1 percent — may not sound like a lot. But over time, those numbers are compounded by what Bogle calls the “relentless rules of arithmetic.”
BOGLE: If the market return is 7 percent and the active manager gives you 5 after that 2 percent cost, and the index fund gives you 6.96 after that four basis point cost — you don’t appreciate it much in a year — but over 50 years, believe it or not, a dollar invested at 7 percent grows to around $32 and a dollar invested at five percent grows to about $10. Think what an investor thinks about when he looks at that number. He says, “Wait a minute! I put up 100 percent of the capital. I took 100 percent of the risk and I got 33 percent of the return.” Well, anybody that thinks that’s a good deal, I’ve got a bridge I want to sell them. Here’s the reality: this is the business, the mutual fund, actively-managed business, where you not only don’t get what you pay for, you get precisely what you do not pay for. Therefore, if you pay nothing, you get everything.
Jack Bogle is plainly a cheerleader for the revolution he helped start. There are, to be sure, plenty of critiques of indexing, or at least shortcomings — we’ll get into those later. But the fact is that the revolution does seem to be happening. The question is …
BOGLE: Why did it take so long? That’s what the question really ought to be.
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On October 14 of 2013, the University of Chicago finance professor Eugene Fama began his day just like any other.
FAMA: I was doing my exercises and preparing my class for that day — when they called.
“They” being the Royal Swedish Academy of Sciences committee that awards the Nobel prize in economics.
FAMA. Ten minutes later, there were reporters at the door. It was amazing.
DUBNER: Wow. How did you like that?
FAMA: I said, “Look, I have a class to go to. I can’t deal with you.” So I went and taught my class. They wanted to come into the class and I said, “These kids pay a fortune for these classes! Stay out there.”
DUBNER: So you’re sometimes called “the father of finance” which—
FAMA: I think it’s the grandfather at this point.
DUBNER: Well, here’s the thing that seems strange to me: to a lot of people, given that it’s the 21st century and you’re not 500 years old, hasn’t finance been around for centuries?
FAMA: Not as an academic discipline. If you go back to the late ’50s, there really was nothing called “academic finance.” Well, there was something being taught in business schools as finance, but it really had no strong research underpinnings. If you look back at that time, the people in finance weren’t economists. I don’t know how you’d characterize them.
FAMA: Yeah, they were professional people. Some of them had come over from accounting, but they weren’t strong in economics, so they didn’t think of questions in those terms. For example, if you took an investments course at that time, it was a course on picking stocks, basically. How do you analyze companies to pick stocks? Of course, they had no model of what determines prices, so there was really no way to answer that question in any rigorous way. But at that point we were developing lots of research that said, “This is basically very difficult to do, if not impossible, and it’s kind of pointless. We don’t really know anybody who can teach people how to pick stocks because we don’t know anybody who can pick stocks.”
DUBNER: You’re famous for developing what we now know as the efficient market hypothesis. Explain it to a layperson.
FAMA: It’s easy to explain. It’s a simple proposition. The proposition is that prices reflect all available information, which in simple terms means since prices reflect all available information, there’s no way to beat the market. Now, that’s an extreme statement of the hypothesis, and the difficult part is actually developing tests of it because you have to say something about what the market is trying to do in setting prices.
Because it’s so hard to test, the efficient market hypothesis is not universally accepted. Some behavioral economists argue that the standard human cognitive errors create imperfect pricing that a shrewd investor can exploit. What’s Jack Bogle’s take?
BOGLE: The markets are highly efficient — although, importantly, not perfectly efficient. Sometimes they’re very efficient and sometimes they’re not. It’s hard for we poor souls on Earth to know which is which
RITHOLTZ: The basic concept of, “Can you beat the market?” — it’s more subtle than some people want to argue.
Barry Ritholtz again:
RITHOLTZ: It’s not black and white. It’s not that you can’t beat the market. You can and some people have and have for long periods of time. Look no further than Warren Buffett. The challenge is being able to select who’s going to be able to beat the market, for them to beat the market consistently year in year out, and then to do it in excess of costs, fees, taxes, commissions. That’s the brilliance of Eugene Fama, identifying that before anybody else saw it.
Fama developed the idea in the late 1960s.
FAMA: The academic world grasped this stuff basically immediately. There was no resistance to it to it at all. It took a much longer time for it to penetrate into the applied community.
DUBNER: And why was that?
FAMA: That’s the $24 question. Well, an even higher price than that would be given the relevance of how long it’s taken for people to really wake up to the data and what it says about active investing.
DUBNER: In retrospect, was the objection simply protectionist thinking by the financial services industry or was it something more than that?
FAMA: The financial services industry had a lot to lose from this line of research because basically we were saying to them, “You’re charging people for stuff you can’t deliver.” So I was not a popular kid.
DUBNER: Well, obviously the idea caught on. It’s often said that right now we’re in the midst of a “passive investment revolution.” Do you agree with that characterization? Is revolution too strong a word or no?
FAMA: Well, when my co-author Ken French was president of the American Finance Association, in his presidential talk, he said that, “It basically took 50 years to go from zero percent passive to 20 percent passive. Then, in the next 10 years it’s gone up to like 30.” We’re still nowhere near taking over the world.
DUBNER: When is active management a good thing? Or maybe put it another way, when is it worth it for me to pay my 1 or even 2 points for an active manager?
FAMA: I would say I don’t know anybody for whom it’s worth it because I don’t think — I’ve analyzed more data than almost anybody, given that I’m so old. But the problem that people don’t understand is that active managers, almost by definition, have to be poorly diversified. Otherwise, they’re not really active. They have to make bets. What that means is there’s a huge dispersion of outcomes that are totally consistent with just chance. There’s no skill involved in it. It’s just good luck or bad luck. You can’t tell the difference between the two based on returns alone. This is looking at the world before costs. When you look at the world after costs — which is what people eat; they have to pay the cost of the people charging them — well, then, the whole industry looks pretty bad.
DUBNER: If you want to give yourself a bad chance versus the market and pay extra for it, that’s when you should get an active manager, basically?
FAMA: Right. Be my guest.
DUBNER: It sounds like college endowments. No offense. I don’t know how the University of Chicago runs its endowment. But the Ivy Leagues certainly …
FAMA: Badly. I’m chuckling, [but] it’s not a laughable matter. But in the old days they used to invite me annually to go talk to the person who ran the endowment. It was clear he was totally not interested. Finally, I gave up and they gave up.
RITHOLTZ: The joke is that Harvard is a $38 billion hedge fund with a small college attached to it.
Barry Ritholtz manages money but he’s got a couple side gigs too.
RITHOLTZ: I also am a columnist for Bloomberg View, and I host a weekly podcast called Masters in Business.
In one column, he wrote, “If ever there was an argument for endowments to turn to passive indexing, Harvard is it.” This was shortly before the Harvard endowment shook up its management team after years of poor returns. I asked Ritholtz about it.
DUBNER: Harvard’s annualized net returns for the past 10 years were less than 6 percent. In fact, when you look at the top-performing Ivy endowments, they were all around 8 percent for those 10 years. Again, sophisticated, expensive management with access to all kinds of information and investments. Just out of curiosity I went and looked at my boring own kids’ college savings fund, which is stashed in a pretty dull and very cheap 529 plan. There’s just a handful of choices, index funds. There’s one growth fund, one value fund, a couple of bond funds, and it costs pretty much nothing. And lo and behold, my ten-year annualized net return beat every single Ivy endowment. Those are the best and the brightest. Why on earth would anyone want to pay those fees for active management, whether you’re an individual investor like me or a huge endowment like Harvard?
RITHOLTZ: Look, just because you’re at an endowment running billions of dollars associated with some of the most sophisticated investors, there’s no reason to think you’re not going to succumb to the same cognitive errors and psychological failings that every other human being does. There’s groupthink, there’s a refusal to admit that you were wrong. There is an even bigger embarrassment of saying, “I don’t know.” One of my favorite things to do is anytime I’m on TV and someone asks me a question, “Hey, where’s the Dow going to be a year from now?” I love to just say, “I don’t know.” They don’t know how to respond to it. When you’re in a room full of peers, when you’re in a room full of consultants, and everybody is pretending to be knowledgeable and sophisticated, there are all sorts of group dynamics that lead to — the technical term is “suboptimal decision making.”
DUBNER: The financial services industry is obviously gigantic. A lot of people have a lot of relatively high-paying jobs for which they’re supposed to create value for people who are investing money. But the data show — forget about whether it’s Ivy League endowment data or across-the-board investment data — the data show that a lot of money that investors spend to get better returns is essentially wasted. First of all, would you agree with that statement?
RITHOLTZ: Most of the money they spend is essentially wasted; not a lot. I would say the vast majority.
DUBNER: All right. The argument would be that they’d be better off buying a few index funds for essentially pennies on the dollar compared to what they’re paying their investment professionals and that the financial services industry is kind of a tax on stupid people who think they’re being really smart. Do you see it that way?
RITHOLTZ: It’s worse than that! It’s not a tax on stupid people who think they’re smart. It’s a tax on smart people who don’t realize their propensity for doing stupid things. Look at all the endowments. Look at how far behind the eight ball most of the state pension funds are. These aren’t dumb people. These are really smart, accomplished people. They, unfortunately, don’t want to admit they don’t know something, [and] are very put off by counter-intuitive information. It’s the Lake Wobegon syndrome: everybody wants to believe that they’re above average. “Sure it’s hard to beat the market, but I can.” What’s amazing is there are actually S&P 500 index funds that have a giant fee attached to it. I can’t explain how that works.
DUBNER: And that’s a tax on stupid, no?
RITHOLTZ: That is a tax on stupid, for sure.
DUBNER: You’re literally paying whatever — double, triple, five times for exactly the same product?
RITHOLTZ: That’s right. Triple. I want to tell you the Vanguard S&P 500 index fund is about 5 or 6 basis points. Schwab recently cut 1 to 2 or 3 basis points. There are S&P 500 funds with 50 and 75 and 100 basis points. It’s an insane — that is a tax on dumb.
The Dartmouth finance professor Ken French has been closely watching the growing appetite for index funds.
FRENCH: It’s not something that just started today. It’s been going on for the last 20 or 30 years. It does seem to have picked up speed.
That said, French doesn’t quite see the passive-investing revolution as a revolution.
FRENCH: I believe we are seeing a shift from active toward passive. That’s pretty clear, but I don’t think it’s quite as pronounced as most people argue.
That’s because so much new money has been flowing into E.T.F.s.
FRENCH: An E.T.F. is an exchange traded fund.
Which may look a lot like a passive index fund …
FRENCH: But what’s unique about E.T.F.s is you can trade them all day.
And the volume of trading in E.T.F.s, French says, suggests that many traders are not truly passive.
FRENCH: I think of passive as essentially a buy and hold. They buy it today and they hold it for years and years. We’re not seeing that in the E.T.F. marketplace. Some of the people are certainly doing that, but it appears a large fraction of them aren’t.
That said, there’s plainly been an acceleration away from traditional active management. Why?
FRENCH: I interpret that as one of the consequences of the financial crisis. Before the crisis, people had this view that Wall Street was our friend. After the crisis, there are a lot more cynical about fees that are being charged and services that are being provided by Wall Street.
RITHOLTZ: At a certain point, the investing public turns around and says, “This is rigged. This is a tough gig. Why am I wasting my time picking stocks, paying commissions, paying high mutual fund costs? I could just index.”
There are, of course, plenty of alternative views — especially from those who profit from old-school active investing. Still, you can imagine that if every investor in the world held pretty much the same investments — well, what would that lead to? A research note from the investing firm Sanford C. Bernstein argued that passive investing is, “worse than Marxism,” in that it threatens the legitimate give-and-take that is central to any market. Ken French again:
FRENCH: One of the beautiful things that happens out there in the market is price discovery, and I would never argue all prices are right, but prices are pretty darn good. We learn an awful lot about how resources should be allocated from what the prices are in the financial markets. If nobody is doing price discovery, we lose a really valuable service. What I always say is, “If it’s somebody I don’t like, I’m more than happy to have them go out there and spend their money investing actively because as a group, they’re making the world better off.”
For what it’s worth, Ken French, for all his skepticism about how modern investing works — he himself does some work with the huge investment firm Dimensional Fund Advisors. So does Eugene Fama. For all the noise about the passive revolution, it’s worth remembering that only about 30 percent of all mutual and exchange-traded funds are being passively managed. But it’s enough to concern plenty of people who worry about homogenization — especially when the federal government gets involved.
SCARAMUCCI: My name’s Anthony Scaramucci. I’m the founder of SkyBridge Capital.
When we spoke with Scaramucci, last year, he’d just sold SkyBridge Capital in anticipation of getting a job with the Trump administration. He eventually got that job as White House Communications Director, only to be fired after less than a week. When we spoke, I asked Scaramucci about the yet-to-be-instated fiduciary rule. That’s an Obama-era regulation that was pitched as ensuring that financial advisors act in their clients’ best interests.
DUBNER: You called the fiduciary rule, “a case study in government overreach, a clear example of how faulty regulation can have severe unintended consequences.” You also promised to help President Trump repeal it. What are some of those unintended consequences of a rule to try to change the behavior of the people who are paid to manage other people’s retirement money?
SCARAMUCCI: It’s really not changing their behavior. What it’s doing is it’s actually limiting the choices for the end user or the end investor. Because if you read the entire rule, which I’ve read, it’s a governmental decision to allocate capital into index funds and E.T.F. funds that the government is deeming those things as being more efficient. They’re more effective in terms of their lower cost analysis and, for the time being, the government is actually right. If you look at the last 5 or 10 years, those funds have performed better and charge less fees than, let’s say, a hedge fund or a private equity firm.
But the problem with that analysis is that you’re not taking a 120-year, modern, economic historical analysis of business cycles and stock market trends. You’re really only looking at the last 10 years. The buffet table of investment opportunities for the average user — let’s say, my mom and dad, which I’m super concerned about — gets curtailed. I’m just going to sell you the things that the government wants me to sell you. What will end up happening is everybody will be overloaded in E.T.F.s, they’ll be overloaded in indexes. And when the market crashes — because they will have eliminated many of the financial advisers, you’ll lose 60 to 70,000 financial services jobs as a direct result of that rule. It’s a jobs killer.
But what it also does is it fails to recognize the full economic value of a financial adviser. The economic value of a financial adviser is not just the return and the net return, net of the fees, but it’s also the psychological effect and the coaching that that financial adviser provides that family. The rule is bogus, Stephen, and the rule needs to be repealed. The people that really understand the rule know that. By the way, I love my clients, as most financial advisers do. I’m not trying to rip off my clients. I’m not trying to do something that’s dishonest. I’m just trying to increase, continually, their options in terms of what they can invest in.
Think what you will of Scaramucci’s take on the overconcentration of investments in index funds. If the trend does continue, it’s hard to dispute, as he says, that a lot of financial-services jobs will be lost. I asked Barry Ritholtz about how his industry planned to protect — or reform — itself.
DUBNER: As we’ve seen throughout history with any industry or institution that’s got leverage, that’s got money, that’s got a history itself, reform never comes from within. Nobody is going to say, “You know what? Our industry is really not providing value. We’re getting paid billions, trillions of dollars to manage this money and we’re actually doing a pretty crappy job. A monkey with a dart board would literally do better for just the price of monkey chow. So you know what? Let’s break up. Let’s send everybody home, say we’ve had a nice run. We’ve had these nice 100, 200, 300, 400 thousand dollar jobs just for shuffling other people’s money around poorly.” If the revolution really does come to pass and the world says, “You know what? The financial services industry as it’s currently configured — we only need about 5 percent of it.” What happens?
RITHOLTZ: First, no self-respecting person in finance would work for those absurdly low figures you quoted. Let’s put that aside. Second, the financial markets go through this regular creative destruction every few years. Back in the early ’70s, commission prices were fixed. You couldn’t discount a commission if you wanted to. It was actually a legal regulation. Once that changed suddenly everybody predicted the end of the world of finance. “Oh my God, what’s going to happen? They’re going to start cutting prices!” That is what happened. You cut prices. More people were able to access the capital markets. It worked out really well.
Every few years we go through one of these major innovations. Not too long ago, E.T.F.s didn’t exist. We take for granted that for five bucks I could go out and buy an E.T.F. of every major index I want. That’s a shocking change that has also had significant impact. As we go through this process of these convulsions, the financial-services industry became too large. It became too outsized, it became too over-compensated. It was the tail that was wagging the dog. It used to be financial services companies operated in service to big corporations and small investors and everything in between, but eventually they started being a reason for their own existence.
That’s now going through a change. Probably, before we lose 90 percent of people in finance or 95 percent, there’ll be something else that happens. It seems that every time there’s any major trends, whether it’s towards global investing or passive investing or day trading, it’ll last for a couple of years and then something new and shiny comes along and enough people are interested in it that a substantial portion of the previous trend participants will chase that. However, I will say that the evolution towards low-cost, towards indexing, and towards being aware of how your own behavior impacts your investing, is something that’s going to be here for the foreseeable future.
All right, so we learned today that low-cost indexing seems to make a lot of sense, at least for a lot of people in a lot of situations. But what about all the other things you have to do to be a fiscally sane, and responsible, adult? Glad you asked! That’s what we’ll talk about on the next Freakonomics Radio. Because a lot of people — including a lot of otherwise really smart people — are totally clueless when it comes to their personal finances.
Harold POLLACK: How do I save for retirement? How do I deal with all these questions about budgeting and when to buy a house and all that kind of stuff? Oh, I just have to look at these nine rules on this card.
Everything you ever wanted to know about personal finance — and it fits on one index card. That’s next time, on Freakonomics Radio.
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Freakonomics Radio is produced by WNYC Studios and Dubner Productions. This episode was produced by Greg Rosalsky. Our staff also includes Alison Hockenberry, Stephanie Tam, Merritt Jacob, Harry Huggins and Brian Gutierrez; we also had help this week from Sam Bair. The music you hear throughout the episode was composed by Luis Guerra. You can subscribe to Freakonomics Radio on Apple Podcasts, Stitcher, or wherever you get your podcasts. You can also find us on Twitter, Facebook, or via e-mail at email@example.com.
- John Bogle, founder of The Vanguard Group.
- Eugene Fama, professor of finance at the University of Chicago.
- Kenneth French, professor of finance at Dartmouth College.
- Barry Ritholtz, co-founder and C.I.O. of Ritholtz Wealth Management.
- Anthony Scaramucci, White House Communications Director.
- “The Arithmetic of Active Management,” William Sharpe (January/February, 1991).
- “Challenge to Judgment,” Paul Samuelson (Fall, 1974).
- “Historical Timeline of Fiduciary Duty for Financial Advice,” Mark Schoeff Jr., Investment News (April 5, 2016).
- “Luck Versus Skill in the Cross-Section of Mutual Fund Returns,” Eugene Fama and Kenneth French (October, 2010).
- “Bernstein: Passive Investing is Worse for Society Than Marxism,” Luke Kawa, Bloomberg (August 23, 2016).
- “The Passivists,” The Wall Street Journal (October, 2016).
- “Whither Efficient Markets? Efficient Market Theory and Behavioral Finance,” Laurie Kaplan Singh (May 19, 2010).
- “How Much is a Trillion Dollars? What a Trillion Can Buy,” FOX Business (April 30, 2015).