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Commentary:   April  2015

Dennis C. Butler, President
Centre Street Cambridge Corporation
Private Investment Counsel

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    of all guest columns written by Dennis C. Butler, CFA 

April 2015

 Whoever is winning at the moment will always seem invincible.

                                                                                                                             — George Orwell 

Once again a controversy has erupted over the merits of "active" versus "passive" investing. The debate can be summarized as follows: does it make sense to pay extra for someone to pick and choose securities for a limited portfolio when one can, through index funds, capture the returns achieved by an entire market or a segment thereof very cheaply? Due to the introduction of Exchange Traded Funds ("ETFs") doing the latter has never been easier, and less than stellar results among active managers relative to various market indexes have lent weight to the claims of the advocates of the passive approach. Their arguments appear to have caught on, as investors have shifted large sums to an increasing variety of index fund products.

Indeed, money flows into passive vehicles — including traditional index mutual funds and the newer ETFs — have surged in recent years, as revealed in a report from the Investment Company Institute. In 2013, for example, index mutual funds attracted $114 billion in new cash (up from  $59 billion of inflows in 2012) and held $1.1 trillion in assets at the end of the year. Demand for U.S. domestic equity index funds tripled that year, and the share of indexed assets compared to all equity mutual funds was 18.4% at year-end, reflecting steady growth from 9.5% in 2000, and at an increasing rate beginning around 2007.

 The ETF structure has proven to be an exceptional draw for the indexing movement because it permits investors to purchase shares at any time, unlike traditional mutual funds, which transact on a daily basis at "net asset value." Asset growth for ETFs was double that of index mutual funds between 2007 and 2013. Both types of funds attracted $795 billion in cumulative new assets over that period. By contrast, active equity mutual funds saw money outflows of $575 billion. Clearly, indexing has gained favor in recent years; even investor Warren Buffett has included the methodology in his estate planning and argues for its use by the average person as an alternative to picking stocks or active funds.

 Our take on this debate reflects the "non-passive" investment approach that we advocate — take action when and where necessary and appropriate. Necessary and appropriate action is almost always contrary to the market; indexing embraces the market. Most of the time we are inactive, avoiding risk and patiently waiting for good investment opportunities to appear. We also firmly believe that when it comes to investing, things are never quite as simple as they sometimes appear, nor as complicated as generally portrayed. We believe that smart investors should maintain a high degree of skepticism about trends in the investment business. We find that our own personal "Ockham's Razor" is very useful in these situations: in finance it is never a good idea to do what everyone else is doing.

 It follows that the popularity of indexing should instill caution at this time. The last two decades have seen indexing twice gain favor — during the late 1990s and now. Both episodes followed long periods of rising stock prices leading to relatively high valuations (extremely high in the 1990s period). Market history following the end of the prior outbreak of exuberant faith in the market's future should be reason enough to proceed carefully.

 This argument from what we might call "market wisdom" finds backing in fundamental considerations that should lead those contemplating buying into the current indexing wave to examine the passive approach with a critical eye. First, there is no such thing as passive investing. The indexes on which "passive" funds are based are artificial groupings of securities whose components are rejiggered from time to time by their sponsoring organizations (Dow Jones, for example) — hence, they are actively "managed" just like any other fund, although usually with far less turnover (one significant advantage of index funds). Second, and more importantly, committing capital, whether to a stock, bond, oil futures contract, property, or index fund, is an active decision entailing certain expectations and consequences. Whether the consequences are pleasant or not depends on whether the expectations were based on sound reasoning.

 Sound expectations are rooted in economic realities. Whether an index fund or a share of stock, the ultimate result of any investment decision depends largely on the price paid. The value of a security or fund is the stream of future cash flows to which it is entitled, "discounted" to the present at some interest rate. Pay a high price and that rate — the "return" on your investment — could be very small, or even negative. There is no escaping this essential factor. Any potential capital commitment must be analyzed and its price/value characteristics weighed. Operations failing in such analysis can quickly descend into speculation. Those buying index funds in 1999 based on the simplistic notion that just "owning the market" would get them 10% per year (a common belief at that time) soon found themselves regretting that they had purchased an asset that was "priced to perfection" with little prospect of yielding an acceptable result (Actually, it was much worse. Due to the way in which indexes are typically constructed, fund owners thinking they were buying into a broad universe of companies were, in reality, putting most of their money into a small number of stocks selling at bubble prices.).

 Active managers' broad failure to "beat the market" provides the passive side with a potent argument that has the most sticking power in this debate. It, too, deserves careful scrutiny. The meaning of the phrase "beating the market" has evolved. Once applied to speculators who managed to get out of the market with their capital intact, it now defines the investment industry's aim to achieve results in excess of what the market (or a specified "benchmark") provides — "alpha," to use the industry terminology. For the untrained individual investor attempting to create their own portfolio of securities or selecting from among the enormous variety of funds that are now available, this is not a realistic goal. Research repeatedly demonstrates that untutored individuals make very poor investment decisions. One study in particular showed that over one 15-year period when stocks returned about 12% annually, individuals trading mutual funds saw a 3% return on investment using funds that, on average, had achieved returns of about 10%. Why such a mediocre result? Individuals trade too much, buy high, and sell low. From this perspective the 10% return from active management represents considerable value-added on the part of fund managers, despite their having trailed the indexes, when compared with what fund purchasers themselves achieved.

 If "beating the market" is a false goal for individuals, it is a false god for fund managers, as that 10% figure above is testimony. Over a period of decades the money management and fund industries have become singularly focused on this objective, in the process corrupting the investment process. Short-termism and high rates of turnover create even more hurdles to good results, especially on an after-tax basis. Activities once viewed as speculative, such as trying to predict the next hot market sectors, have become commonplace, even though they usually fail to produce any positive "alpha." Paradoxically, trying to beat the market contributes to "underperforming" the market. The market is best "beaten" when it is ignored.

 The conditions needed to do well vis a vis market indexes are probably not compatible with the industry's present structure and procedure set. Competitive pressures are not conducive to patience. Long ago an investment theorist said, "A good investment is not the same as a successful speculation." Looking for a stock to "go up" faster than your competitors' is a far different exercise that buying a business at a reasonable price. The former is an enticement to jump ship at the slightest disappointment, while the latter is more conducive to careful analysis and a willingness to let things develop over time  — the essence of true investment. Long-term thinking is rare when corporate managements and institutional investors collude in focusing on the short-term results required to feed the maws of the bonus culture. Finally, the industry, having grown into behemoth and bureaucratic organizations beset by their own imperatives, is simply unable to respond in a nimble fashion to the ebb and flow of investment values.

 If the aim is to "outperform" everyone else, then investors face a daunting task — do it yourself and hope you get lucky, or place your trust in an industry whose size and methods tend to promote mediocrity. There are no panaceas when it comes to protecting capital and building wealth.



The purpose of saving and accumulating financial capital is to fund the development of the physical and intellectual capital necessary to provide for the needs of a growing population, i.e., economic growth. Since the financial crisis, financial capital has been accumulating at a rapid clip, and a large chunk of it has gone into bonds, growing bond market assets at the fastest rate in nearly 15 years. Investors' need for income in a low-yield world has generated unusually strong demand for fixed-income securities, reducing the cost of that source of financing for most issuers, at times to historically low levels. Yet that capital is making its way less frequently into investments in productive assets. Corporations have used new issuance to pay off older, more expensive debt, and fund growing dividends and more share buybacks — nice for shareholders in the short-term, but not exactly conducive to an expansion of the economic pie.

 If you can't grow, buy. Cheap debt, good economic news, a healthy stock market, and rising animal spirits are feeding a boom in merger and acquisition activity, making bankers, lawyers, and target-company shareholders happy. "M&A" grew at the fastest rate since 2007 during the first quarter, according to the Financial Times. The aggregate impact of these transactions on economic growth and efficiency is debatable, especially when large layoffs are involved. Viewed as a by-product of central bankers' efforts to spur economic activity through their monetary initiatives, then perhaps the gains for the economically well-placed are acceptable, as long as those efforts eventually bear fruit.

Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 33 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at

"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28).   "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:

Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139

Telephone: 617.441.9695



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Revised:  April   8, 2015 TAF

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