In a recent New York Times article, Robert Olstein, the portfolio manager of the actively-managed Olstein All Cap Value fund, offers his take on how investing with index funds is “…like saying mediocrity is O.K. – that it’s more than O.K., it’s the best that anyone should hope for.”

Mr. Olstein’s frustration with the rising popularity of index investing comes through loud and clear in the article. In it, he offers the standard litany of arguments to support active investment management.  Below are some of his points countered by a dose of reality:

  • Index funds returns are average and investors shouldn’t settle for mediocrity
    • According to the 2012 Standard & Poor’s Index vs. Active Scorecard (SPIVA), the S&P 500 index outperformed over 75% of actively managed U.S. large cap funds over the previous five years. That percentage tends to increase over time.  If the vast majority of active managers underperform their index, then by definition, the index return must be greater than the vast majority of active managers.  That’s not mediocrity.
  • Active manager underperformance, implies Olstein, is driven by “sloppy investing”, so apparently the key to outperformance is quality research.
    • Active managers’ incentives to outperform their respective indexes are massive in terms of compensation and notoriety.  Given the enormous resources, both in money and intellect, focused on the goal of beating the market, Olstein’s suggestion that all the resulting active manager underperformance is simply a result of “sloppy investing” seems delusional.
  • That by focusing on specific types of companies (“boring companies”) or valuation metrics (“free cash flow yield”), active managers can have an edge over other investors.
    • Strategies such as overweighting unloved stocks and focusing on specific valuation metrics have been worked over by the multitude of professional and amateur investors looking for an edge.  Despite this, the evidence is overwhelming that active managers fail to consistently beat their benchmarks.

Much of the frustration expressed by advocates of active investment management toward the success of index investing stems from the counter-intuitive nature of the issue.  Active investment management proponents believe that their strategies should enable them to outperform the market.  In a triumph of hope over reason, they ignore the overwhelming empirical evidence and Nobel Prize  winning theory1 which demonstrate that even if active management should work, it doesn’t.

1Professor Eugene F. Fama was awarded the Nobel Prize in Economic Science in 2013.  His work on the Efficient Market Hypothesis laid the theoretical basis for index investing.