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The best investment advice you'll never get

For 35 years, Bay Area finance revolutionaries have been pushing a personal investing strategy that brokers despise and hope you ignore.

No one running a university endowment, independent foundation, or pension fund could match his numbers during his tenure: over the last 21 years, chief investment officer David Swensen has averaged a 16 percent annual return on Yale University’s investment portfolio, which he built with everything from venture capital funds to timber. He’s been called one of the most talented investors in the world. But lately he’s becoming perhaps even more famous for his advice to individual investors, which he first offered in his 2005 book Unconventional Success. “Invest in nonprofit index funds,” he says unequivocally. “Your odds of beating the market in an actively managed fund are less than 1 in 100.”

 

And there’s more. A recent entry on the Motley Fool, the popular investment advice website, made the following blanket statement: “Buy an index fund. This is the most actionable, most mathematically supported, short-form investment advice ever.” As long as 10 years ago, in his annual letter to his shareholders, Warren Buffett advised both institutional and individual investors “that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”

One would think, with that kind of advice floating about, that the whole country would by now be in index funds. But in the three decades since Wells Fargo kicked things off, only about 40 percent of institutional money and 15 percent of individuals’ money has been invested in index funds. So why is indexing catching on so slowly?

A big reason, according to Geddes, is that putting investors into index funds is simply not in the interest of the industry that sells securities. “They just won’t accept indexing’s minuscule fees,” he says. By now, most major brokerage firms offer index funds in addition to traditional mutual funds, but money managers typically don’t mention them at all. You usually have to ask about them yourself.

And it makes a certain kind of sense. If a naive investor calls a broker with $100,000 to invest, would the broker be likely to recommend the Vanguard 500 Index with its .19 percent annual fee, of which he receives nothing and collects but a small portion of his firm’s approximately $100 transaction fee? Or might he suggest the client buy Putnam’s Small Cap Growth Fund B Shares, which carry a 2.3 percent annual fee, 1 percent ($1,000) of which goes to him? And will he tell his client about the hidden transaction charges that further reduce the return on investment? It’s simply not to his advantage to do so.

It’s hard to find active fund managers who are willing to talk about these issues. I spoke to several, but no one was comfortable discussing the high cost of their practice, and few were willing to talk on the record. Ron Peyton, president and CEO of Callan Associates, a San Francisco–based institutional investment consulting firm, offered a list of advantages of active management, which essentially boiled down to the fact that it’s more fun. “They can raise and lower cash positions [read: buy and sell whatever stocks excite them at any given moment] and go into fixed-income or foreign securities [read: look for investments wherever they want].” I know from experience that he’s right, but it’s kind of beside the point.

The most forthright comments came from Baie Netzer, a research analyst in the Orinda office of Litman/Gregory Companies, a San Francisco–based investment management firm specializing in mutual funds. Netzer told me outright, “Eighty percent of active managers underperform the market. But we do believe that some managers add value, and those are the ones we look for.” Still, if you factor in fees and transaction costs, you have to wonder how much that remaining 20 percent would slip.

But even if the number of active managers who consistently beat the market is small, Stanford’s Bill Sharpe still sees a real need for their services. While he is a strong partisan of index funds, he is neither as surprised nor as concerned as Geddes that they don’t represent a higher proportion of overall investment. “If you’d told me 35 years ago that indexing would one day represent 40 and 15 percent of investments, I would have asked you what you were smoking,” says the personable Sharpe with his characteristic chuckle. If everyone invested in index funds, he points out, the market itself would die a natural death. “We need active managers,” he says. “It’s buyers and sellers who keep prices moving, which is what drives the market. Index funds simply reflect what the market is doing.” He believes we’d even start to see a decline in market efficiency if index funds rose to 50 percent of total investments.

Does this mean that, when we look at mutual funds, half our options would still be burdened with unconscionable fees and hidden costs? Hopefully not. With the call getting louder from financial experts and industry watchers to reform and regulate mutual funds, it’s hard to believe that the fee system can last much longer, particularly with strong Republican voices like Peter Fitzgerald’s in Congress.

But while Wall Street has considerable soul-searching to do, full blame for the gouging of naive investors does not lie with the investment management industry alone. There is an innate cultural imperative in this country to beat the odds, to do better than the Joneses. In some ways the Leuthold Group was right when it said that index funds are un-American. It’s simply difficult for most of us to accept average returns on our money, or on anything for that matter. The ultimate example of the nation’s attraction to the big score is, of course, right now under our noses. If on August 18, 2004, you had invested $100,000 in Google, that stock would now be worth $550,000. So while evidence mounts that it’s almost impossible to hit the jackpot with cost-burdened mutual funds—and that for every Google, there’s an Enron—we simply refuse to stop trying.

Perhaps Solli and Geddes had it right when they selected the name for their company. The real purpose of this whole revolution is “to make things clear, to reveal the truth.” As Solli puts it, “As long as people know what they’re dealing with, they can invest their money with full awareness. Whether it’s playing it safe with indexing or taking a flier on a hedge fund—at least they’re the ones in control.” 

What about hedge funds?

So, the bulk of your savings is safely tucked away in a sensible index fund or two. Why not set aside 5 or 10 percent and take a chance on the post-dot-com insider’s investment craze?

It’s certainly tempting. The most high-profile manager, Edward “Eddie” Lampert, has reportedly earned investors in his ESL Investments hedge fund an average return of 29 percent a year since 1988. After successfully buying Kmart with his investors’ money, Lampert turned the merged retailer around and in 2004 personally took home $1 billion.

Another of the world’s most successful funds is San Francisco’s Farallon Capital Management, which has amassed assets of $12.5 billion over two decades by delivering post-fee returns of 17 percent a year on its flagship fund, according to a 2005 article in Institutional Investor magazine. Forty-eight-year-old Tom Steyer’s investors include universities, pension funds, and individuals; at any one time, the magazine said, the managers there might be nursing 300 to 500 investments in everything from real estate—Farallon recently bought into the Mission Bay development—to international finance.

But the road from Wall Street is scattered with the bones of bitter hedge fund investors. Since 1995, more than 1,800 known hedge funds have folded completely. In the last few months alone, two large funds—MotherRock and Amaranth Advisors—have gone south.