ITA Wealth Management

I understand why mutual fund managers, newsletter writers, brokers, CNBC etc. don’t want the small investor to know the truth about index mutual funds or ETFs. After all, their lively hood depends on active stock pickers. It is at the very heart of the investing industry to push stock picking, market timing, and active management. Missing the mark or the benchmark keeps active investors coming back to the gaming table.

Mark Hebner writes, “If investors consciously want to gamble, then that is a different story. They can try to outperform the index and their fellow investors if they wish. But, they must realize they will not be able to outperform the indexes for any lengthy period of time. Although they may win a few times at the roulette wheel, they will count themselves lucky, but hardly skillful. After all, if a majority of the gamblers in Vegas actually won, who would pay for all the fancy lights?”

When an active investor tells you they are beating the market, ask them the following questions. They should be able to answer all questions clearly or tell you they have the information available. Even passive portfolio investors need to be able to answer these questions.

• How do you define “the market?” If they use the VTSMX index or the Wilshire 5000, then fine. Be sure to push them beyond the S&P 500, although that is not too shabby a standard.
• Do you measure the Internal Rate of Return (IRR) for the portfolio and if so, what software is used to make the calculation?
• Now here comes the first tough question. How is the IRR measured for the portfolio benchmark (VTSMX index fund for example)? Does the software correctly handle cash flowing in and out of the benchmark? If the investor can not answer this question with sufficient clarity then the original argument of “beating the market” falls apart as they do not have an accurate method for comparing portfolio performance with benchmark performance.
• How is risk measured for the portfolio? What risk is the investor taking to “outperform the market or benchmark?”
• Over how many years has the managed portfolio sustained a lead over the market? Is this true for various five or ten-year rolling periods?

Photograph: London, England