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June 28, 2011

Why the Deaf, Dumb, Blind Kid Can't Keep Winning Forever

How could a deaf, dumb and blind kid play a mean pinball? I have always found The Who's 1969 classic frustrating: the poor kid can't see or hear, and yet he is blessed with a compensatory talent for... pinball?  Couldn't they have given Tommy a more believable talent, like, say, truffle-sniffing?  The very strangeness of the song always made me think it must represent something important, but what? Well, after reading a recent newspaper article, I have figured the song's meaning out. Pinball Wizard is about index funds.

The article that enlightened me was touting the benefits of passive investing. It cited a study showing that in 2010, 65 percent of actively-managed large-cap funds were beaten by the S&P 500 Index ETF, commonly known as the "Spyder." Other studies have shown similar results-after expenses, index funds have beaten more than two-thirds of their peer active funds over the previous 10 years. The index fund managers had superior average performance without using their ears to listen to earnings calls, their mouths to ask questions of corporate management or their eyes to read research reports.  Turns out that on Wall Street, the deaf, dumb, blind kid really can play a mean pinball. 

How do you think they do it?  What makes them so good? Unlike Tommy's strange prowess with the silver ball, the theory behind index funds' superior performance is straightforward: they are what economists call "free-riders." Thanks to the legions of analysts grinding through accounting footnotes late into the night, the passive index investors can assume that all available public information is quickly baked into the stock price without their help, and therefore they don't need to burden themselves with complicated things like earnings forecasts and cash flows.

They base their businesses on the concept of market efficiency, which states that the investing pinball will ricochet in such unpredictable ways that playing without even looking is as valid a strategy as trying to predict the ball's path. And that means that passive investors can focus on keeping their operating and transaction costs low. Like the pinball wizard, they ain't got no distractions, don't care about no opening bells, don't see no news a'flashin', don't need to buy or sell.

Investors have bought in. It's been almost 40 years since Burton Malkiel began preaching that index funds were a logical choice in a world of efficient markets, but in the past three years their growth has gone through the roof. According to a Tabb Group study, in 2007, only 21 percent of managed long-only U.S. Equity assets were in passive funds. In just three years, Tabb estimates that this percentage more than doubled, climbing to 44 percent in 2010. 

There are a lot of explanations as to what caused the surge in passive investing. The popularity of ETFs is often cited as one of the prime suspects, and the numbers do somewhat back this notion up, with ETF assets having crossed the trillion dollar mark last year after their 18th consecutive year of market share growth.

Another explanation is that the 2008 credit crisis changed investor psychology. After investors witnessed almost all stocks plummet in unison, they concluded that exposure to stocks in general, or "beta" as professionals call it, is a far more important driver of returns than individual stock picking.  

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