Index Funds: The 12-Step Program for Active Investors – Book Review

Almost a perfect counterpoint to The Little Book That Beats The Market (review), this book could easily be titled The Big Book That Shows You Can’t Beat The Market. It weighs nearly 5 pounds, and is almost 400 pages long. This thing is a beast!

Instead, the title is Index Funds: The 12-Step Program for Active Investors. This is actually a pretty good title as well. Instead of starting at the pure beginner level, it assumes that you know a little bit about the market. Maybe you’ve dabbled in stocks, or have some hot mutual fund picks on your 401(k). The basic layout of the book is this:

1) Present an active-trading idea, and then

2) Provide multple examples of academic research by Nobel Laureates and historical data proving that the proposed idea is very much against the odds.

Here are some examples:

Active-trading idea #1: Stock picking, or the idea of picking specific stocks that can beat the market

Countering research:

  • Per three separate studies, the chances of a money manager beating a market over the long term (10+ years) is 1 in 36, 1 in 39, and 1 in 41. This is about the same as picking the right number on a roulette wheel in Las Vegas.

  • If you take the S&P 500 over the 1957 to 1988 period, only 12 of the 500 stocks, or 1 in 42, beat the market. Could you have picked those out ahead of time?

Active-trading idea #2: Time picking, the idea that one can pick the right time to be in or out of the market in general.

Countering research:

  • 95% of marketing-timing newsletters go out of business

  • In one study, out of 2,528 trading days, just 40 days made up 88% of the returns.
  • In another, only 90 days out of 30 years contained 95% of all market gains. That’s 3 days a year.

Active-trading idea #3: Manager picking, the idea that one can let a all-star fund manager help them beat the market.

Countering research:

  • Lots of fund advertise the most recent 5-year returns, suggesting that this is a result of skill. But in fact, the top 30 mutual funds from sequential 5-year periods underpeformed the market in the next 5 years. 5-year performances mean nothing.

  • The Forbes Magazine Honor Roll picks from 1971 to 1990 also subsequently underperformed the market after their selection.

The next part of the book talk about the how style drift is important in comparing apples to apples with regards to returns. That is, you should make sure to define “market” correctly. If a manager is picking lots of small stocks, it is unfair to compare his/her returns to the S&P 500. The effect of taxes and portfolio turnover is also addressed.

The rest of the book talks about how professors Fama and French devised the 3-factor model, which says that the vast majority of returns can be explained by three things:

  1. How much you are exposed to the market (Percentage in stocks)

  2. Size of the stocks (Small cap? Large cap?)
  3. Price of the stocks (Value? Growth?)

By using these factors to maximize return for a given unit of risk, twenty model portfolios are created. Fama and French also created Dimensional Fund Advisors (DFA), and all the portfolios are constructed mainly from these funds.

Unfortunately, DFA funds are only sold through specific financial advisors, which means first of all, you’ll need at least $100,000 if not $250,000 to invest in order to even get one of these people to talk to you. If you do have that much dough, you’ll still have to spend about 1% of your portfolio every year in fees, not even taking into account the expense ratios of underlying funds. Whether the performance of DFA index funds can justify these extra expenses is another argument which I won’t go into here.

Of course, this book is written by Mark Hebner, President of Index Fund Advisors, which are one of these DFA advisors. This could be seen by some as a conflict of interest. After reading the book, I must say the book is sales-pitch free and pro-index funds in general, but the latter part is definitely pro-DFA funds (although not specifically promoting IFA as an advisor). I really do wish that he did model portfolios with publicly-available index funds from Fidelity, Vanguard, and others. Also, if you buy funds directly through Vanguard or Fidelity there is no transaction fee, whereas for DFA funds you’ll have to pay brokerage commissions of about $25 a trade.

Conclusion
This book is not the easiest read, but it’s not horrible either. I would not recommend it for beginning investors. I also don’t like that it is does not offer any investors with less than $100,000 to invest any portfolio suggestions. In that way, it seems to only be targetting people who are candidates for their advisory services. However, I still use it as a general template for the Efficient Frontier.

In the end, I would categorize it as more of a reference book for index funds and also a guide to investing with DFA funds if you are so inclined. I plan to keep this book around to help remind me of specific examples of why active-investing is a hard thing to justify.

If you want to take a closer peek, most of the material in this book is online at the IFA website under the 12 Steps tab.

Overall Rating: 3 Stars [ratings explained]

(I would have given this book 2½ stars if I wasn’t committed to a simple rating system…)

Make your own opinion!
As I got this free from the publisher, a copy of this book will also be given away to a lucky blog reader in November.

Comments

  1. Quote “In one study, out of 2,528 trading days, just 40 days made up 88% of the returns. ”

    What’s the flip side of this argument? How many days make up the % of total losses in the market?

  2. I really liked the book.

    By the way, I don’t believe that promoting DFA funds is necessarily a conflict of interest. IFA is presenting their case for choosing DFA funds. IFA could choose any funds they wanted to.

  3. For those who don?t have the $100,000 minimum, I think Vanguard and/or T Rowe Price are the best choices. Diversified portfolio, dollar cost averaging, and no load/low expenses can all be combined to create a formidable investment that can rival anything that DFA can put together. There also doesn?t have to be a mix of index mutual funds comprising a solid portfolio. A combination of actively managed and passively-managed index funds will make for nice returns. The catch is to do your homework so that you choose funds that you are comfortable with. Like they say, if you can?t sleep at night because of your choices, you either picked poorly or can?t stomach the ups and downs of the market. And if you want material from a book, go to the library ? after all, you did pay for your public library through taxes.

  4. Steve the K says:

    I am probably wrong, but, IMHO, all mutual fund total returns should be compared to the S&P 500, espeically if their costs are significantly more than, say, Vanguard’s 500 Index fund. After all, why pay more for market underperformance when you can put your money in VFINX and forget it for a few decades?

    Granted that at certain times certain stocks will be better than others, e.g., Value vs. Growth, Small vs Mid vs Large cap, etc., but moving money around to the “hot” sector is essentially market timing.

    As Ron Muhlenkamp said at a conference, a money manager that advocates diversification means that they don’t know a good investment from a bad investment.

  5. I echo Ron’s opinion. The 0.9% annual fee plus trading cost for individual transactions on top of the underlying DFA fund fees are hard to justify.

    There’s a good thread on morningstar for discussions on how to get to DFA funds, link

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