Blessed by the Potato

An active portfolio manager recently criticized index investing because Valeant became the biggest TSX component and then blew up, as Nortel did in ages past. The implication being that active investing would have avoided concentrating so much into a stock like that.

This is a flawed argument. First, he’s suggesting that active management could have avoided the Valeant collapse, which we can’t just take as a given. After all, it didn’t get that way because of the index investors — Valeant became the biggest TSX component because on average active investors gave it that valuation. Now, it’s possible (especially in this case of a cross-listed stock with an international presence) that American active investors are what drove the price up, leading to its over-weight status in the Canadian index (even if Canadian mutual funds didn’t hold it to that proportion), or a small minority of Canadian active investors just going crazy for the stock drove up its proportion in the index, but sparing the portfolios of most active investors.

Whatever, it happened: Valeant became huge then blew up¹. That makes 2015 an easy comparison year for active funds versus the index, right? And indeed, over half of Canadian equity funds managed to out-perform the index that year, a massive increase over the typical numbers. However, despite the gimme at the end of the period, nearly two-thirds of funds still under-performed on a 5-year basis — this is clearly not a fatal flaw in index investing.

Which makes it a really insidious sort of criticism because there is a nugget of truth in there. It would be better if bubbles never formed and blew up, but that’s too hard to avoid in practice, and over the long term (which is what matters), indexing is still the better bet. Even if every once in a while the indexes do throw a soft pitch inefficiency to the active investors, it’s too hard to take advantage of (net of fees) consistently enough to win out.

Oh, and while 2015 was a pretty good year for Canadian active investors versus the average, note further down in the report that 85% of US equity funds under-performed the S&P500 that year, and 99% under-performed on a 5-year basis.

Every now and then index investing will include blow-ups like this (or miss run-ups), making an easy comparable for the active managers. Despite the odd case of that happening, over the long term index investing has been the better choice.

1. Fun fact: VRX is the biggest near-miss in my active investing portfolio. Screwing that trade up is perhaps the strongest signal that I’m too busy for even a small active “play” portfolio and it’s time for 100% indexing for me. I decided to short VRX in August 2015, after the AZ Value posts but before Philidor hit the news. I put in an order to buy some puts, but was too stubborn to cross the spread. My bid did not get filled at the end of the day, and then I was too busy with work to enter it again the next few weeks. Then the Philidor revelations came out and I was dumb enough to think that falling from ~$300 to ~$240 meant that I was chasing it down and most of the negative news was baked in. If I had just been willing to cross the spread and pay like $20 more for my puts, or even to come back and keep the bid alive, I would have had about a 15X return on that short. It is no small source of embarrassment and rage and kicking myself that I actually had done the research and entered an order, and still managed to miss out. As Wayfare said, “there’s this great book on passive index investing you should read…”