Wrongheaded Advice from Kiplinger's Steve Goldberg

I like Kiplinger's Personal Finance magazine. And I like Kiplinger.com columnist Steve Goldberg. I think both do a pretty good job helping investors navigate their way through the thickets of the financial world. Perhaps Steve was just trying to be outlandish this week. Or maybe he had a hard time finding something to write about. Whatever the case, the latest installment of his column, headlined Why I Would Avoid Index Funds, is just plain nonsense.

In the column, Steve says that he sees "good reasons to favor actively managed funds over the next year or two." The thrust of his argument comes down to two points. First, the bear market has left actively managed funds with a lot of capital losses that they can use going forward to offset any gains, thereby minimizing investors' tax hit. His second argument is, essentially, that it's a "stock-picker's market," and the fact that so many blue-chip stocks are underpriced relative to some of their doggier compatriots means that a smart fund manager should be able to add value in the near-term.

Let's unpack each of these arguments, shall we?

First, the tax issue makes very little sense. Yes, it's true that most equity funds (actively managed or indexed) are carrying capital losses on their books. And it's also true that these losses should increase the funds' tax efficiency. (Mutual funds must pass any realized capital gains through to their fund shareholders each year. But they'll be able to use the capital losses inflicted by the bear market to offset those gains going forward.)

Index funds are typically much more tax efficient than actively managed funds -- largely because of their lower turnover -- which accounts for part of their long-term record of outperformance. Steve argues that because this advantage might be mitigated over the next year or two, it heightens active management's appeal.

Well, let's think this through for a minute. If you're worried about taxes, you're by definition holding your investment in a taxable account, no? So let's assume an investor follows Steve's advice and swaps an index fund for an actively managed fund for the next two years. At that point, you'll have two choices: 1) sell your investment to return to an index fund, incurring (one hopes) a capital gains tax on the sale; or 2) stick with the actively managed fund, which will almost surely become more tax inefficient going forward as those capital losses are used up.

Does that make sense? If tax efficiency is one of your primary motivations (and I agree it should be high on the list) it would seem odd to undertake a strategy that will lower your portfolio's tax efficiency over the coming years, regardless of whether or not your active management bet comes through.

Next, Steve trots out the old "stock-picker's market" argument, and even quotes a fund manager who -- surprise, surprise! -- agrees with him that we're entering a stock-picker's market. (As an aside, aren't fund managers supposed to be, by definition, good stock pickers? In any market? Are they implying that in a non-stock-picker's market -- whatever that is -- their success is due to dumb luck?)

Goldberg argues that because firms like Johnson & Johnson, Microsoft, and Procter & Gamble are (supposedly) undervalued, smart fund managers who overweight stocks like these at the expense of the "junky stocks" that have led the market in recent months will be able to earn index-beating returns.

Perhaps that's true, of course. But it's also true that the three firms Goldberg mentioned are three of the most widely-followed (and owned) corporations on the planet. The future might demonstrate that their valuations today were much too conservative, but right now, they're valued at precisely what millions of investors (dominated, by the way, by professional money managers) say they're worth.

Secondly, these smart stock-pickers who are shrewdly accumulating overweight positions in these firms are offset, dollar for dollar, by professionals on the other side who are underweighting these firms. Each is making a bet. One side will win, the other will lose. Indexers, of course, will be right in the middle -- benefiting a bit less (before costs) than the winners on the upside, or losing a bit less (again, before costs) than the losers on the downside.

Bear markets, bull markets, stock-pickers markets or dumb-luckers markets. There's always a cadre of experts willing to argue why the conditions now -- right now -- dictate that it makes sense to favor active management over indexing.

The fact that they've been consistently wrong over the past four decades in all sorts of market conditions doesn't seem to dissuade them. If their "advice" wasn't so costly and (in many cases) their self-interest so blatant, you'd almost have to admire their pluck -- almost.

At the end of his column, Goldberg acknowledges that "[t]he market gods stack the odds against actively managed funds." Yes, they do indeed. Which is why most investors are better off sticking with index funds over the long-term, regardless of what we believe will or will not happen over the next year or two.

Image via Flickr user kalleboo CC 2.0