Pod Insights Freakonomics Radio 297. The Stupidest Thing You Can Do With Your Money About this episode It's hard enough to save for a house, tuition, or retirement. So why are we willing to pay big fees for subpar investment returns? Enter the low-cost index fund. The revolution will not be monetized.
Transcript 8,368 words · 11 speakers
Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.
0:01 Stephen J. Dubner? Freakonomics Radio is sponsored by PNC Bank. Boring. Great word, bad rep. Yet, time and time again, here at Freakonomics, we find that when something culture-changing happens, boring things like calculations and careful planning are usually behind it. Which begs the question, why not apply it to other aspects of life? Like banking, for example? Well, PNC Bank did, since its inception, proving time and again that the best banking strategy isn't the exciting type, but the steady, reliable, definitely-not-yolo type. PNC Bank: brilliantly boring since 1865. "Brilliantly boring since 1865" is a registered mark of the PNC Financial Services Group, Inc. PNC Bank, National Association, Member FDIC.
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2:51 Stephen J. Dubner? Hey there, Stephen Dubner. I thought you might like to know about the latest episode of our other live podcast, Tell Me Something I Don't Know. The episode is called Behavior Change Ultra Egghead Edition, and it features some of the smartest people in behavioral science, including people you've heard before on Freakonomics Radio, like Angela Duckworth, the Penn psychology professor and author of Grit, and David Leibson, Chair of the Harvard Economics Department.
3:18 Speaker 01 I'm a behavioral economist. My academic expertise is procrastination.
3:25 Stephen J. Dubner? In 30 seconds or less, how can someone get grittier?
3:29 Speaker 02 Grit is passion and perseverance for very long-term goals. It takes more than 30 seconds.
3:39 Stephen J. Dubner? You can find Tell Me Something I Don't Know wherever you get Freakonomics Radio. And if you want to be on the show or attend a live taping, visit tmsidk.com. We've got six shows coming up in New York City in early October at Joe's Pub at the Public Theater. Hope to see you there.
4:01 Stephen J. Dubner? What would you say if I told you that everyday investors, people like you and me, are just throwing away billions and billions of dollars?
4:09 Speaker 03 It's not something that just started today. It's been going on for the last 20 or 30 years.
4:16 Stephen J. Dubner? Is it some kind of a tax?
4:18 Speaker 04 It's a tax on smart people who don't realize their propensity for doing stupid things.
4:25 Stephen J. Dubner? Just how stupid is this stupid thing?
4:27 Speaker 03 Basically, we were saying you're charging people for stuff you can't deliver.
4:31 Stephen J. Dubner? But in recent years, there has been a backlash. Some would even say it's become a revolution.
4:37 Speaker 05 It's definitely a revolution.
4:39 Speaker 04 We are in the middle of the Copernican revolution about the proper way to invest, or at least the rational way to invest.
4:51 Stephen J. Dubner? Today on Freakonomics Radio, the revolution in low-cost index investing, also known as Wall Street's worst nightmare.
4:59 Speaker 04 You know, there's too much BS in Wall Street.
5:16 Speaker 06 From WNYC Studios, this is Freakonomics Radio, the podcast that explores the hidden side of everything. Here's your host, Stephen Dubner.
5:30 Stephen J. Dubner? It's hard to think of any other realm where empiricism, or at least what's dressed up to look like empiricism, clashes so directly with delusion. I'm talking about investing, the stock markets primarily. The alleged empiricism comes in the form of sales pitch data.
5:48 Speaker 03 It's easy to think, by seeing the ads and reading newspaper articles and stuff, that if you're just clever enough, you're going to win.
5:58 Stephen J. Dubner? The delusion comes in the form of how the stock markets actually work.
6:02 Speaker 03 We don't understand the negative some nature of active investing. Whatever you win, I lose. Whatever I win, you lose. And we both paid to play that game.
6:13 Stephen J. Dubner? That's Ken French.
6:14 Speaker 03 I am the Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth.
6:23 Stephen J. Dubner? So the negative sum nature of investing is one problem that's often overlooked.
6:28 Speaker 03 And then the second problem we all have, I suppose we don't all have it, but most people suffer from overconfidence, particularly in noisy environments where the feedback is weak. And that describes the stock market. It's incredibly noisy, and it's really easy to misinterpret what the return on your portfolio means.
6:49 Stephen J. Dubner? But wait a minute. We know how to interpret our portfolio returns, don't we? Those big money management firms and mutual fund firms and investment advisors, they're so helpful in telling us how much our hard-earned money is growing, right? Okay, it can be kind of hard to keep track of all the fees they're deducting, but still, isn't it amazing that the firm you chose, no matter which one you chose, just happens to be better than everybody else at picking the best stocks and funds?
7:23 Speaker 04 You know, there's too much BS in Wall Street, and being able to say, hey, here's what the data shows, is really a useful skill.
7:31 Stephen J. Dubner? That's Barry Ritholtz.
7:32 Speaker 04 I run an asset management firm called Ritholtz Wealth Management.
7:36 Stephen J. Dubner? All right, so explain how you, Barry Ritholtz, actually make money. Who is paying you to do what?
7:45 Speaker 04 So we get paid a percentage of assets, I want to say, I haven't looked at it this quarter, but it's somewhere under 1%, about 0.88 or 0.89, somewhere in that range. So the more assets we gather and the better those assets perform, the more revenue the firm sees.
8:06 Stephen J. Dubner? That is a pretty typical setup. Many investors pay firms to manage their money, sometimes a percentage of assets, sometimes a flat fee. In return, you may get a variety of services, including advice about insurance or taxes, and of course, investment advice. How best to save for a house, or your kid's tuition, or retirement, whatever. Now, why pay someone for that advice? Because, let's face it, investing can be confusing and intimidating. All that terminology, all those options. So you hire someone to navigate that for you, and they, in turn, use their expertise to pick the very best investments for your needs. This is called active management.
8:50 Stephen J. Dubner? They actively select, let's say, the best mutual funds for your needs, and you pay them for their expertise. You also pay those mutual funds, by the way. Sometimes there's what's called a sales load when you buy it, and an expense ratio, a recurring fee the fund deducts from your account. So between the mutual fund fees and the investment fees, that might be a couple percent off the top. And that's whether your funds go up or down, by the way. So hopefully, they go up. Hopefully, the active management you're paying for is at least covering the costs.
9:23 Speaker 03 What we actually found was the top 2% to 3% had enough skill to cover their costs, and the other 97% or 98% didn't even have that.
9:34 Stephen J. Dubner? In 2010, Ken French and Eugene Fama published a study in the Journal of Finance called "Luck Versus Skill in the Cross-Section of Mutual Fund Returns."
9:45 Speaker 03 So what Fama and I were doing in that paper is trying to figure out, when a fund does really well, should we attribute that to, this is a manager that is incredibly talented and really beating the market? Or are we just looking at the result of luck?
10:05 Stephen J. Dubner? That is, did their funds rise in value because of their stock picking skill? Or perhaps simply because the market was rising? And again, the Fama-French finding?
10:15 Speaker 03 So the top 2% to 3% enough skill to cover their costs. Everybody else, down below that.
10:22 Stephen J. Dubner? Ouch. It's enough to make you think that maybe it's not worth paying those investment experts for their expertise. If only there were some simple, cheap way to avoid all that active investing that often doesn't pay off and just passively own, say, a small piece of the entire stock market. Well, as you may know, there is. They're called index funds and ETFs for exchange traded funds. They can be bought very cheap and in recent years, a lot of people have been buying them.
10:54 Speaker 04 When we look at the fund flows over the past few years, there is a massive outflow from active fund management.
11:05 Speaker 05 The number comes out to, I think, around a trillion and a half flowing into index funds and a half a trillion flowing out of active funds, which is a $2 trillion shift in investor preferences. It's definitely a revolution.
11:20 Stephen J. Dubner? That is John Bogle.
11:22 Speaker 05 Often called Jack. I'm the founder of Vanguard. I'm the founder of the world's first index fund.
11:28 Stephen J. Dubner? How big a deal is Jack Bogle? Here's what Barry Ritholtz thinks.
11:32 Speaker 04 Jack Bogle is one of the unsung heroes of the American middle class. He has allowed people to invest over the long haul very inexpensively with excellent results in a way that they probably wouldn't have been able to do without him and without Vanguard.
11:50 Stephen J. Dubner? Warren Buffett, the most famous investor in the world, had this to say recently. If a statue is ever erected to honor the person who has done the most for American investors, the hands down choice should be Jack Bogle.
12:03 Speaker 04 Vanguard is clearly the leaders in low cost indexing. They're now $4 trillion, right? That's an astonishing number.
12:13 Stephen J. Dubner? How astonishing? $4 trillion could buy you every major sports league in America and Apple, the company, all of it, and put 8 million kids through college and you'd still have a trillion dollars left over. That's how much money we have collectively given to Vanguard. Why? Because they were the first to offer an alternative to the old school, expert driven, high fee investing model. Let's get back to Jack Bogle.
12:43 Stephen J. Dubner? You said recently, last year, "What's clear is we're in the middle of a revolution caused by indexing. It's reshaping Wall Street, it's reshaping the mutual fund industry." Now, for the man who really can claim way more credit than anyone else for starting the revolution, does it seem like a revolution or more of an evolution? In other words, it's been a long time coming.
13:03 Speaker 05 It is a revolution, still going on. It's starting. In the last few years, it's actually kind of accelerated, and I don't think that acceleration can continue. But I do think the dominance of the index fund will continue, simply because we're in an industry where cost is everything. And no one wants to compete on cost. Managers don't want to compete on cost, they want to make money for themselves. It didn't bother me that it took a long time. You know, it takes time for people to understand, keep up. I did my best to help.
13:40 Stephen J. Dubner? One way Bogle helped was by setting up Vanguard as a cooperative. It's owned by the fund's shareholders. Rather than distributing profits, it lowers its fees.
13:52 Stephen J. Dubner? You, as the founder of Vanguard, you as the father of index fund investing, how have you turned out financially? Are you worth billions and billions and billions?
14:01 Speaker 05 No, I'm not even worth a billion. They laugh at me. I'm not even worth 100 million. But, you know, I was never in this business to make a lot of money for myself. I mean, I've been nicely paid, particularly in the days when I was running the company. And I'm not a spender. I buy my, a new sweater every once in a while, or a new shirt from L.L. Bean. And my wife is the same way. We're just not interested in things, toys. So we're very happy with our standard of living. We have a nice, small house that we love. We have a wonderful family. And at almost 88 years old...
14:41 Speaker 05 You know, I might be the most blessed man in the United States of America.
14:44 Stephen J. Dubner? Bogle created Vanguard in 1975, when things weren't going so well for him.
14:50 Speaker 05 It was a way for me to get back in the business, to get back in my old company, which I'd been fired from.
14:56 Stephen J. Dubner? The old company was Wellington Management, where Bogle had spent more than two decades. In 1970, he had become CEO. In 1974, he was fired for making what he admits was an extremely unwise merger decision. When he started Vanguard, it was just another traditional, actively managed money firm, and part of that business still exists. But Bogle had long questioned the wisdom of picking stocks.
15:22 Speaker 05 In Princeton University in 1951, when I was choosing a topic for my senior thesis, I chose the mutual fund industry. "The Economic Role of the Investment Company" was the title of my thesis. I'd examined the records of some funds. We didn't have what we had today in records, but I looked at a half a dozen funds anecdotally. And I said in my thesis, this is virtually a direct quote, "Mutual funds can make no claim to superiority over the market averages." And that's the harbinger of the index fund.
15:55 Stephen J. Dubner? A harbinger, maybe, but Bogle spent his first couple decades in the business dancing the same dance as everyone else. Then, in 1974, the same year Bogle was fired from Wellington, the Journal of Portfolio Management published a paper by the economist Paul Samuelson called "Challenge to Judgment."
16:14 Speaker 05 I was inspired by his article.
16:15 Stephen J. Dubner? Samuelson was a Nobel winner and an extremely influential thinker.
16:20 Speaker 05 I'm trying to think whether to say he was 1,000 times smarter than I was, or 100 times, but it was something like that.
16:27 Stephen J. Dubner? Samuelson's paper challenged the performance of active managers and suggested that, quote, "At the least, some large foundation should set up an in-house portfolio that tracks the S&P 500 index, if only for the purpose of setting up a naive model against which their in-house gunslingers can measure their prowess." Jack Bogle, who was in the midst of launching Vanguard, took it to heart. Others had been thinking through the idea, but Bogle and Vanguard were the first real players to take the plunge. The notion was brutally simple. Most stock pickers think they are better than the market and they aren't. Therefore, investors should just buy the whole market.
17:11 Stephen J. Dubner? And since you're not paying the big salaries and all the other costs that go along with those stock pickers, the fund would be much cheaper to buy. When you founded it, it was treated as heresy, even laughable by most people on Wall Street. Talk about what it was like to experience that reception.
17:33 Speaker 05 Well, I don't, I don't cave in very easily. You may have sensed that. And in a certain way, the more dissent I got, the more confident I was that I was right. I'm not kind of a contrarian person. So people laughed. There was this great poster that said, "Stamp out index fund." There's Uncle Sam with a cancellation stamp all over it, all over the poster. Index funds are un-American.
18:00 Stephen J. Dubner? And they were considered un-American. That argument was what?
18:02 Speaker 05 The, the argument is, in America, we don't settle for average. We're all above average. But of course, we're not all above average. And, but it was basically, the poster was put out by a brokerage firm. When I think about the index fund, no sales loads, no portfolio turnover. You know, you don't buy and sell every day like these active managers do. It's Wall Street's nightmare. And it still is. So it was a, that kind of reception didn't bother me. Fund was known as Bogle's folly. The original underwriting was supposed to be 150 million. This is the original underwriting of the index fund. And the underwriters, sheepishly, on the day the underwriting was completed, came in
18:46 Speaker 05 with $11 million instead of 150 million.
18:50 Stephen J. Dubner? And did you lose a little confidence then, or no?
18:53 Speaker 05 No. They said, you know, why don't we just drop the whole thing? It was probably the worst underwriting in the history of Wall Street. And I said, no, we're not going to drop it. We have the world's first index fund. That's good enough for me. So we went ahead, started to run it. It took a long time for people to get the idea.
19:14 Stephen J. Dubner? But increasingly, people are getting the idea that rather than spending, let's say, $10,000 to buy five different mutual funds, each made up of a basket of hand-selected stocks, you'd spend all $10,000 on one fund that simply tracks an entire stock index, the S&P 500, maybe. It's going to be a lot cheaper than buying those separate actively managed funds. And as the data have shown again and again, it will likely perform better as well. Over the past decade, according to The Wall Street Journal, between 71% and 93% of US stock mutual funds either closed or failed to beat their closest index funds.
19:56 Speaker 05 If we go back to 1970, we find that there were approximately 400 funds in business. And I think, basically, 330 or 40 have gone out of business. So it turns out in that period, there were two mutual funds who beat the market by more than 2% per year. Two. That's half of 1% of all the funds that started the business. Those are your odds.
20:23 Stephen J. Dubner? Those may be the odds, but the perception is different. Warren Buffett, a stock picker who does beat the market, is a national hero. In schools all across America, when kids are introduced to the concept of investing, they're often encouraged to become little Buffets, playing stock market games where they pick individual stocks, rather than being taught the sensible route of dollar-cost averaging their way into low-fee index funds. It's a bit like learning to drive on a Formula One circuit.
20:56 Speaker 03 The notion that we can all get rich by trading actively just doesn't make any sense whatsoever.
21:03 Speaker 05 You have to understand one important thing about the market. And that is, for every buyer, there is a seller. And every seller, there is a buyer.
21:12 Speaker 03 Every time somebody wins, somebody loses even more.
21:15 Speaker 05 So when transactions take place, the only winner, net, is the man in the middle, the croupier in the gambling casino.
21:23 Speaker 03 You have to believe you really are superior to the other folks that you're trading against.
21:29 Speaker 04 I draw the parallel between being an outstanding, market-beating manager, trader, whatever. With being an all-star in any professional sports league, it's such a tiny percentage. If you don't think that you're really one of the best people out there doing this, you probably shouldn't even start. But every kid who ever picked up a baseball bat, a basketball, football, dreams of winning the championship, hitting the bottom of the ninth home run. And the problem is, if you invest based on those fantasies, the odds are strongly that you're going to be disappointed.
22:07 Speaker 05 So this is actually simple wisdom.
22:12 Stephen J. Dubner? Simple, perhaps, but elusive. In part because the alternative, the gamble of picking stocks, is so seductive, which may explain why it took so long for index funds to really catch on. The index fund is more predictable and boring, which, as Jack Bogle sees things, is its virtue.
22:32 Speaker 05 So it diversifies away the risk of individual investments. It diversifies away the risk of picking a hot manager. And it diversifies away the idea that you can pick market sectors, like healthcare, technology, or whatever it might be.
22:48 Stephen J. Dubner? And then there's the cost comparison. We'll start with the typical mutual fund.
22:52 Speaker 05 They charge a lot for this service. We estimate the average expense ratio is almost 1% for an actively managed fund. And then these active funds often have sales loads. The index funds do not. And the active funds further turn over their portfolios at a very high rate, and that's costly. And you add that all up, and the cost of owning a mutual fund, on average, is 2%.
23:20 Stephen J. Dubner? And how does that compare to an index fund?
23:22 Speaker 05 You can buy an index fund, S&P 500 index fund, let's say in this case, for as little as Four basis points, four one-hundredths of 1%. So in a 7% market, you're going to get 6.96%.
23:37 Stephen J. Dubner? That difference, 2% versus four one-hundredths of 1%, may not sound like a lot, but over time, those numbers are compounded by what Jack Bogle calls "the relentless rules of arithmetic."
23:50 Speaker 05 You know, if the market return is 7% and the active manager gives you 5 after that 2% cost, and the index fund gives you 696 after that four basis point cost, you know, over time, you don't appreciate it much in a year, but over 50 years, believe it or not, a dollar invested at 7% grows to, I think around $32, and a dollar invested at 5% grows to about $10. So think what an investor thinks about when he looks at that number. He says, "Wait a minute. I put up 100% of the capital, I took 100% of the risk, and I got 33% of the return."
24:35 Speaker 05 Well, anybody that thinks that's a good deal, I've got a bridge I want to sell them. Here's the reality. This is a business, the mutual fund actively managed business, where you not only don't get what you pay for, you get precisely what you do not pay for. And therefore, if you pay nothing, you get everything.
24:58 Stephen J. Dubner? Jack Bogle is plainly a cheerleader for the revolution he helped start. There are, to be sure, plenty of critiques of indexing, or at least shortcomings, we'll get into those later, but the fact is that the revolution does seem to be happening. The evidence is in the data, and the evidence is in the air. Five months ago, a journalist tweeted out a Washingtonian article suggesting that White House Press Secretary Sean Spicer was going to be replaced. Spicer tweeted back, quote, "Getting government updates from Washingtonian is like getting stock tips from Us Weekly." To which Us Weekly replied, "Thanks, Spicy. Us Weekly does not recommend investing in individual stocks. Stick with a broad mix of low-cost index funds."
25:45 Stephen J. Dubner? That said, just last week, Sean Spicer did resign, but that doesn't make us weekly wrong about index funds. The question is,
25:54 Speaker 05 why did it take so long? That's what the question really ought to be.
25:59 Stephen J. Dubner? Coming up on Freakonomics Radio, why did it take so long?
26:03 Speaker 07 I mean, the academic world grasped this stuff basically immediately.
26:07 Stephen J. Dubner? And when index funds are too much of a good thing.
26:11 Speaker 08 And so what will end up happening is everybody will be overloaded in ETFs. They'll be overloaded in indexes. And when the market crashes.
26:20 Stephen J. Dubner? It's coming up after the break.
26:24 Stephen J. Dubner? Freakonomics Radio is sponsored by Southern New Hampshire University. The best investments are the ones you make in yourself, and no one knows that better than Southern New Hampshire University. With more than 200 online degree programs, no set class times, and low online tuition, Southern New Hampshire University is built to fit your life today and set you up for success tomorrow. Education is an investment. Why not make it a smart one? Apply for free at SNHU.edu/freakonomics.
26:57 Stephen J. Dubner? Freakonomics Radio is sponsored by PNC Bank. Boring, great word, bad rep. Yet, time and time again, here at Freakonomics, we find that when something culture-changing happens, boring things like calculations and careful planning are usually behind it. Which begs the question, why not apply it to other aspects of life? Like banking, for example. Well, PNC Bank did since its inception, proving time and again that the best banking strategy isn't the exciting type, but the steady, reliable, definitely not YOLO type. PNC Bank, brilliantly boring since 1865. Brilliantly boring since 1865 is a registered mark of the PNC Financial Services Group, Inc. PNC Bank, National Association, Member FDIC.
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28:19 Stephen J. Dubner? On October 14th of 2013, the University of Chicago Finance professor Eugene Fama began his day just like any other.
28:26 Speaker 07 I was doing my exercises and preparing my class for that day when they called.
28:32 Stephen J. Dubner? They, being the Royal Swedish Academy of Sciences Committee that awards the Nobel Prize in Economics.
28:39 Speaker 07 10 minutes later, there were reporters at the door. It was amazing.
28:44 Stephen J. Dubner? Wow. How'd you like that?
28:45 Speaker 07 I wasn't, I said, look, I have a class to go to. I can't deal with you. So I went and taught my class. They wanted to come into the class and I said, these kids pay a fortune for these classes. You stay out there.
28:59 Stephen J. Dubner? So you're sometimes called the father of finance, which-
29:03 Speaker 07 Yeah, I think it's the grandfather at this point.
29:07 Stephen J. Dubner? Well, here's the thing that seems strange to me. You know, to a lot of people, given that it's the 21st century and you're not 500 years old, hasn't finance been around for centuries?
29:17 Speaker 07 Not as an academic discipline. If you go back to the late 50s, there really was nothing called academic finance. Well, there was something being taught in business schools as finance, but it really had no strong research underpinnings. And if you look back at that time, the people in finance weren't economists. They, they were, I don't know how you'd characterize them.
29:43 Stephen J. Dubner? Kind of accountants more?
29:45 Speaker 07 Yeah, they were professional people. Some of them had come over from accounting, but they weren't strong in economics. So they, they didn't think of that kind of- Questions in those terms. So, for example, if you took an investments course at that time, it was a course on picking stocks, basically. How do you analyze companies to pick stocks? Of course, they had no, they had no model of what determines prices, so there was really no way to answer that, that question in any rigorous way. But, you know, at that point, we were developing lots of research that said, this is basically very difficult to do, if not impossible. And it's kind of pointless to, we don't really know anybody who can teach people how to pick
30:30 Speaker 07 stocks because we don't know anybody who can pick stocks.
30:33 Stephen J. Dubner? So you're also famous for developing what we now know as the Efficient Market Hypothesis. Explain it to a layperson.
30:40 Speaker 07 Oh, it's, it's easy to explain. It's a simple proposition. Proposition is that prices reflect all available information, which in simple terms means, since prices reflect all available information, there's no way to beat the market. Now, that, that's an extreme statement of the, of the hypothesis, and the difficult part is actually developing tests of it, because you have to say something about what the market is trying to do in setting prices.
31:08 Stephen J. Dubner? Because it's so hard to test, the Efficient Market Hypothesis is not universally accepted. Some behavioral economists argue that the standard human cognitive errors create imperfect pricing that a shrewd investor can exploit. What's Jack Bogle's take?
31:26 Speaker 05 The markets are highly efficient, although importantly, not perfectly efficient. They, you know, sometimes they're very efficient and sometimes they're not, and it's hard for we poor souls on, on earth to know which is which.
31:39 Speaker 04 You know, the basic concept of can you beat the market, it's subtler than I think some people want to argue. Barry Ritholtz again. It's not black and white. It's not that you can't beat the market. You can, and some people have, and have for long periods of time. Look no further than Warren Buffett. The challenge is being able to select who's going to be able to beat the market, for them to beat the market consistently, year in, year out, and then to do it in excess of costs, fees, taxes, commissions. And that's the brilliance of Eugene Fama, identifying that before anybody else saw it.
32:17 Stephen J. Dubner? Fama developed the idea in the late 1960s.
32:20 Speaker 07 I mean, the academic world grasped this stuff basically immediately. There was no resistance to it at all. I mean, it took a much longer time for it to penetrate into the applied community.
32:32 Stephen J. Dubner? And why was that?
32:34 Speaker 07 That's the $24 question. Well, I guess an even higher price than that would be irrelevant, given how long it's taken for people to really wake up to the data and what it says about active investing.
32:49 Stephen J. Dubner? Well, in retrospect, was the objection simply protectionist thinking by the financial services industry? Or was it something more than that?
32:57 Speaker 07 Well, the financial services industry had a lot to lose from this line of research because basically we were saying to them, you're charging people for stuff you can't deliver. So I was not a popular kid.
33:10 Stephen J. Dubner? Well, obviously, the idea caught on. It's often said that right now, we're in the midst of a passive investment revolution. Do you agree with that characterization? Is revolution too strong a word or no?
33:22 Speaker 07 Well, it, when my co-author Ken French was president of the American Finance Association, in his presidential talk, he said, it basically took 50 years to go from 0% passive to 20% passive. And then in the next 10 years, it's gone up to like 30. So we're still nowhere near taking over the world.
33:48 Stephen J. Dubner? So when is active management a good thing? Or maybe put it another way, when is it worth it for me to pay my one or even two points for an active manager?
34:00 Speaker 07 I would say, I don't know anybody for whom it's worth it. Because I don't think, I've analyzed more data than almost anybody, given that I'm so old. But I think the problem that People don't understand is that active managers, almost by definition, have to be poorly diversified, otherwise they're not really active. So they have to make bets. And what that means is there's a huge dispersion of outcomes that are totally consistent with just chance. There's no skill involved in it. It's just good luck or bad luck. And you can't tell the difference between the two based on returns alone. And this is looking at the world before costs.
34:40 Speaker 07 When you look at the world after costs, which is what people eat, they have to pay the cost to the people charging them. Well, then the whole industry looks pretty bad.
34:51 Stephen J. Dubner? So if you want to give yourself a bad chance versus the market and pay extra for it, that's when you should get an active manager, basically.
35:00 Speaker 07 Right. Be my guest.
35:02 Stephen J. Dubner? Well, it sounds kind of like college endowments, no offense. I don't know how U of C runs its endowment, but the Ivy League certainly.
35:10 Speaker 07 Badly. In the old-- I'm chucking-- it's not a laughable matter. But in the old days, they used to invite me annually to go talk to the person who ran the endowment. And it was clear he was totally not interested. And finally, I gave up and they gave up.
35:30 Speaker 04 The joke is that Harvard is a $38 billion hedge fund with a small college attached to it.
35:37 Stephen J. Dubner? Barry Ritholtz manages money, but he's got a couple of side gigs, too.
35:40 Speaker 04 I also am a columnist for Bloomberg View, and I host a weekly podcast called Masters in Business.
35:48 Stephen J. Dubner? In one column, he wrote, "If ever there was an argument for endowments to turn to passive indexing, Harvard is it." This was shortly before the Harvard endowment shook up its management team after years of poor returns. I asked Ritholtz about this.
36:06 Stephen J. Dubner? Harvard's annualized net returns for the past 10 years were less than 6%. In fact, when you look at the top performing Ivy endowments, they were all around 8% for those 10 years. Again, sophisticated, expensive management with access to all kinds of information and investments. So just out of curiosity, I went and looked at my boring, my own kid's college savings fund, which is stashed in a pretty dull and very, very cheap 529 plan. And there's just, you know, a handful of choices, index funds, there's one growth fund, one value fund, a couple of bond funds, and it costs pretty much nothing. And then lo and behold, my 10-year annualized net return beat every single Ivy endowment. Those are the best and the brightest.
36:49 Stephen J. Dubner? So why on earth would anyone want to pay those kind of fees for active management, whether you're an individual investor like me or a huge endowment like Harvard?
37:00 Speaker 04 Look, just because you're at an endowment running billions of dollars associated with some of the most sophisticated investors, there's no reason to think you're not going to succumb to the same sorts of cognitive errors and psychological failings that every other human being does. There's group think, there's a refusal to admit that you were wrong, there's an even bigger embarrassment of saying, I don't know. One of my favorite things to do is anytime I'm on TV and someone asks me a question, hey, where's the Dow going to be a year from now? I love to just say, I don't know. And they don't know how to respond to it. When you're in a room full of peers, when you're in a room full of consultants and
37:44 Speaker 04 everybody is pretending to be knowledgeable and sophisticated, there are all sorts of group dynamics that lead to, the technical term is suboptimal decision making.
37:57 Stephen J. Dubner? So the financial services industry is obviously gigantic. A lot of people have a lot of relatively high paying jobs for which, you know, they're supposed to create value for people who are investing money. But the data show, forget about whether it's Ivy League endowment data or across the board investment data, the data show that a lot of money that investors spend to get better returns is essentially wasted. First of all, would you agree with that statement?
38:22 Speaker 04 Most of the money they spend is essentially wasted. Not a lot. I would say the vast majority.
38:28 Stephen J. Dubner? All right. So the argument would be that they'd be better off buying a few index funds for essentially pennies on the dollar compared to what they're paying their investment professionals and that the, you know, financial services industry is kind of a tax on stupid people who think they're being really smart. Do you see it that way? Or is that a-
38:49 Speaker 04 It's worse than that. It's not a tax on stupid people who think they're smart. It's a tax on smart people who don't realize their propensity for doing stupid things. Look at all the endowments. Look at, look at how far behind the eight ball most of the state pension funds are. These aren't dumb people. These are really smart, accomplished people. They unfortunately, don't want to admit they don't know something, are very put off by counterintuitive information. You know, it's the Lake Wobegon syndrome. Everybody wants to believe that they're above average. Well, sure, it's hard to beat the market, but I can.
39:31 Speaker 04 What's amazing is there are actually S and P 500 index funds that have a giant fee attached to it. I can't explain how that works.
39:41 Stephen J. Dubner? That's a tax on stupid, no?
39:42 Speaker 04 That, that is a tax on stupid, for sure.
39:44 Stephen J. Dubner? You're literally paying whatever, double, triple, five times for exactly the same product, no?
39:48 Speaker 04 That, that's right. Triple, I want to tell you the Vanguard S and P 500 index fund is about five or six basis points and Schwab recently cut one to two or three basis points. There are S and P 500 funds with 50 and 75 and 100 basis points. It's an insane, that, that is a tax on dumb.
40:11 Stephen J. Dubner? The Dartmouth Finance professor Ken French has been closely watching the growing appetite for index funds.
40:17 Speaker 03 It's not something that just started today. It's been going on for the last 20 or 30 years. It does seem to have picked up speed.
40:27 Stephen J. Dubner? That said, French doesn't quite see the passive investing revolution as a revolution.
40:33 Speaker 03 I believe we are seeing a shift from active toward passive. I think that's pretty clear. But I don't think it's quite as pronounced as most people argue.
40:46 Stephen J. Dubner? That's because so much new money has been flowing into ETFs.
40:50 Speaker 03 An ETF is an exchange traded fund.
40:54 Stephen J. Dubner? Which may look a lot like a passive index fund.
40:57 Speaker 03 But what's unique about ETFs is you can trade them all day.
41:02 Stephen J. Dubner? And the volume of trading in ETFs, French says, suggests that many traders are not truly passive.
41:09 Speaker 03 I think of passive as essentially a buy and hold. They buy it today and they hold it for years and years. And we're not seeing that in the ETF marketplace. Some of the people are certainly doing that, but it appears a large fraction of them aren't.
41:24 Stephen J. Dubner? That said, there's plainly been an acceleration away from traditional active management. Why?
41:32 Speaker 03 I interpret that as one of the consequences of the financial crisis. So before the crisis, people had this view that Wall Street was our friend. And after the crisis, they're a lot more cynical about fees that are being charged and services that are being provided by Wall Street.
41:52 Speaker 04 And at a certain point, the investing public turns around and says, hey, you know, this is rigged. This is a tough gig. Why am I wasting my time picking stocks, paying commissions, paying high mutual fund costs? I could just index.
42:09 Stephen J. Dubner? There are, of course, plenty of alternative views, especially from those who profit from old school active investing. Still, you can imagine that if every investor in the world held pretty much the same investments, well, what would that lead to? A research note from the investing firm Sanford C. Bernstein argued that passive investing is, quote, "worse than Marxism" in that it threatens the legitimate give and take that is central to any market. Ken French again.
42:38 Speaker 03 One of the beautiful things that happens out there in the market is price discovery. And I would never argue all prices are right, but I think prices are pretty darn good. And we learn an awful lot about how resources should be allocated from what the prices are in the financial markets. So if nobody is doing price discovery, we lose a really valuable service. So what I always say is if it's somebody I don't like, I'm more than happy to have them go out there and spend their money investing actively because as a group, they're making the world better off.
43:19 Stephen J. Dubner? For what it's worth, Ken French, for all his skepticism about how modern investing works, he himself does some work with the huge investment firm Dimensional Fund Advisors. So does Eugene Fama. For all the noise about the passive revolution, it's worth remembering that only about 30% of all mutual and exchange traded funds are being passively managed. But it's enough to concern plenty of people who worry about homogenization, especially when the federal government gets involved.
43:51 Speaker 08 My name's Anthony Scaramucci. I'm the founder of Skybridge Capital.
43:55 Stephen J. Dubner? When we spoke with Scaramucci a few months back, he had just sold Skybridge Capital in anticipation of getting a job with the Trump administration. Just last week, that finally happened. He was named White House Communications Director. When we spoke, I asked Scaramucci about the soon-to-be-instated fiduciary rule. That's an Obama-era regulation that was pitched as ensuring that financial advisors act in their clients' best interests.
44:23 Stephen J. Dubner? You called the fiduciary rule, and I will quote you here, "a case study in government overreach, a clear example of how faulty regulation can have severe unintended consequences." You also promised to help President Trump repeal it. What are some of those unintended consequences of a rule to try to change the behavior of the people who are paid to manage other people's retirement money?
44:47 Speaker 08 Well, it's really not changing their behavior. What it's doing is it's actually limiting the choices for the end user, the end investor. Because if you read the entire rule, which I've read, what it really is, it's a governmental decision to allocate capital into index funds and ETF funds, that the government is deeming those things as being more efficient, they're more effective in terms of their lower cost analysis. And for the time being, the government is actually right. If you look at the last five or 10 years, those funds have performed better and charged less fees than, let's say, a hedge fund or a private equity firm. But the problem with that analysis is that you're not taking a 120-year, modern, economic,
45:32 Speaker 08 historical analysis of business cycles and stock market trends. You're really only looking at the last 10 years. And so, the buffet table of investment opportunities for the average user, let's say, my mom and dad, which I'm super concerned about, gets curtailed. I'm just going to sell you the things that the government wants me to sell you. And so, what will end up happening is everybody will be overloaded in ETFs, they'll be overloaded in indexes. And when the market crashes, because they will have eliminated many of the financial advisors, you'll lose 60,000 to 70,000 financial services jobs as a direct result of that rule. So it's a jobs killer. But what it also does is it fails to recognize the full economic value of a financial advisor.
46:16 Speaker 08 The economic value of a financial advisor is not just the return and the net return, net of the fees, but it's also the psychological effect and the coaching that that financial advisor provides that family. So, the rule is bogus, Stephen, and the rule needs To be repealed and the people that really understand the rule know that. And by the way, I love my clients as most financial advisors do. I'm not trying to rip off my clients. I'm not trying to do something that's dishonest. I'm just trying to increase continually their options in terms of what they can invest in.
46:56 Stephen J. Dubner? Think what you will of Scaramucci's take on the over concentration of investments in index funds. If the trend does continue, it's hard to dispute, as he says, that a lot of financial services jobs will be lost. I asked Barry Ritholtz about how his industry planned to protect or reform itself.
47:18 Stephen J. Dubner? As we've seen throughout history with any industry or institution that's got leverage, that's got money, that's got a history itself, reform never comes from within. Nobody's going to say, you know what? Our industry is really not providing value. We're getting paid billions, trillions of dollars to manage this money. And we're actually doing a pretty crappy job. Like a monkey with a dartboard would literally do better for just the price of monkey chow. So you know what? Let's, let's break up. Let's, let's send everybody home, say, we've had a nice run. We've had these nice hundred, 200, 300, $400,000 jobs just for shuffling other people's money around poorly. If the revolution really does come to pass and the world kind of says, you know what?
48:03 Stephen J. Dubner? The financial services industry, as it's currently configured, we only need about 5% of it. What happens?
48:10 Speaker 04 Well, first, no self-respecting person in finance would work for those absurdly low figures you quoted. So let's put that aside. And then second, you know, the financial markets go through this regular creative destruction every few years. You know, the, back in the early 70s, commission prices were fixed. You couldn't discount a commission if you wanted to. It was actually a legal regulation. And once that changed, suddenly Everybody predicted the end of the world of finance. Oh, my God, what's going to happen? They're going to start cutting prices. And that is what happened. You cut prices. People were, more people were able to access the capital markets.
48:54 Speaker 04 It worked out really well. And every few years, we go through one of these major innovations. Not too long ago, ETFs didn't exist. We take for granted that, wait, for five bucks, I could go out and buy an ETF of every major index I want? That's a shocking change that has also had significant impact. And so, as we go through this process of these convulsions, you know, maybe the, not maybe, definitely, the financial services industry became too large. It became too outsized. It became too overcompensated. It was the tail that was wagging the dog.
49:33 Speaker 04 It used to be financial services companies operated in service to big corporations and small investors and everything in between, but eventually, they started being a reason for their own existence. So that's now going through a change, probably before we lose 90% of people in finance or 95%. There'll be something else that happens. It seems that every time there's any sort of major trends, whether it's towards global investing, or passive investing, or day trading, you know, it'll last for a couple of years,
50:15 Speaker 04 and then something new and shiny comes along, and enough people are interested in it, that a substantial portion of the previous trend participants will chase that. However, I will say that I think the evolution towards low cost, towards indexing, and towards being aware of how your own behavior impacts your investing, is something that's going to be here for the foreseeable future.
50:46 Stephen J. Dubner? All right. So we learned today that low-cost indexing seems to make a lot of sense, at least for a lot of people in a lot of situations. But what about all the other things you have to do to be a fiscally sane and responsible adult? Glad you asked. That's what we will talk about on the next Freakonomics Radio, because a lot of people, including a lot of otherwise really smart people, are totally clueless when it comes to their personal finances.
51:17 Speaker 09 How do I save for retirement? How do I deal with all these questions about budgeting? And when to buy a house and all this kind of stuff? Oh, I just have to look at these nine rules on this card.
51:30 Stephen J. Dubner? Everything you ever wanted to know about personal finance, and it fits on one index card. That's next time on Freakonomics Radio.
51:45 Stephen J. Dubner? Freakonomics Radio is produced by WNYC Studios and Dubner Productions. This episode was produced by Greg Rosalsky. Our staff also includes Alison Hockenberry, Merritt Jacob, Stephanie Tam, Eliza Lambert, Emma Morgenstern, Harry Huggins, and Brian Gutierrez. We also had help this week from Sam Behr. The music you hear throughout our podcast was composed by Luis Guerra. You can subscribe to Freakonomics Radio on Apple Podcasts or Stitcher, wherever you get your podcasts. You should also check out our archive at Freakonomics.com. There you can stream or download every episode we've ever made. You can also read the transcripts and find links to all the underlying research. We can also be found on Twitter, Facebook, or via email at [email protected] . Thanks for listening.
52:44 Stephen J. Dubner? Freakonomics Radio is sponsored by EverPure. Is the value of AI not living up to the promise? The problem is probably your data, not your AI models. When it's scattered across different systems, getting your data AI-ready is a challenge. You keep your AI waiting and everything slows down. EverPure unifies your data so you can see it, understand it, and control it all from one simple place and get it AI-ready fast. Unlock the true value of your AI at everpuredata.com.
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53:47 Stephen J. Dubner? Freakonomics Radio is sponsored by Southern Company. The world and its energy needs are always changing. Southern Company's commitment to meeting this demand stays the same. That's because Southern Company believes energy is more than a utility. It's what powers possibilities. So they are looking ahead and investing $80 billion in infrastructure upgrades and are committed to fueling growth in ways that benefit all customers so that reliable and affordable energy is accessible for generations to come. Go to southerncompany.com to learn more. Southern Company, building the future of energy.
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