SINCE THE INCEPTION OF the first index mutual fund in 1975, traditional index funds (TIFs) designed for the long-term investor have proved to be both a remarkable artistic success and an incredible commercial success.

In previous chapters, we’ve demonstrated—pretty much unequivocally—the success of index funds in providing long-term returns to investors that have vastly surpassed the returns achieved by investors in actively managed mutual funds.

Given that artistic success, the commercial success of indexing is hardly surprising. (Although it was a long time coming!) The principles of the original S&P 500 Index model have stood the test of time. Today, the lion’s share of the assets of TIFs are those that track the broad U.S. stock market (the S&P 500 or the total stock market index), the broad international stock market, and the broad U.S. bond market.

Assets of these traditional stock index funds have soared from $16 million in 1976 to $2 trillion in early 2017—20 percent of the assets of all equity mutual funds. Assets of traditional bond index funds have also soared—from $132 million in 1986 to $407 billion in 2017— 13 percent of the assets of all taxable bond funds. Since 2009, TIF assets have grown at an 18 percent annual rate, slightly faster than their ETF cousins.

Success breeds competition.

In many arenas, indexing has become a competitive field. The largest managers of TIFs are engaged in fiercely competitive price wars, cutting their expense ratios to draw the assets of investors who are smart enough to realize that costs make the difference.

This trend is great for index fund investors. But it slashes the profits of index fund managers and discourages entrepreneurs who start new fund ventures in the hopes of enriching themselves by building fund empires.¹

Passive ETF strategies designed to outpace stock market returns.

How, then, have index fund promoters taken advantage of the proven attributes that underlie the success of the TIF? Why, they create new indexes and join the exchange-traded fund (ETF) parade! Then, they claim (or at least strongly imply) that their new index strategies will consistently outpace the broad market indexes that up until now have pretty much defined how we think about indexing.

ETF managers charge a higher fee for that higher potential reward, whether or not it is ever actually delivered (usually not). Offering the promise of earning excess returns, a whole host of ETFs have sprung up to entice investors and speculators alike.

Active managers versus active strategies.

Let’s consider the difference between the approaches of traditional active money managers and the approach of ETF managers. Active managers know that the only way to beat the market portfolio is to depart from the market portfolio. And this is what active managers strive to do, individually.

Collectively, they can’t succeed. For their trading merely shifts ownership from one holder to another. All of that swapping of stock certificates back and forth, however it may work out for a given buyer or seller, in the aggregate it enriches only our financial intermediaries.

But active managers have a vested financial interest in making the case that if they have done well in the past, they will continue to do so in the future. And if they haven’t done well in the past, well, better days are always ahead.

Sponsors of ETFs, on the other hand, make no claim to prescience. Rather, most rely on one of these two strategies: (1) Offer broad market index funds that investors can profitably trade in real time. (This seems to be a specious claim.) (2) Create indexes for a wide range of narrow market sectors that investors can swap back and forth, earning extra profits. (In fact, the evidence goes the other way.)

So what’s happening is that the responsibility for investment management and portfolio strategy is being shifted from active fund managers to active mutual fund investors. This crucial shift has broad implications for Main Street investors. I confess to being skeptical that this change will serve investors well.

The new breed of passive indexers are active strategists.

The new breed of passive indexers have largely chosen the ETF structure to market their products. It’s an easy market to enter. In recent years, “smart beta” ETFs (whatever exactly that means) have become a hot product.

Smart beta managers create their own indexes—not, in fact, indexes in the traditional sense, but active strategies claiming to be indexes. They focus on weighting portfolios by so-called factors—stocks with similar forces driving their returns. Rather than weighting portfolio holdings by their market capitalizations, they may focus on a single factor (value, momentum, size, etc.) or they may use a combination of factors such as corporate revenues, cash flows, profits, and dividends. One smart beta ETF portfolio, for example, is weighted by the dollar amount of dividends distributed by each corporation, rather than weighted by the market capitalizations of its components.

Not a terrible idea, but not a world-changing one, either.

As a concept, smart beta is not a terrible idea, nor is it a world-changing one. Smart beta ETF managers rely on computers to parse heavily mined past data on stocks that will enable fund managers to identify factors that can be easily packaged as ETFs. The goal is to create great profits for the manager by gathering the assets of investors seeking a performance edge.

Mark me as from Missouri on these strategies. Of course it seems easy. But it isn’t. Consistently outpacing the market is difficult, in part because of the power of reversion to the mean in mutual fund returns. Today’s winning factors are all too likely to be tomorrow’s losing factors. Investors who disregard RTM are all too likely making a huge mistake.

“Remembrance of things past.”

With the rise of ETFs, once again remember the “Go-Go” fund craze of 1965–1968 and the “Nifty Fifty” craze of 1970–1973; popular fads are driving product creation in the fund industry. These products are great for fund sponsors, but almost always awful for fund investors. Let me remind you of this time-honored principle: Successful short-term marketing strategies are rarely—if ever—optimal long-term investment strategies.

And this will not surprise you—the fundamental factors that ETF entrepreneurs typically identify as the basis for their portfolio strategies have actually outpaced the traditional indexes in the past. (We call this data mining. You can be sure that no one would have the temerity to promote a new strategy that has lagged the traditional index fund in the past.) But in investing, the past is rarely prologue to the future.

Recent events confirm skepticism about the power of smart beta.

Nonetheless, the assets of these smart beta ETFs (renamed “strategic beta” by Morningstar) have ballooned—from $100 billion in 2006 to more than $750 billion currently. They have accounted for a remarkable 26 percent of mutual fund industry cash flows during the first four months of 2017.

At the same time, the two major strategic beta styles—value and growth—have done a U-turn. During 2016, the value index rose 16.9 percent, while the growth index provided a far smaller 6.2 percent gain. But so far in 2017 (through April) the growth index has leaped by 12.2 percent, while the value index has struggled to earn a 3.3 percent gain. Yes, both are short periods to evaluate factor strategies. But, perhaps unsurprisingly, it seems that RTM has struck once again.

“The new Copernicans”?

The members of this new breed of smart beta ETF indexers are not shy about their prescience. They claim variously, if a tad grandiosely, that they represent a “new wave” in indexing, a “revolution” that will offer investors a “new paradigm”—a combination of higher returns and lower risk.

Indeed, the believers in factor-based indexes have described themselves as “the new Copernicans,” after the sixteenth-century astronomer who concluded that the center of our solar system was not the earth, but the sun. They compared traditional market-cap-weighted indexers with ancient astronomers who attempted to perpetuate the Ptolemaic view of an Earth-centered universe. And they assured the world that we’re at the brink of a “huge paradigm shift” in indexing. Over the past decade, smart beta has represented a small paradigm shift. But even its earliest advocate, the so-called “godfather of smart beta,” recently described a smart beta crash as “reasonably likely.” (I doubt it.)

Let’s look at the record.

Over the past decade, both the original “fundamental” index fund and the first “dividend-weighted” index fund have had the opportunity to prove the value of their theories. What have they proven? Essentially nothing. Exhibit 16.1 presents the comparisons.

You’ll note that the fundamental index fund earned higher returns while assuming higher risk than the S&P 500 fund. The dividend index, on the other hand, earned lower returns and carried lower risk. But when we calculate the risk-adjusted Sharpe ratio, the S&P 500 Index fund wins in both comparisons.

The similarity of returns and risks in all three funds should not be surprising. Each holds a diversified portfolio with similar stocks—simply weighted differently. In fact, given the remarkably high correlation of 0.97 of both smart beta ETFs with the returns earned by the S&P 500, both could easily be classified as high-priced “closet index funds.”

What the S&P 500 index portfolio offers is the certainty that its investors will earn nearly the entire return of the stock market index. These two smart beta ETFs may also do that. We just don’t know. You must ask yourself these questions: “Among similar portfolios, do I prefer a certain (relative) outcome or an uncertain one? Is it better to be safe than sorry?” Only you can decide.

When an active manager of an equity fund claims to have a way of uncovering extra value in our highly (but not perfectly) efficient U.S. stock market, investors will look at the past record, consider the strategies, and invest or not. Many of these new smart beta ETF managers are in fact active managers. But they not only claim prescience, but a prescience that gives them confidence that certain sectors of the market (such as dividend-paying stocks) will outperform the broad index as far ahead as the eye can see. That thesis defies reason—and the lessons of history.

“The greatest enemy of a good plan is the dream of a perfect plan.” Stick to the good plan.

Traditional market-cap-weighted index funds (such as the Standard & Poor’s 500) guarantee that you will receive your fair share of stock market returns, and virtually assure that you will outperform, over the long term, at least 90 percent of the other investors in the marketplace. Maybe this new paradigm of factor indexing—unlike all the other new paradigms that I’ve seen—will work. But maybe it won’t.

I urge you not to be tempted by the siren song of paradigms that promise the accumulation of wealth that are far beyond the rewards of the traditional index fund. Don’t forget the prophetic warning of Carl von Clausewitz, military theorist and Prussian general of the early nineteenth century: “The greatest enemy of a good plan is the dream of a perfect plan.” Put your dreaming away, pull out your common sense, and stick to the good plan represented by the traditional index fund.