Motley Fool Answers' July Mailbag: Is Wall Street's Performance Just the Sum of Active Fund Managers' Moves?

If there's one thing Motley Fool Answers hosts Alison Southwick and Robert Brokamp enjoy, it's hearing from their listeners, so they particularly relish the monthly mailbag episode. But even they can be overwhelmed by the quantity and breadth of those queries, so this time around, they've invited a couple of friends to help out: serial podcast guest Jason Moser and Answers newbie Abi Malin.

In this segment, they first examine a theory that would support the idea of passive investing: That the action in the market is so totally dominated by institutional trades made by algorithms that it's pointless to try to take an active approach, so just buy low-cost index funds. Then, they look at the pros and cons of the index strategy vs. the dividend investing strategy.

A full transcript follows the video.

This video was recorded on July 31, 2018.

Alison Southwick: The next question comes from Guillaume from Quebec, Canada.

Robert Brokamp: I love Quebec.

Jason Moser: Mais oui.

Southwick: I've never been!

Brokamp: Oh, you've got to go.

Southwick: I've never been to Canada anywhere. I think I would get along with Canada very well.

Moser: We had to fly through Toronto in March. Stopping through Toronto to get to the Bahamas going in the opposite direction.

Brokamp: What?

Moser: I know. Cheaper tickets. We ended up sleeping in the airport. People were very nice, though. Way to go, Canada. Thanks.

Southwick: Thank you, Canada. Here's the question. Guillaume writes, "Thanks to podcasts like yours, I went from don't talk to me about personal finance to woo-hoo, a new episode just got released over the course of a year." Aw!

Brokamp: That's nice.

Southwick: Isn't that nice? "I have two questions that are somewhat related. One is I recently heard the following analogy. If you put all the active fund managers into a single room, they are basically the market. In every transaction one of them makes a good deal and the other doesn't. Since it's very hard to identify in advance who will win and who will lose, you are better off just buying the market; using an index fund and getting the average performance of all the folks in the room.

"Of course, this came from an advocate of passive investing strategies, but how accurate is this analogy? Are market values really just a result of transactions between active fund managers? What about retail investors buying their own stocks or companies buying shares in other companies?" We'll get to part two later.

Abi Malin: I spent a lot of time this morning researching this one and looking for up-to-date figures, and it's actually kind of hard to find. The most recent thing I could find was from 2009 and it was from the Virginia Law Review. Just for a couple of metrics around those questions, retail investors own less than 30% of stock in US corporations and according to data from the New York Stock Exchange, trades by individual investors represent, on average, less than 2% of New York Stock Exchange trading volume for New York Stock Exchange listed firms. Basically what that means is not only do retail investors have less to invest, but they do it less frequently. It's not that they're not relevant, but it's not as market moving as some of these institutional investors. But I think it's really a nuanced analogy with the second message, which is that it can be really challenging to outperform "the market." I guess when you think about that, there's a couple of other things I just want to throw out.

According to J.P. Morgan, only 10% of all trading is regular stock picking. We define regular as "fundamental discretionary trades." That means basically looking at what the company is doing and where they predict that those numbers can go. What remains is a mixture of things, but 60% trade on quantitative investing based on computer formulas and machines or passive means. I've actually seen that number in a various range of things from like 50% to 90%.

When you think about people using these automated strategies or these quant-based strategies, you see a large number of people performing at an average level. If you think about returns as a bell curve, you have a lot of people in the middle and then those tails get even smaller. So in some regards that would make it harder to outperform as most people encounter mean reversion.

Then there's another layer of outperformance. According to Goldman Sachs, as of June 28 this year the top 10 stocks in the S&P 500 have contributed more than 100% of S&P 500's year-to-date returns. If you took out the top 10 stocks, we would have actually had a down market for that first six months. Within that, Amazon was 45% of your year-to-date return and contributed 36% of the index's total return. You have a really high concentration of very few stocks, which also means that if you're a retail investor you're severely disadvantaged if you don't own those stocks and outperformance, I would say, is borderline impossible.

I think that analogy is relevant and I think it's something to keep in mind, but I don't think it is the end-all, be-all consideration. If you take our approach of buying good companies and holding them over the long term, I think you can still do it because there are companies that we're obviously less confident in and to make an average some are below the average and some are above, and then you meet in the middle.

So hopefully if you're finding good companies, you can still outperform, but I would acknowledge that that is a very relevant analogy.

Southwick: And if most of the market is just looking at what tickers blip on a screen...

Malin: It's money following money.

Southwick: It's just a totally different way to invest.

Malin: Completely.

Southwick: The second part of the question. "Besides the active vs. passive debate, there is another debate among retail investors, and that is indexers vs. dividend lovers. Would you please explain the pros and cons of each strategy and if there is a way to combine both without being overexposed to some stocks?"

Malin: Dividend investing across a long period of time has proven to be a strategy for outperformance in comparison to market indexes think S&P 500. There's a couple of ways to do it, but the question of whether this trend continues is a significant question just because right now they're demanding a higher valuation with comparatively lower outlooks. Generally speaking, if a company pays a sizable dividend, they're likely more mature and less growth-oriented.

The benefits of index investing is that you generally have a wider exposure to a variety of industries, but the drawback, there, is that you're going to have a high concentration in large-cap tech, which has been successful in recent times but could prove a weak point in the case of a market downturn just given their rich valuations.

I know you mentioned it but investing in an index and investing for dividends are not necessarily opposing strategies; but, if you invest in both you will find yourself overexposed to some large-cap payers; i.e., J.P. Morgan, ExxonMobil, Johnson & Johnson, P&G, Coca-Cola, and the list goes on. In my opinion, my answer to that question is that I personally wouldn't do a 50-50 split between those two. It varies by person. If that's how you feel most comfortable, typically dividend payers are thought of as maybe a little bit more stable. A little more recession-proof. If that's where your mind is at, I think there's an argument to be made for that, but I don't know that I would necessarily recommend that.

Southwick: A lot comes down to the risk tolerance, right?

Malin: Right.