The main difference between index fund investing today and in Graham’s time are the fees, which in some cases were up to a 9% entry fee back then while now you can buy a market fund with a yearly asset management fee of 0.04%.
Further, in his time, there weren’t any actual index funds which are the key investment vehicles at the moment, especially if an ETF.
Graham On Mutual Funds
Graham believes that the average investor does better by investing in funds rather than investing is stocks directly as funds promote the “good habits of savings and investing.” Those good habits are, unfortunately, not promoted by ETFs as the only purpose of them are to be tradable which is something you don’t want to do when you are a defensive investor and own a fund.
What’s interesting is that the funds analyzed by Graham performed better than the Dow Jones Index, and in line with the S&P 500. However, when digging deeper and analyzing the best performers, he points out how some of the managers took undue speculative risks to reach those results which is something investors should be careful of.
Graham further describes the typical stock market story where funds always set out to beat the market and the handful that do attract even more capital which allows them to continue to do so for a while. When the opposite happens, such funds are usually merged into other funds, so you don’t hear about them anymore.
Something similar is going on with current markets where index funds have done really well and as money keeps coming in, they continue to do well. However, Graham describes such performance by using a French quote:
“Plus ça change, plus c’est la même chose”
Which literarily means: “The more it changes, the more it is the same.”
Applying this to the new environment, as index funds keep going up, I’m scared of what it will look like when the 35-year trend reverts.
Buy Closed-End Funds
If you want to invest in funds, Graham’s take is to buy closed-end funds that can’t take anymore financing and thus focus on performance. Needless to say, one such fund is Berkshire. Further, you should buy only a 10% to 15% discount to asset value.
In the case of BRK, this should be at around 1.2 of book value as much of BRK’s value is not on the books.
Back To Index Funds
So, according to Graham, if we must buy actively managed funds, we should buy discounted closed-end funds in order to get value when we buy.
As index funds weren’t yet introduced back then, we can only estimate what Graham’s take would be on them. But given Graham’s preference for a simple 75% to 25% stock bond allocation for the defensive investor, an index fund like the S&P 500 would make it even easier. And when stocks are expensive, you’d hold more in bonds, and vice versa.
As the price to earnings ratio of the S&P 500 is now 24.87 implying a long term earnings yield of 4%, we could say stocks are expensive as the 2-year Treasury bond yields 2.57% at no risk. Further, corporate earnings are stretched thanks to tax benefits and 8 years of economic expansion and low interest rates.
4% at high risk, as the S&P 500 can easily go down to 1,500 points versus 2.57% at no risk, is something each of us has to consider.
Nevertheless, if we return to Graham’s key investing habits of saving and investing on a monthly basis, you should actually rejoice in a stock market crash as you would be able to buy more and have a higher dividend yield and return on investment over time.
I’m not usually saying that index funds are bad, but simply that the risk at current levels is too high for the returns and the lower yielding Treasury is better from a risk reward perspective than an index fund.
I think Graham would agree as stocks were extremely expensive for him in 1971 where we can see above the price to earnings ratio was close to 19.