New Jersey Business Valuations - Growth of Index Funds

Video Transcript 

My name is Robert Bonavito, New Jersey forensic accountant. This video is part of a series of videos where I discuss forensic accounting topics for educational purposes only. If this was a litigated matter, I would take a different approach, have different conclusions based on different facts and circumstances.

My name is Robert Bonavito, New Jersey forensic accounting, and today we're going to discuss the growth of index funds. And is valuation dead? And what do I mean by that?

I mean right now, there's about five trillion dollars invested in index funds and there is about 10 trillion dollars invested in actively managed funds. And it's projected that the passive index funds are going to eventually overtake the managed funds, meaning that when you do evaluation, it's not really helping you determine if a stock is appropriate price to where you can take advantage of.

For example, we do a lot of private companies' valuations in my firm, but once a while we do a public company. And we do a valuation, I look at the stock price and, you know, if the price I come up with is $40 a share, and the stock's selling at $30 a share, well, that stock is undervalued based on my appraisal, and we should buy it. But if I come up with a value of 20 and it's selling for 30, well, maybe we should short that stock, because it's overpriced.

And, you know, I've been doing this for quite a while, and, you know, most of our appraisals are pretty accurate, and eventually they become true. But, you know, overall the studies proves beyond a doubt that passive index funds, low-cost index funds will outperform the, you know, actively managed funds in 98% of the case, and the 2% that outperform them in a long term, it's usually just luck.

And the reason why what pundits are saying is why we can't outperform indices, is basically because our experience, what they say is experience in the investment community, is not like the experience of some of the other professions where you become better at it. For example, if I was a vascular surgeon, you know, I study arteries and veins for 30 years. It's a regular environment, and I would know more than someone who's only doing it 10 or 20 years, and I can then apply that experience and be a better doctor.

But what you're saying is because the stock market...it's not a regular environment, okay, what happened last year is not going to happen this year because there is, you know, human interaction and companies and their complexity that there's no regular environment. So if you learn that PE ratios are a good way to value stocks 10 years ago, well maybe that's not good anymore, and it doesn't matter how long you study it because the stock market's not regular.

Okay, you're saying that actively managed funds are not gonna be able to outperform these indices. And another big problem, where you compare, like, being an investment manager to being a doctor, remember with investment managers you're competing against an index fund, so even though you may be able to make more money investing in the market, you're not going to be able to make more money than the indices, because that's who you're competing against.

So, you know, it's a little bit more complex, and maybe it's not a fair challenge, but generally, you know, even though I do business appraisals and valuations, and I believe that, you know, our experience is applicable, and I can find undervalued or overvalued companies, you know, when we spend the time to actually do it for companies listed on the New York Stock Exchange, but what the signs are saying is "No. Okay, the way to go is to find low cost indices and invest in them over a long period of time, and you are gonna beat 98% of the investment managers." And based on the way that the money in these funds is increasing it seems to be true. But we will see.

Anyway, my name is Robert Bonavito. If you have any question, feel free to email me.