Professional Documents
Culture Documents
Index Funds
Adopt a passive approach. Main focus is on achieving maximum diversification at a minimum expense by holding a fixed percentage of every security in the market, or a representative basket. Performance is determined by the asset class, index funds make little attempt to do better. If the asset class does poorly, index funds do poorly. If the asset class does well, index funds do well. These funds are quite boring because they offer no potential to beat the market, most investors arent even aware they exist. Many sophisticated investors (and those that aspire to be) flatly refuse to even consider indexing because it is just too mediocre and too dull.
Active funds
When you buy an active fund, you are making a bet on a team of professional investors, and their ability to generate high returns. May perform quite differently to the asset class as the manager adjusts the portfolio based on their research. You pay extra for this research, usually about an extra 1%pa. It seems defeatist to settle for asset class returns. Why would anyone settle for average performance when you can be above average?
Percentage of active funds underperforming their benchmark index after fees in the 5 years to 31 March 2004
100% 80% 60% 40% 20% 0%
Aus shares
Intl shares
Aus bonds
Aus cash
Underperforming Outperforming
Source: Mercer/Morningstar IDPS Survey
Median fund manager return vs comparable index 5 years to 31 March 2004 15.00% 10.00% 5.00% 0.00%
Listed property Aus shares Intl shares Aus bonds Cash
-5.00%
Active fund
Source: Mercer/Morningstar IDPS survey
Index
A portrait of failure: the performance of every US large cap fund with a 15 year history vs the S&P500 and CRSP 1-10 indexes. 15 Years ending 31 December 2001 (285 Funds)
Annual returns of buy and hold index vs actual annual returns enjoyed by US mutual fund investors from 1984 to 2002
14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% US Stocks Index US Bonds Mutual fund investor 2.57% 4.24%
12.22%
11.70%
Frightening thought.
The average American mutual fund investor only managed to earn 2.57%pa during one of the strongest bull markets US equities have ever seen, underperforming the S&P500 index by a truly staggering 10%pa. Inflation was about 3.14%pa over this period! The most inept investor in the world could have made about 12.22%pa by buying and holding an S&P500 index fund. Dalbar Inc place the blame squarely on the shoulders of market timing. The pattern is always the same: investors are notorious for buying in during the dying moments of a bull market and tend to get in near the top. Then the market falls and investors react by selling. They then stay out of the market for a long time until another long bull market has convinced them it is once again safe to invest, just in time to catch the next big fall! If these levels of market timing skill and fund selection prowess continue, what kind of return will these investors earn if the market isnt as strong? The 1990s were a truly fantastic time to be invested in equities. Despite the strong markets, investors still managed to snatch defeat from the jaws of victory. Incredibly, these figures dont take into account taxes, advisor fees, wrap account fees or transaction fees. OUCH!
Inflow and outflow data has been suggested to be useful as a contrarian timing signal. Unusually high mutual fund inflows are often a sign of an impending market top, serious outflows often auger a market bottom. Although exactly how much money one could make by doing the opposite is questionable, there is little doubt that performance chasing is historically a bad strategy.
"Investors continue to sour on stocks. So far this year, investors have made net withdrawals of $11.3 billion from their stock mutual funds accordingincluding a hefty $3.7 billion just last weekaccording to AMG Data Services. Source: Gregory Zuckerman, "Investors Rush to Buy Bonds, Fleeing Stocks," Wall Street Journal, March 11, 2003
Source: TAM Asset Management, Inc Investment Policy Guidelines & Strategies Within the Context of The Prudent Investor Rule, average active fund = average of 7125 US domestic equity mutual funds in the Morningstar Principia Pro Database July 1991 - July 2001.
The average active fund does not outperform the index, and the average managed fund unit holder does even worse because they trade too much. Active funds are less diversified and therefore more volatile than index funds and there is no evidence that they outperform in down markets, quite the contrary in fact. Especially in the conservative asset classes like bonds and cash, and even property securities, there are almost no outperforming active funds and based on the statistical evidence it is very hard to justify active investing in these sectors. The stock market has its Warren Buffetts, Peter Lynchs and John Templetons, but not other asset classes.
Research houses in general refuse to even go near index funds, they wont rate them, insisting that their job as researchers is to identify funds that will beat the index. While corporate pension funds are taking up indexing enthusiastically, indexing is still anathema to financial advisers and private DIY investors share no more enthusiasm for index funds than the professionals. Index funds are unpopular with every type of investor because almost 100% of investors think they are above average and possess superior investment skills. Is this faith warranted based on the evidence from Dalbar Inc and others? Mathematically, is it possible for most people to be above average or are investors deluding themselves?
The average performance of all investors will be the same as the market. It is impossible for everyone to be above average, mathematically it just cant happen!! Half will fail because somebody always gets stuck holding the bad stocks! The aggregate return of all investors in the market will be the market return, (obviously), because all the investors own all the stocks. The market return is the weighted average of passive returns plus active returns. If the index funds have the same pre-fee return as the market (which is what they set out to do), then the other type of investor (active) will also have the same prefee return. If index funds bought, say, 30% of every stock issued, the remaining 70% left to the active investors would still have market index weightings. This is a zero sum game, the average return of all active investors before costs is necessarily going to equal the average return of the market. Active investment is usually more expensive than passive investment so active funds, as a group, will do worse than index funds after fees. No amount of trading or research will change that. Some will outperform, but as a group they will underperform. Like a poker game, money is redistributed but not created or destroyed by active management. Costs drag down the average performance of all investors. The average performance of all investors will be the market average return, minus the average expenses. To ensure that your net performance is above average, diversify extensively and keep expenses well below average.
Whether the market is up or down, low cost diversified investors will still outperform the majority of investors after costs, even if some investors still manage to outperform. Source: The Inefficient Market Argument For Passive Investing, Professor Steven Thorley, the Marriot School at BYU. Used with permission.
Figure 1a: Distribution of Simulated Portfolio Returns for 1996 Before Costs 1000 900 800 Portfolio Count 600 500 400 300 200 100 0 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50 Percent Return Portfolio Count 700 Index Fund Return 1000 900 800 700 600 500 400 300 200 100 0 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50 Percent Return Figure 2a: Distribution of Simulated Portfolio Returns for 1994 Before Cost Index Fund Return
Figure 1b: Distribution of Simulated Portfolio Returns for 1996 After Costs 1000 900 800 Portfolio Count 600 500 400 300 200 100 0 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50 Percent Return Portfolio Count 700 Index Fund Return 1000 900 800 700 600 500 400 300 200 100 0
Figure 2b: Distribution of Simulated Portfolio Returns for 1994 After Cost Index Fund Return
-5
10
15
20
25
30
35
40
45
50
Percent Return
66% 1 year
56% 2 years
66% 3 years
Over longer time frames, survivorship bias affects the data. If you close down or merge the underperforming funds (and delete them from your database), replacing them with new funds with better track records, youll bias the sample average upwards, making active funds look better as a group. In a previous slide the arithmetic of active management I mentioned that somebody always gets stuck holding the bad stocks. Survivorship bias is the mechanism for ensuring that these people are ignored. The database will exclude a number of below average performers, making the average look a lot better. US researcher Burton Malkiel (author of A Random Walk Down Wall Street) estimates that survivorship bias adds 1.4%pa to the return of the median fund manager. For small company funds and sector funds, estimates exceed 2%pa.
Survivorship bias
Source: Russel Investment Group, periods ending 30 June 2004, Insights IN107.
Another bias called creation bias is introduced when fund managers create new funds. They give seed capital to a lot of money managers, but the ones that underperform during their trial period are never opened to the public. In this way, all new stock funds (that the public hears about) come with a suitably high past performance, further tainting the data. It is of course nearly impossible to get accurate figures to quantify the size of creation bias.
Survivorship bias of course affects other asset classes as well. This means that active funds do even worse in international markets than they do in the biased sample. (Scary thought!) Estimates made in the US show that barely 15% of active stock funds outperform the S&P500 index over the long term once survivorship bias has been corrected. Most funds will underperform, but how do we identify the exceptional ones?
The top 25% of share funds in 1997: how many of these gave top quartile performance again in the next three years?
25% 20% 15% 10% 5% 0% 25%
The top quartile Australian funds of 1999: how did they perform in the year before and the year after?
30 25 20 15 10 5 0 1998 1999 2000 Second Top Bottom Third
Source: Frank Russell Australia, data by Morningstar
Number of funds
*Source: Frank Russell Australia, though Morningstar retorted with a similar finding on Frank Russells recommendations, which have done little better.
If you are going to select active funds, you are best not going on recent past performance (if anything, do the opposite, but I dont recommend blind contrarianism as a strategy). According to Morningstar, about 75% of investors invest in last years top quartile funds, which explains DALBAR Inc.s figures. While long term performance data seems to have some value, it is mainly effective as a negative filter. Long term losing funds tend to be discontinued by the fund manager, they rarely get better by themselves. Winners dont reliably repeat. I dont take fund research house ratings very seriously. For example $1,000 invested in funds given a 5 star rating by Morningstar Australia between June 1998 and June 2000 would have produced $1,460 at the end of the two year period. But $1,000 invested in a four star fund would have produced $1,588, despite the funds lower rating.* Hulbert Financial Digest, an American investment newsletter, tracked the performance of Morningstar US 5 star picks from 1991 to 1997 and found they lagged the S&P500 on average by nearly 3%pa. Ok, so what does work then?
J a n u a ry 1 9 8 0 to D e c e m b e r 2 0 0 3 . L a rg e c o m p a n ie s v s s m a ll c o m p a n ie s v s v a lu e c o m p a n ie s
25% 20% 15 % 10 % 5% 0%
1 2 . 8 0 % 1 3 . 9 4 % 1 1 .7 3 %
1 9 .6 2 % 1 7 .7 8 % 1 6 .0 4 %
A u s l a r g e l o b a lA u s s m a lG l o b a lA u s va l u G l o b a l G l e la rge sm all va l u e A n n u a l r e t u r nn n u a l i s e d vo l a ti l i ty A
Source: Dimensional Fund Advisors
Value premium
Academics who used to favour the random walk hypothesis and dart throwing no longer debate whether there is a performance premium for value stocks, they now debate why there is a performance premium. Is the value premium because value stocks are underpriced (inefficient market) or because they are more risky (efficient market)? This is still hotly debated in academic circles and there is evidence to support both arguments, so in reality it is probably a bit of both. A value premium has been demonstrated in virtually every market examined, including USA, Europe, Asia, Australia, UK and various smaller markets. Dimensional Fund Advisors run two passive value funds that buy the cheapest 30% of stocks on the market, the DFA Australian Value Trust, and the DFA Global Value Trust.
Value vs growth
The academic definitions of value and growth are polar opposites, they usually define value stocks as being the stocks with the lowest price to earnings ratios (PER) or price to book ratios (PBR). Growth is defined as the stocks with the highest ratios. Value and growth are practically irrelevant in large cap funds, there are few deep value or extreme growth stocks in the top 100. Thanks to their preoccupation with tracking error, many large cap value and growth managers hold virtually identical portfolios. This has lead to a myth that value and growth are just investment styles that perform about the same in the long term. In fact, deep value, really extreme value stocks as identified by PER or PBR performs markedly better than high priced growth stocks. Small cap value companies perform extremely well, but small cap growth are a disaster in both risk and return - speculators beware!
The most reliable indicator of future performance is the fund fee: more expensive funds underperform the most. This accounts for the majority of variation between fund managers over the long term. The next indicator is asset allocation, which dominates short term returns (quarterly data), but in the long term accounts for a significant but not dominant difference. Obviously funds with a higher weighting to stocks instead of bonds do better in the long term and deep value small company stocks are particularly rewarding. Stock picking obviously has an impact on performance, but identifying skilled stock pickers in advance is hard. By the time the managers skills are recognised the fund may have become so large that keeping up this high performance becomes extremely difficult. Headhunting is also rife, so you may find that the manager you respect may well not be working there much longer. Tax efficiency has a major effect on post-tax returns. This goes beyond just franking levels, you also need to look at capital gains distribution rates, the amount of short term distributions (as opposed to long term discountable capital gain distributions), and also unrealised capital gains on unsold stock. If you must use a tax-inefficient fund, consider buying it in super, stick with tax efficient funds for personal investments.
Source: Common Sense on Mutual Funds by John Bogle
Fund size
It is a well established fact that the bigger a fund becomes, the more difficult it is to add value. (Though of course index funds dont find size a handicap and in fact some fund managers have used size to their advantage using methods like block trading.) Billion dollar funds simply cant invest in small and/or illiquid companies because they impact prices too much and would take too long to buy or sell their holdings. There is a direct conflict of interest between a fund managers marketing people that would like the fund to become infinitely large, and the investment people that want to keep it manageable. There is no point researching small companies because the manager couldnt possibly invest a meaningful amount in them, so big funds are forced to deal in the more efficient large cap sector of the market, where outperformance is largely a matter of luck! Buying a very large fund with high fees & high turnover is an almost guaranteed way to underperform over the long term. Corollary: dont buy funds that advertise on TV! In the last few years, boutique fund managers have really come into their own, managers like Investors Mutual, Hunter Hall, MMC, Platinum and PM Capital have amazed investors with spectacular performance. There is little or no evidence that these managers are any more risky than more familiar large funds.
Break down your performance figures into income and growth? Growth is more tax efficient for most investors. Break up the income component into realised capital gains and dividends / interest / rent? If the income figure is more than, say, 4 or 5%, much of it is probably trading profits and indicates that the manager is probably churning the portfolio. Break up the realised capital gains into discountable (long term) CG vs non-discountable short term CG? Personal investors and super funds pay a much lower rate of tax on long term capital gains. What is your normal expected portfolio turnover, and what has it been in each of the last three years? Anything more than 30 or 40% is high churn. What is your franking level?
If everyone indexed, would the market cease to be efficient? Would there be a bubble in index stocks?
The critics of indexing have made this claim since indexing first started gaining momentum in the 70s, but it lacks credibility. Studies have found that index funds account for only a small percentage of monthly transactions in stocks, typically under 5%. To claim that 5% of trades by passive investors doing no analysis set the prices for the other 95% of trades by active investors defies common sense. If sheer weight of dumb indexed money was what drove index stock prices then it is hard to understand how individual stocks move so differently. There are always stocks moving against the trend, indicating that those 5% of trades are not as influential in price setting as critics claim they are. Studies have failed to find any evidence of index bubbles.
Summary
Active funds as a group do not beat index funds. If you want a low stress high probability investment strategy, forget beating the market and buy and hold index funds. Value strategies outperform growth over the long term, though not necessarily every single year. Value has beaten growth in every decade since the 1930s, and has done so in many international markets. There is also a slight performance premium for smaller companies, particularly small value companies. Small growth companies, usually the favourites of speculators and stock brokers are historically the most risky and worst performing class of stock. Costs matter a lot. If you want to improve performance you are more likely to get better results by focusing on tax efficiency, brokerage, reducing turnover and minimising fees. There simply is no more reliable way to increase returns. Fees will probably matter more in the next ten years than the last, because average returns are probably not going to be as high.
Recommended reading
Common Sense on Mutual Funds by John Bogle The Intelligent Asset Allocator by William Bernstein A Random Walk Down Wall Street by Burton G. Malkiel The Intelligent Investor by Benjamin Graham Common Stocks and Uncommon Profits by Phil Fisher One up on Wall Street by Peter Lynch Beating the Street by Peter Lynch How to Pick Stocks Like Warren Buffett by Timothy Vick Contrarian Investment Strategies: The Next Generation by David Dreman John Neff on Investing by John Neff Money Masters of Our Time by John Train Masters of the Market by Anthony Hughes, Geoff Wilson and Matthew Kidman
Disclaimer:
This article contains the opinions of the author but does not represent a personal recommendation of any particular security, strategy or investment product. The author's opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. Investors should seek the advice of their own qualified advisor before investing in any securities.