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Archive for the 'Index Investing' Category
April 15th, 2007
Posted by Matt at 5:21 pm
Index Investing is a strategy that consists of investing in passively-managed mutual funds and/or ETFs that are designed to mimic a particular index (i.e. S&P 500, NASDAQ 100, Russell 2000). Typically, index fund advisors use one of three fund families which are: Dimensional Fund Advisors (DFA Funds), Vanguard and Fidelity Spartan funds. (If you advisor recommends any other family for index funds, you’re likely paying too much.)
Indexes were originally created by the Dow Jones Corporation around the turn of the 20th Century. They chose a sampling of stocks for the purpose of representing an entire sector of the stock market. The first index Dow Jones created was the Railroad company index, which no longer exists (a little factoid that is rarely discussed). The second was the Dow Jones Industrial index which still exists today but only one of the original stocks in the index is still included.
At the heart of index investing is an academic theory created in the 1950’s by Harry Markowitz called Modern Portfolio Theory (MPT). MPT makes numerous assertions but most notably it says:
Capital markets are efficient meaning that no one person can beat or time the markets on a consistent basis and
Risk and return are positively correlated therefore taking additional risks will lead to higher returns.
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Posted by Matt at 3:34 pm
There are a large number of American financial advisors who are deeply committed to the idea that MPT is one of the greatest financial innovations in investing since the creation of the equity markets themselves. I refer to these Index fund advisors as MPTer’s. I will argue that while there are better solutions than indexing, it does provide a sound means of allocating capital. Unfortunately, too many American financial advisors charge their clients far too much for this solution.
- You’ll never do much worst than average (in spite of countless assertions to the contrary by your high school English professor)
- Since the market has historically gone up 2/3 of the time, you’ll make money more often then you’ll lose it (Odds better than Vegas, baby!)
- Index investing is completely rational and therefore eliminates emotional errors in investing (I actually would disagree with this on certain levels. Over short periods of time, it eliminates emotional errors but many index fund advisors make large, macro errors which I’ll cover later.)
- Keeps investing costs to a minimum (Bankrupting those good-for-nothing bums on Wall St)
- It is a tax-friendly strategy because it defers realized gains (Bankrupting those good-for-nothing bums in Washington)
While I’ll agree that you could do a lot worse than using an index investing approach, I personally believe that it has numerous disadvantages which is why I am not a proponent of index investing. In the next post in this series, I’ll cover the many disadvantages of index investing.
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Posted by Matt at 3:03 pm
While I believe that index investing has its merits, I do not believe that it is the only means of getting your investment compass to point true north. Advisors who buy into MPT fail to acknowledge the many issues with indexing – so allow me to provide some counterpoints to their argument.
Let’s start with the philosophical. To say the markets are efficient is to assume that man is infallible. Anyone making that assumption needs to check out the nightly news. The fact is that the markets are made up of a bunch of people (investors) who consistently make irrational decisions based on emotions such as pride, greed, fear, envy, ect. If you are able to eliminate those emotions from investment decisions, it’s very possible to beat the market on a consistent basis. To paraphrase Michael Lewis in his bestseller Moneyball, “Irrationality creates enormous opportunities for those who have the ability to resist it.”
Let’s continue with the philosophical…The market is a zero sum game, where the average participant performs right at the index prior to expenses. Once you factor in expenses, the average market participant does lose to the market by a slight margin (1-2%). To say that over half the market’s participants don’t beat the index is about as insightful as saying the average NFL record this year was 8-8. (And I’m willing to bet you that next year it will be 8-8 as well.) MPTer’s make the argument than no man or woman can consistently beat the market which is asinine because many have. The performance records of investing legends such as Jim Rogers, George Soros, Warren Buffett and John Templeton prove that beating the market on a consistent basis is attainable.
Now, let’s proceed to more practical issues with Index Investing, First, it provides no protection against losses in a bear market. When the market loses, you lose.
MPTer’s often ignore secular trends and investor time frames. (MPTer’s can’t go 5 minutes with out blubbering something about “Over long periods of time, the market does this or that…unfortunately, as my 87 year-old grandmother points out, we don’t all have that much time.) The problem lies in the fact that the market has historically gone very long periods of time and not done squat. For example, it took the market 25 years to recover from the ’29 crash. It wasn’t until 1980, that the S&P bested its 1966 peak (14 years if you’re counting). Japan’s NIKKIE index is still 60% below its 1989 peak. If you’re caught in one of those periods known as a secular bear market, don’t count on any income or appreciation from your equity portfolio for a long time.
There are a lot of bright analysts and economists who make convincing arguments that our equity markets are currently embedded in a long-term secular bear market. Ed Easterling of Crestmont research is one of these such analysts. He says in his paper titled “Markowitz Misunderstood: Modern Portfolio Theory Should Come With a Warning Label”:
Almost unanimously throughout the past century, when the P/E is above average (average is 14.5), subsequent returns are below average. As well, below average P/E’s drive above average returns…So since the current P/E is well above average, shouldn’t the assumption for Markowitz’s model be below average returns?
If you have a 100 year time-frame, index investing is great way to go, but if you have a 20-30 year timeframe, index investing is as much subject to secular trends as any other equity focused strategy.
Index investing discounts volatility. I wrote a blog post on this subject so feel free to read it if you’re so inclined. The short of it is that realized returns have historically been around 2% less than average returns. Click here for post
Index investing deemphasizes the importance of inflation: Stocks and bonds do poorly in an inflationary environment. So, if you’re 100% invested in equities and bonds during an inflationary period, the negative impact of sub-par returns in equities will be compounded by a loss in purchasing power. (I think it is interesting that index investing is gaining so much popularity just as inflationary pressures are picking up.)
THE BIGGEST FLAW OF THEM ALL: Chasing Returns!!! I find it ironic that one of the most prolific arguments made index fund advisors is that “chasing returns” is a loser’s game. Ironically, Index investors are most egregious offenders when it comes to “chasing returns” – they are just far slower to react to trends.
Not a single index investor that I know of recommended real estate in the late 90’s, but now they all include real estate in their portfolios. The biggest proponent of index investing in my hometown of Dallas, TX is a fellow by the name of Scott Burn’s. In the late 90’s, Burns, the creator of the infamous “Couch Potato Portfolio”, couldn’t even spell Real Estate but a few years ago he created the The Four & Five-Fold Portfolios which conveniently include a 20% allocation to REITs. (I’m actually a big fan of Mr. Burns. His work to uncover the insidious evils of variable annuities and all things insurance is priceless.)
Few, if any, MPTer’s currently suggest building a commodity allocation in your portfolio - the only asset class that truly provides negative correlation to equities and bonds. But they will all include a commodity allocation in the next 5 years after the biggest gains of the current commodity secular bull market have already been missed. (A few started recommending commodities prior to the pullback in the space last summer. The pullback was just strong enough to scare these advisors away causing their clients to lose out on the second stage of the secular commodity bull market.)
There is a very basic, fundamental flaw with index investing which is that they use backwards tested data in making forward looking projections. They calculate what would have worked best and assume that that strategy will continue to work best. Unfortunately, the markets work in the exact opposite manner resulting in MPTer’s “buying high” and “selling low”. Furthermore, it results in them adding sectors or asset classes long after the “easy” money has been made. (Ironically, Markowitz’s paper ever-so-briefly addresses this issue but it is largely ignored by MPTer’s who see their strategy as flawless.)
MPTer’s don’t include Commodities because the sector was such a lousy performer over the last two full decades. If they included a commodity allocation, their “projected returns” based on the extrapolation of historical returns would be far less appealing. However, in 2000, the best thing you could have done was move your portfolio to commodities. (Did you know, that the Dow Jones Index is actually down when priced in Gold since it started its rally in Oct of ’02. Click here for post .)
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Posted by Matt at 3:00 pm
In short, the answer is very little. Index investing is basically a commodity and the profit margin on a commodity will eventually be reduced to zero. In order to manage a portfolio of index funds, advisors are required to carry out the following two points of execution:
Step 1: Pick an appropriate model portfolio out of a book based on your age and risk tolerance, assign your account to that model and click the mouse on the button that says “Allocate Portfolio”. (Time spent – 15 minutes.)
Step 2: Repeat Step 1 every 12 months. (Time spent – 1 minute if you can remember the login information for your broker. Otherwise, 5 minutes.)
(I admit than many Index fund advisors provide annual financial plans in addition to the aforementioned, incredibly time-consuming tasks. Time spent – 1.5 hours)
Despite its simplicity, it has come to my attention that there are advisors charging over 100+bps or 1% for an indexed strategy. The hypocrisy of it all is that American financial advisors who promote index investing do so because of the low cost structure of indexing, yet they charge around 1% for practically no work.
Assuming that your account is worth $500,000 and you’re paying 1% for management, that’s a $5,000 annual fee for approximately 2 hours worth of work. That’s $2,500/hour! What an incredible gig! Hell, I’d get it into if I wasn’t so painfully aware of how poorly domestic equities and bonds will perform over the next 5 years.
Conclusion 1: You could do a lot worse than an index investing approach by buying expensive, actively managed funds that consistently underperform the market.
Conclusion 2: Unfortunately, you’ll still lose money in an index fund approach over the next several years as equities and bonds seek to reach more normal valuations.
Conclusion 3: Index investing is a losing strategy in an inflationary environment. Inflation was uncharacteristically low in the 80’s and 90’s so investors are discounting it.
Conclusion 4: DON’T OVERPAY FOR INDEXING! Do it yourself by following Scott Burn’s strategy, The Couch Potato Portfolio, or find an advisor that will only charge you 10 – 20 bps for 2 – 3 hours of work each year. Better yet, have them charge you an hourly rate instead.
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