Active v. index investing

The next decision is whether these funds should be ‘actively’ managed or whether you should opt for an index tracking fund.

Active fund management is based on two main beliefs. Firstly, that markets are priced inefficiently so that good fund managers can pick stocks that are undervalued. Secondly, that these same individuals have the ability to time their investment decisions, in other words, know when is a good time to buy and when is a good time to sell. This is often referred to as market timing. There is ample evidence to suggest that neither of these claims is correct.

Index investing on the other hand makes no attempt to distinguish between ‘good’ and ‘bad’ companies, predict market movements or forecast future share prices. Index fund managers diversify portfolios to track specific benchmarks or indices such as the FTSE 100 or FTSE All Share. No attempt is made to pick specific companies within the index and the managers attempt to keep costs to a minimum and the tracking error as small as possible.

They key reason behind our choice of index over active funds is our overwhelming belief that markets are efficient. This theory says that prices are always fair and rapidly reflect any relevant information. It does not mean that prices are always perfect – some prices may be too high and some may be too low - but there is no reliable way to tell. This means that neither the large institutions nor the small investor following a tip sheet can systematically pick winners.

Rex Sinquefield, Director of Dimensional Fund Advisors, the pioneers of a more sophisticated type of passive investing based on asset classes, believes that there is clear evidence that markets are efficient. Sinquefield states that the role of free markets and the ability to price goods correctly can be traced back to Adam Smith and his landmark work the “Wealth of Nations”. Smith and others such as Freidrich Hayek showed that the price system is a mechanism for communicating information. The knowledge for producing any good or service is never possessed by a single individual or group. It is dispersed among many market participants. The price system spreads this knowledge and coordinates the actions of many.

In 1917 a new style of economy was conceived, based on the concept that a few intelligent people could set prices more efficiently than the free market. The belief was that this would increase social welfare and lead to economic growth in a more efficient manner than a free market system. Socialism grew rapidly in Eastern Europe and a mass experiment began to engineer growth. However, with the total collapse of all but a small handful of the old style command economies, it is now clear that without a mechanism to gather and disseminate information efficiently on the best way to price goods and services, such a system was always doomed. As Sinquefield succinctly puts it himself;

“Who still believes markets don’t work? Apparently it is only the North Koreans, the Cubans and the active managers.”

There is so much evidence from academic research proving that active management does not work that it would be impossible to reproduce it all here. However, there are three main conclusions to draw.

There is no evidence that fund managers possess stock selection skill

This was first shown by Michael Jensen in 1964. He looked at 115 mutual (collective) funds in the US covering a period 1946-1964 and concluded that only 39 of the funds outperformed the market after costs. Whilst only one fund outperformed the market by more than 3% per year, 21 funds underperformed by more than 3% per year. There have been numerous studies since Jensen which have reported the same findings.

The fact that these money managers are not beating the index does not mean they are stupid. In fact, the large investment banks and fund management houses employ many of the brightest brains around. The fact is that they are all doing the same job, analysing the same corporate data and the same economic statistics. The huge numbers of people doing this work in effect is part of the problem for active managers. It is those same people who are trying to beat the market that make it so efficient.

There is no evidence that past performance is a guide to future performance

Dimensional Fund Advisors and S&P/Micropal’s ongoing study looks at what happens to the investor who picks a mutual fund with excellent past performance. For each 5 year period they select the best 30 domestic mutual funds. They then follow the performance of these going forward.

In each period studied, the previous winners underperformed the S&P index going forward, sometimes by a large margin!

There is no evidence that market professionals can time markets

John Graham & Campbell Harvey published a comprehensive review of 237 market timing newsletters in their paper “Grading the Performance of Market Timing Newsletter” in the Financial Analysts Journal – November/December 1997. Their aim was to measure their ability to time the market and their conclusion was that less than 25% of the recommendations were correct. There were no advisors whose calls were consistently correct. In fact, the only consistency was at the wrong end of the pile with several newsletters being wrong with incredible regularity.

The table below, taken from Fidelity International research shows the annualised returns over 15 years to the end of April 2011 of the FTSE All Share index. The message is that it is very easy to get it wrong.

Average annualised returns (%) over 15 years – effect of missing best days

Source: Datastream, from 30/04/1996 to 29/04/2011, annualised return. Returns based on the performance of the FTSE All Share, with initial lump sum investment of £1,000, on a bid to bid basis with net income, excludes iniitial charge.

One could argue that if you missed the 10 or 40 worst days, you would significantly outperform the market and, of course, this is true. In fact, if you missed the 40 worst days you would have boosted your annual return from 6.71% to 20.33%!  However, without a crystal ball, that is only possible with the benefit of hindsight. What the above figures show is that over the longer term, risk should be rewarded with higher returns but if you try to time the market, and get it wrong, those higher returns can easily be eroded.

Two additional benefits to the buy and hold strategy are that trading commissions can be significantly reduced and taxes can be reduced or deferred by buying and selling less often and holding longer.

It is worth pointing out that these academics are not approaching their studies with vested interests – their research is independent. If active management outperformed, this is what they would show. Their research is not subject to the bias of the marketing material from fund management houses and brokers tempting investors with the potential of out performance.

Some people will rightly ask at this point that if the evidence is so compelling in favour of index funds, why do stockbrokers and independent financial advisors not recommend them on a regular basis? There can only be two answers to this. Either they have not done the research, or they are not incentivised to do so. With the management fee on index funds generally set at 0.1% to 0.7% there is no margin to pay advisors. However, with active funds where the management charge is usually around 1.5%, it is normal for 0.5% of the value of the holding to be paid to the advisor on an annual basis. Therefore, if an advisor holds £20,000,000 of client money in actively managed funds, he will be receiving recurring revenue of £100,000 p.a. from the fund management industry. From a purely financial point of view, it does not therefore pay an advisor as well to recommend index funds.

Further research

When some more numbers are looked at, they are quite startling. Frank Armstrong, a financial planner based in the US, looked at performance of the mutual fund industry for 1, 3, 5 and 10 year periods looking back from 1995. He compared their performance to the S&P 500. He found that over 1 year, of 1,097 funds, 110 beat the S&P 500 while 987 fell short. Over 3 year period only 266 out of 609 funds beat the index and over 5 years the figure was 204 out of a total of 470 funds. Over 10 years, only 56 out of 262 funds managed to beat the index.

Inevitably most of the research in this area has been in relation to the US. However, recent research in the UK suggests a similar picture as illustrated by the following extract from September 2004’s Investor’s Chronicle. “Figures from Standard & Poor’s show that, for the five years to 1 September 2004, 78 out of 172 actively managed funds in the UK All-Companies sector – less than half – beat the FTSE All Share Index. For the three years to the same date, the figure was 76 out of 207. Over 12 months, the proportion was less than a quarter – 60, out of 254 funds……..In fact, over the 10 years to 1 September 2004, just 42 out of 122 actively managed funds – just over one-third – beat the index.”

Everyone can’t be above average

Despite the evidence, investors still find it hard to accept that the market return is good enough. This is a natural human reaction, but it is not a rational or sensible one. Whilst simple mathematics states that it is impossible for everyone to beat the market, most people like to think they are better than average, either at picking stocks, or picking fund managers. If a bank with the resources of Merrill Lynch or Goldman Sachs cannot consistently beat the market, what chance is there for the private investor? The dream of the active management industry is encouraged by the marketing departments of large financial institutions, which spend huge sums of money persuading the public that they have the next winner such as Peter Lynch who managed the Magellan Fund, the largest US mutual fund or Antony Bolton who manages Fidelity Special Situations.

It is interesting to note that one sector of the investment community is starting to realise that active management is not all that it is held up to be. A study by Piscataqua Research and Dimensional Fund Advisors on the performance of 243 of the largest pension funds in the US from 1987-1999 is very revealing. The average asset allocation for almost all of these plans over the whole period was similar with 60% in stocks and 40% in bonds. It therefore follows that the best index is a mix of 60% S&P and 40% Lehman Bond Index. Research showed that more than 90% of the plans underperformed this 60/40 index. The large US pension plans have been so discouraged by the poor performers of active managers that they are slowly moving away from it. Currently, about half of all pension stock holdings in the US are in index funds.

As we believe that markets are efficient, we would expect some winners to beat the market and some to under-perform. Probability theory dictates that random distribution should have a small number of winners and a small number of losers, with most based around the average i.e. the market return. However, all the evidence shows that there are fewer winners than expected. This is due to costs which average about 2% for most active funds and skew the distribution so that there are more losers than winners. The annual management charge on most funds that we recommend to clients ranges from just 0.1% to 0.5% per annum.

Surely Warren Buffett’s success proves that active management works?

“The best way to own common stock is through an index fund.” – Warren Buffett.

There is no denying that the performance of the Berkshire Hathaway investment vehicle has been outstanding. However, it is by no means a risk free investment. For the year to mid-March 2000 the stock lost almost half of its value compared to a gain of 12% for the US market. Secondly, as the size of the fund has grown, the pace of returns has slowed a little. Finally, and most importantly, Warren Buffett is not a fund manager in the strictest sense of the word. He is a businessman who becomes actively involved in the management of the companies in which he invests.

Let us look at another legendary investor, Peter Lynch of the Fidelity Magellan Fund. From mid 1981 to mid 1990 when he managed the fund, it compounded 22.5% per annum compared to 16.5% for the S&P 500. This is not actually that unusual. Approximately a dozen funds have beaten the S&P 500 over the last 10 years by 6% (the same margin as Lynch). This would be expected from chance alone. From 1983 when Lynch became well known to the public, he outperformed for 7 more years, the last four only beating the index by a narrow margin.

Despite the resources that Fidelity spend on research and fund managers they have never succeeded in hiring a manager who could replicate the success of Lynch. This must surely be a question UK investors are asking themselves as Anthony Bolton approaches his retirement at Fidelity Special Situations.

Our eyes settle on the likes of Buffett, Lynch and Bolton out of retrospect. Hindsight is a wonderful thing. However, the chances of you or I picking the next superstar out of the crowd are slim.

Stock specific versus market risk

Risk can be split into two types. Firstly there is stock specific risk which relates to individual companies. An example of this would be a fire in a company’s factory destroying all of its production facilities. The other type of risk is market risk. This might be the risk of interest rates rising which could impact on borrowing costs. Market risk affects all companies and cannot be diversified away.

However, stock specific risk is not something that investors need to experience. The Capital Asset Pricing Model (CAPM) developed by Sharpe, Linter and Treynor is one of the most famous of all financial models. In simple terms, CAPM states that the marketplace compensates investors for taking systematic risk but not for taking specific risk. This is because specific risk can be diversified away. When an investor holds the market portfolio, each individual asset in that portfolio entails specific risk, but through diversification, the investor's net exposure is just the systematic risk of the market portfolio. In other words, there is no benefit in holding individual equities, or even actively managed funds, since there is no benefit from taking stock specific risk. Why take the risk if you do not need to? This risk can be reduced to zero by holding all the companies in a market index. This is what an index fund does.

Figures obtained from Larry Swedroe of Buckingham Asset Management help to illustrate this point. He found that for the 10 year period ending in 2003, the S&P produced a return of 11%. Of the 2,829 stocks which survived the whole period, 27% of them produced negative returns, with an average loss of 15% per annum. This resulted in an underperformance of the S&P in excess of 26% per annum. Whilst purchasing individual stocks can result in big winnings, the associated risks are also high.

In summary, the average fund produces the market return. The average investor receives a net return equal to the market return less expenses (often of around 2% p.a.) and the ‘best’ managers produce returns that are easily explained by the laws of chance. This is not because the managers are stupid. They are often very bright, but they are paid large salaries (which are billed to the fund) and trade frequently (with the commission being billed to the fund.) This combined with the fact that they are increasing the market efficiency makes the chances of beating the market consistently a bet we do not want to take.

Probably the best proof that active management does not outperform over the medium to long term is that there is no academic research whatsoever to show that it does. If active managers were able to prove to the public and pay for academics to support their activities, they would have done so long ago.

Global Diversification

International and UK equity markets have low correlation. It therefore follows that you should include holdings in international equity markets to reduce risk. Whilst most investors are naturally more comfortable concentrating their investments in their domestic market, it is important to remember that having an element of overseas exposure allows you to participate in any potential growth of the global economy. In addition, international exposure will allow you to diversify your portfolio and reduce its volatility without sacrificing the growth potential of equity investments.

All of our portfolios offer some level of exposure to international markets through competitively priced index funds.

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