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The superficial charm of index trackers

Every few years, a new set of poachers turn gamekeeepers and loudly tell the public that active fund management is a waste of time. Today’s poster children for consumer salvation through lower charges use the charge stick to beat the drum for index trackers. But this tired old way of playing the active v passive story has passed its sell-by date.

Finance theory says market capitalisation-weighted indices are the market. But the theory is flaky and few people now believe in even the weaker formulations of the efficient market hypothesis. Passive investing in cap-weighted indices has become self-fulfilling simply because of the weight of money following it but that does not justify its use by investors who are genuinely planning for the long term.

It is good to remember Ben Graham’s definition of markets – in the short run, they are a voting machine, in the long run, they are a weighing machine that measures profits, cashflow, assets, dividends.

Opinion may drive markets in the short term but in the long run, value wins. If you do not believe this, you might just as well advise your clients to take their money to a casino because a stockmarket, where there is no such thing as value but only prices and opinions, really is a casino and fund managers are just gamblers.

Predicting tomorrow’s opinions of value rather than assessing value is in fact what most investment managers do and that is what is reflected in the indices

Predicting tomorrow’s opinions of value rather than assessing value is, in fact, what most investment managers do and that is what is reflected in the indices. As J M Keynes and Charlie Ellis have both remarked, this game can be played endlessly between professionals so long as the ignorant public foots their bills.

In the long run, though, the Warren Buffett approach to seek value and ignore opinion and fashion always wins. The idea that you can escape from active fund management’s roundabout of pickpockets by buying an index tracker is appealing. It has all the superficial charm of structured products and, like them, has plenty of less visible disadvantages.

The fact that cap-weighted indices are not in any sense representative of value, which is what investors must be seeking for the market to make any sense, is proved by the many studies showing that value stocks outperform growth stocks and cap-weighted indices regularly and by a hefty margin. Those studies show that over almost any period of 10 years or more in the past, a simple filter-based strategy of buying value stocks would have made higher returns than buying the index.

There are, of course, indices that capture these value stocks, such as the FTSE 350 Higher Yield index. There are also indices that give you small-cap stocks which have, over the long term, always produced higher returns for investors.

Nobody knows how long you might have to wait from today for a small-cap or value strategy to outperform the Footsie by its average historical margin or what extra volatility you might experience along the way. But neither of these factors is relevant if you are talking about a reliable long-term investing strategy.

And it is easy to show that equal-weighted or fundamental-weighted indices are less volatile than cap-weighted indices and should therefore be preferred by riskaverse investors.

Chris Gilchrist is director of Churchill Investments and editor of The IRS Report


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There are 11 comments at the moment, we would love to hear your opinion too.

  1. “ignore opinion and fashion”
    If you can, as the pressure is huge not to.
    Just look at just this page flashing and bulging all day every day.

  2. Amusing and thought-provoking. But Warren did say “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”

  3. ‘many studies showing that value stocks outperform growth stocks and cap-weighted indices regularly and by a hefty margin’

    Why do most fund managers continue to underperform the index then?

  4. Why can’t these guys just be honest. There is a place for both, active and passive.

    If they spent less time point scoring and more time thinking about the client then maybe we would all benefit, especially the client.

    Its like putting two compliance people together.

    You would never get a straight answer.

    Clients understand “if the index you track rises you make money , if if falls you lose.

    Not, if, when, buts and maybe’s.

    Make it simple

  5. agree with swanny – there is a place for both.

    I do wish though that the index supporters would include all costs – platform and advice costs in particular – when making comparisons.

    Although it is true that index beats passive more often than not – with no platform or advice costs – the reverse is often true when an expensive adviser and platform start actively managing passives.

  6. The sage of Omaha does indeed specialise in seeking out value – but, by his own admission, this only works if you are
    a) prepared to invest the time and
    b) prepared to ignore popular sentiment

    Investors themselves won’t do (a) and fund managers are way too timid to do (b). That’s why most are closet trackers. The unpalatable (for fund managers, this is) truth is that they simply don’t know what will happen next. It’s not their fault. The market is subject to way too many variables to be accurately called. Given that fact, what we should expect from managers is a market average return consistent with that which would arise from random outcomes.
    Of course, once you load on the manager charges, what you’d then expect from the group as a whole is inferior performance – and, quel surprise, that’s just what we do see.

    Nigel Tinsdale cuts straight to the point with his question. Whatever the fund management communities bluster they never really address this

  7. Trackers have gained popularity over recent years, would I be wrong in thinking this is largely due to the growth in wraps, where advisers can now charge an extra 0.5% to 1% per annum adviser charge?

  8. shame on you Anonymous 10:46

    Are you suggesting that there are IFAs out there who would do such a thing ?

    No the extra cost is for all the wonderful advice given, for the “added value” whatever than means of being in a wrap and for actively managing the passive holdings.

  9. An interesting and seemingly well informed article though, as ever, the proof of this particular pudding surely lies in the hard data and of that we see none (here). What would be really useful is a table setting out the actual performance data of a range of indices from all round the world so we could compare them with those of a range of actively managed funds in the same sectors. That surely would settle the matter once and for all.

    Whilst it’s undoubtedly true that most active managers fail to outperform their corresponding indices, the whole point of active portfolio management is to monitor regularly the constituent funds and from time to time drop and replace those which have gone stale and lost their superior form. Some of the funds in the portfolios we’ve put together for clients have been on our recommended roster for ten years or more whilst others have been replaced. Currently we’re engaged in recommending all our clients (who hold it) to ditch Fidelity European (for many years but no longer one of Fidelity’s flagship funds) in favour of Black Rock European Dynamic. LionTrust First Income was a great performer for quite a long time but we advised all our clients several years ago to switch out of it in favour of a better alternative.

    Whether or not a strategy of buying a basket of passive funds and just sticking with them might have produced better returns I have to confess I don’t have the data on, though my instincts tell me not. If you do recommend a buy passive and hold strategy, though, it’s probably a bit difficult to justify charging much if anything in the way of trail.

    One thing we do know, though, is that the FT-SE 100 isn’t a growth index ~ it’s a barometer index of the general state of confidence in UK plc and the dynamic growth phase of almost all the companies in it happened on the way there. But FTSE 100 companies do tend to be good for dividends.

    When all is said and done, how many investors wish they’d have invested ten years ago in a cheap and cheerful FTSE 100 index tracker in preference to something a bit more expensive such as Rensburg UK Mid-Cap Growth?

  10. I’m delighted that Mr Gilchrist (as erudite as ever) has shone a light on this. Indexing is a cop out for the freeloaders. Just think of the logic. If everyone invested in index trackers who would buy the equities?

    The concept of index tracking goes further – it denies the very essence of investing. Investing is not a Casino – its purpose is to raise money for companies who then provide goods and services. The investor then is a part owner of the company and his reward is the dividend income and if he’s lucky some capital growth. No one said that a profit is guranteed.

    If you want to see active management that consistently whups the indices time and time again just look at (for example) two investment trusts. RIT Capital Partners and Personal Assets Trust. Now THAT’S the way to make money!

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