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