Brent Sheather: Deviation isn't all bad

Index funds are popular with intelligent investors, in part because of their low annual fees, argues Brent Sheather. Photo / Thinkstock

Readers of this column will know that it advocates achieving exposure to shares and other risky assets, in part, via passive funds, also known as index funds. These things are frequently listed on the stock exchange, have ultra low annual fees (most of the time), are not burdened with patently unfair performance fees and, best of all come with no unnecessary surprises, ie they track their index. Consequently they are extremely popular with institutional investors around the world who typically index about half their share portfolios and even Warren Buffett is a fan.

Despite the many and oblivious attractions of index funds (US $1.8 trillion in assets as at 31/03/2014) some financial advisors/stock brokers see them as a threat to their business models because:

• Their low annual fees - as low as 1/20th of 1 per cent - make the high fees implicit in their investment solutions look, um, high.
• Index funds don't pay commission, trailing fees or offer free holidays to waste of time sales parties masquerading as continuing professional development.
• Index funds by definition highlight the number one rule of investment, diversification, which many private bankers and other snake oil salesman, in their advice to clients, conveniently forget and replace with a "we can pick winners and who cares about the risk" strategy with the rationale being that the finance industry can make more money telling clients to buy ten stocks and then shuffling them regularly than they can by selling the clients an index fund.

Anyway that's all old news but it's fun rehearsing it again! What is new is that the Editor of the highly regarded research publication Bank Credit Analyst (BCA) this week in a letter to clients reviewed the literature as regards index funds and concluded that for most institutional investors index funds were a no-brainer, which is a relief. But the BCA report is not just another exercise in active manager bashing. For a start a good few fund managers subscribe to BCA's research and accordingly the title of the report reflects this; "What am I good for? Debating the merits of active vs. passive management".

Reviewing why index funds are popular with intelligent investors is the first part of this week's story. But the BCA also noted the obvious, that if everybody indexed investors would be in a very bad place, much like if everyone decided to hitch a ride to the beach. It would be a long wait on the side of the road if no one owned a car. So given that 100% indexing is not a viable strategy and given the fact that the average institution only indexes half its share portfolios the BCA looked at what stock picking strategies should be favoured from active managers.

First up the BCA quotes Nobel Laureate William F. Sharpe who said: "the market return must equal a weighted average of the returns on the passive and active segments of the market. If the first two returns are the same, the third must be also". Since active managers incur higher costs it follows that net of fees the average active manager will always underperform the market.

The BCA reviews the latest performance data in the active versus passive debate and, predictably, the news for active managers isn't all that good. The BCA cites some research by Standard & Poors which shows that over the five years to March 2014 only 39 per cent of all US domestic share funds managed to outperform the benchmark S&P Composite Index.

In respect of Largecap Funds benchmarked against the S&P 500, only 27 per cent outperformed over five years. This underperformance is repeated for Midcap, Smallcap, Real Estate, International Funds and Emerging Market Funds. The one area where more fund managers beat the index than underperformed was International Small Companies where 55 per cent outperformed. Now if that wasn't bad enough that data is not adjusted for survivorship bias.

What this means is that those funds which shut their doors in the five years aren't included in the numbers and it's a fair bet that the reason they shut their doors wasn't because they outperformed. LOL.

Vanguard, the biggest provider of low cost index funds in the world, has published performance data for Australian actively managed funds, adjusted for survivorship bias. No surprises there that 60 per cent of all Australian actively managed share funds underperformed the ASX 200 Accumulation Index over the five years ended December 2013 and a huge 79 per cent of Australian based international equity funds underperformed the MSCI World Ex Australia Index over the same period. In the bond sector 64 per cent underperformed the index over a five year period.

The significance of this data to Mum and Dad is that doing as well as the index is not a modest achievement. So to think that you can do better than the index when most professional managers can't manage to do as well as the index is, to put it nicely, probably not all that clever and certainly not realistic. What happens in practice is that, with the benefit of expert bad advice, Mum and Dad take big positions in small stocks with the effect that returns are less than the index and volatility is higher than the index.

The BCA then acknowledges that expert active investors are necessary to keep the market efficient and to direct new capital efficiently and cites evidence which suggests that fund managers who are willing to systematically deviate from their benchmarks can outperform the market long term. "In practice this means favouring low beta stocks that trade at cheap valuations, have begun to exhibit relative price strength, show positive earnings revisions and significant insider buying".

It's a pity we don't have much in the way of independent analysis of the record of active management locally. In any event because the benchmark index has been dominated in the past by Telecom and most fund managers are naturally underweight a neutral position in this stock and Telecom has been a relatively poor performer, outperformance has been a natural result.

The fact that it is difficult for most fund managers to outperform the index after fees is consistent with the efficient market hypothesis which holds that all available information is priced into a stock so it's only new information that moves markets. People like to say that the NZ stock market isn't all that efficient but it appears that things are improving.

On Thursday, 24 April the Goodman Fielder share price rose, inexplicably, by 18 per cent despite no news from the company. That's efficient... maybe too efficient. On the following Monday the company announced that it was in receipt of a takeover offer. It will be interesting to see if there is any vigorous investigation of this anomaly. Recall NZX Chief Executive, Tim Bennett's comment in the Herald on Tuesday March 11th, that "insider trading was a very rare event in NZ".

OK... that could be a Tui advert.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request.