Passive investing - index funds

[rmbbrave]

With investment, it pays to be passive

26 September 2006

The figures say active versus passive is no contest. The best way to invest is through a low-fee tracker fund. John McCrone finds that even passive investment is evolving with baffling speed.


It is the fact that the finance industry does not want to admit and investors still cannot quite believe. When it comes to funds management, you are more likely to make money without the expert help of a funds manager.

Attempts to beat the market are doomed and so you should avoid the usual active investment approach.

Instead, you should simply put all your cash into a low-cost, passively run, index tracking fund – a fund that makes no attempt to pick winners and just mindlessly buys a little of every company going.

Already you will hear the howls of anguish from fund managers, who will be waving glossy prospectuses that prove they are the exception to the rule. But study after study has shown the same thing.

Take the latest Standard & Poor's active versus passive "scorecard" results. In the first half of 2006, three out of five large-cap managed funds – those that focus on the 500 biggest US companies – failed to beat the index.

The numbers look even worse over five years, when 67 per cent of active funds failed to top the passive approach.

Fund managers often defend themselves by claiming they definitely do better in other markets away from the large, well-known firms, where their stock-picking skills can really come into play.

Yet S&P reports that so far this year, the index has beaten the experts 68 per cent of the time in the US small company market, 60 per cent of the time in the large-cap international market, and a stunning 80 per cent of the time in the emerging economies market.

So there is nary a fig leaf to spare the blushes of the managed funds industry in these results.

For index funds enthusiasts, managed funds are already the dinosaur of investing. Index investing is the approach backed by science – all those Nobel prizes in economics. And what many mum and dad investors do not realise is just how much the science has been advancing in just the past few years.

An index or tracker fund is one that buys shares in every company represented in an index in a sector of a market. The reasoning is that the sharemarkets always rise over time – averaging an annual growth rate of 10 per cent for larger companies, 12 per cent for smaller ones.

AdvertisementAdvertisementSo rather than waste time trying to beat the markets by employing exorbitantly paid fund managers, it makes more sense just to hitch a ride on the long-term rise of the markets.

An active fund can charge 2 to 3 per cent in management fees – up to a third of an investor's actual return. And many have extra hidden costs created by their frequent trading.

Passive funds cost next to nothing to run, just their administrative expenses. Fees are consequently 0.5 per cent or less.

The New Zealand Exchange has moved into index funds in a big way. It now offers five Smartshares schemes that track top and middle-sized companies in New Zealand or Australia.

Retail investors can also buy into their equivalent overseas. Giants like Vanguard and Barclays have trillions of dollars under management. Their tracker funds are now usually set up as exchange traded funds, which can themselves be freely bought and sold like shares.

A third approach is to find a financial planner who believes in the passive investment philosophy.

At least three New Zealand financial planners – Bradley Nuttall in Christchurch, Stewart Financial in Hastings, and Strategic Asset Management in Wellington, Auckland and Hamilton – have now built their services around index funds. Or, rather, around the next revolution in passive investing – asset class investment.

Andrew Nuttall of Bradley Nuttall explains that the first tracker funds were simple beasts. They bought all the shares in a standard market index like the S&P 500 or FTSE 100. But now there are funds to

[Halebop]

It's real easy to get the wrong answer when you ask the wrong question. Just like most sharemarket listed companies are "also rans" in the outperformance stakes, most sharemarket fund managers are too. The quality of decision making is not factored into a quantititve study. So of course, it's easy for 70% of active fund managers to underperform an index - their own portfolios are not so far off the index in terms of performance but the fees are multiples of a passive fund.

Still, for proponants of passive investing, why not ask the question of going passive yourself rather than through both a fund manager and financial intermediary, none of whom come free even with a passive fund? The onus is still on paying fees for what will ultimately be within 1 standard deviation of average performance. Instead, I want to know the secrets, skills and failings of those who operate outside 1 standard deviation. What analysis was placed on those active managers who have a long term record of handily outperforming indices even after their fat fees?

[rmbbrave]

Try to find surprises and beware the random
17 October 2006

By DAVID McEWEN
Everyone has heard the story about putting an immense number of monkeys in front of typewriters. "There is a certainty that one of them (will) come out with an exact version of The Iliad," writes Nassim Nicholas Taleb in his new book Fooled by Randomness.


How many investors, however, would be prepared to bet their life savings that the same monkey would write The Odyssey next? Surprisingly, investors are prepared to take exactly that sort of bet when backing financial "experts", many of whom simply have been lucky.

Taleb points out that the brain tends to look for patterns, even in random events. "We tend to think that traders are successful because they are good," Taleb writes. He adds it is just as likely, however, that they have made money because the assets they have purchased have risen for unpredictable reasons.

The concept of "survivorship bias" also can be a trap. For example, managed funds seem to offer reasonable returns on average because those that lose money consistently tend to get wound up. Only those funds that are still around report their results. Those funds that have risen the most are often thought to have the best managers, but it is possible luck rather than skill played its part.

US commentator James Glassman has drawn these lessons from Taleb's book:

If you're doing well in the market, don't get carried away by hubris.

Don't be reluctant to invest purely by instinct, because fundamental analysis is not all it is cracked up to be.

Pay little attention to the day-to-day movements of stocks and news about companies.

Don't expect mutual funds to outperform their peers simply because they have done well in the recent past.

Put money in low-cost index funds or broadly diversified portfolios.

And beware of black swans.

This term is based on a finding by Scottish philosopher David Hume that: "No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion."

In other words, surprises happen.

One of the key elements of Taleb's book is that investors can make money by looking for black swans. One can profit by backing something unpredictable to happen when the market expects existing conditions to continue.

Take two companies that traditionally improve their earnings by 15 per cent a year. One trades at 30 times earnings because everyone expects earnings to go up by 50 per cent in the next few years. The other has had an earnings slump and is on a price-earnings ratio of 9 because everyone expects only 5 per cent growth.

The popular company will be hard-pressed to deliver faster than expected growth, but the unpopular company is unlikely to do worse than expected. Smart investors will invest in the unpopular company.

http://www.stuff.co.nz/stuff/0,2106,...7a1865,00.html

[patsy]

quote:Originally posted by rmbbrave

With investment, it pays to be passive

The figures say active versus passive is no contest. The best way to invest is through a low-fee tracker fund. John McCrone finds that even passive investment is evolving with baffling speed.

Plenty of statistical analysis supports that conclusion. However, I think that the reason for an index performing better than a fund manager is that the index could be likened to a "buy and hold" approach, whereas the fund manager's frequent trading erodes results.

The interesting thing is that if we look at the results of the Sharetrader's stockpicking contest over these past years, the majority of us managed to beat the NZX indeces. Part of the reason is that the contest assumes a "buy and hold" strategy over the year rather than the high turnover that a fund has.

[rmbbrave]

The Undercover Economist: Why the stock market is a wild, unpredictable beast

By Tim Harford


In Tim Harford's book The Undercover Economist, he explains why share prices move the way they do.


One of the most famous dotcoms was the internet bookshop Amazon.com.

Amazon started selling books on the internet in 1995, and in 2003 it sold more than $5 billion worth of merchandise. Amazon's rapid growth and its fight to become profitable is remarkable, but not as remarkable as the price of its shares. In 1997 Amazon shares were first sold to the public at a starting price of $18.

In 1999, Amazon shares soared to more than $100 despite multiple stock-splits designed to increase the number of shares. At the time it was said that Amazon.com was valued at more than all the regular bookshops in the world.

But throughout 2000, Amazon shares slid back toward $18 and beyond. In the summer of 2001 Amazon shares were trading around $8. In 2002, the company was getting good write-ups in the financial press, but shares were still down more than 80 per cent from the peak. Yet since then they have recovered to $40 a share. Which price was the mistake: $100 or $8? Or both?

The answer would be useful, not least because Amazon's rollercoaster performance is common. So can the Undercover Economist say anything about why share prices acted the way they did, and how they might behave in the future?

Economists face a serious problem in trying to say anything sensible about stock prices. Economists work by studying rational behaviour, but the more rational the behaviour of stock market investors, the more erratic the behaviour of the stock market becomes. Here's why. Rational people would buy shares today if it was obvious that they would go up tomorrow, and sell them if it was obvious that they would fall. But this means that any forecast that shares will obviously rise tomorrow will be wrong: shares will rise today instead because people will buy them, and keep buying them until they are no longer so cheap that they will obviously rise tomorrow.

In fact, rational investors should be able to second-guess any predictable movements in the stock market or in the price of any particular share - if it's predictable then, given the money at stake, they will predict it.

But that means that if investors really are rational, there won't be any predictable share movements at all.

All the predictability should be sucked out of the stock market very quickly because all trends will be anticipated. The only thing that is left is unpredictable news. As a result of the fact that only random news moves share prices, those prices, and the indices measuring the stock market as a whole, should fluctuate completely at random. Mathematicians call the behaviour "a random walk" - equally likely on any day to rise as to fall.

More correctly, the stock market should exhibit a "random walk with a trend", meaning that it should on average edge up as the months go past, so that it is competitive compared with other potential investments such as money in a savings account, or property.

If it was expected to edge up by more than that trend, it would already have done so, and similarly if it was expected to edge up by less, or to fall, it would already have underperformed. This is the reason people hold shares at all.

The trend doesn't alter the basic analysis, though, and on any given day the trend is dwarfed by random movements.

This theory should hold even if not every investor is rational.

The ones who are should be enough to force the market into a random walk, providing they are throwing plenty of money into good shares and out of bad ones. Throwing money around shouldn't be too difficult, since presumably the smarter investors make more money.

Should we believe the "random walk" theory? We certainly shouldn't expect it to be absolutely true. If it was, that would be a paradox: perfectly informed investors produce a random market, but a random market doesn't reward anybody for becoming perfectly informed. It wouldn't b

[Steve]

I have been following the Undercover Economist series in the NZ Herald - a very interesting read. We could almost start a thread on each topic!

[Deev8]

quote:Originally posted by Steve

I have been following the Undercover Economist series in the NZ Herald - a very interesting read.

It's worth getting hold of a copy of the book ("The Undercover Economist") - it's all very interesting.

I've also seen a series that Harford did for BBC TV in the UK ("Trust Me I'm an Economist"). That made a pleasant change from most of the rubbish that we see on the box.

[Steve]

I have had a quick look for it at the local bookshops (whitcoulls & paper plus)with no luck, so I intend to try the university bookshop to see if they can get it in for me

[stephen]

Interesting take from Brian Gaynor http://www.nzherald.co.nz/category/s...ctid=10418897"

"Why do some commentators argue in favour of passive funds when there is clear evidence that they have underperformed active funds despite having a huge tax advantage?

The only conclusion is that they are using overseas data and arguments and applying these incorrectly to New Zealand."

Love to read what Mary Holm has to say about this

[zyreon]

index funds have their place, and not just for the faint hearted - they can be used in stock index arbitrage, every security in the market has a use. You can also use leverage e.g. margin lending or index futures or index CFDs.

I think the NZX funds have their merits, the savings plan is a good idea. If you dont have enough time to do your analysis and get educated then index funds could be a key element in your portfolio.

Though I guess it would be good to compile some historical data for the NZ markets to see how well such a strategy actually works...