The Indexing Dilemma

Some years ago I was talking to a money manager client about a big bond deal, managed by my then-firm, that was about to hit the market.  The manager didn’t like the deal very much, but he was going to buy it anyway and in noteworthy size.  His view was that since the deal would be a significant component to the index by which he was benchmarked, he wasn’t prepared to risk being wrong on its value.  I was happy to do the trade, of course, but I was (and remain) troubled by analysis that is so assiduously fearful and defensive.  Isn’t the idea to try to stand out? Shouldn’t a money manager’s primary goal be to do what’s right for his investors?  However, in that context, the last thing the manager wanted was to stand out because the career risk to him of becoming a negative outlier was far greater than the potential benefit of being right.

This psychology is a key but often overlooked component to discussions of indexing and its merits.   

In 1974, Paul Samuelson issued his famous “Challenge to Judgment.” In it, Samuelson challenged money managers to show whether they could consistently beat the market averages. Absent such evidence, Samuelson argued that portfolio managers should “go out of business – take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives.” In his view, investors were better off investing in a highly diversified, passively managed portfolio that mimicked an index than using judgment to pick stocks. Indeed, the idea behind indexing is to effect broad diversification within asset classes and broad diversification across asset classes so as to achieve market-like returns.  That is seen as good because – it is said – one can’t beat the market.

Unable (or unwilling – more on that later) generally to meet Samuelson’s challenge, active managers have steadily ceded market share to passive-style investment vehicles. In 1975, John Bogle launched the First Index Investment Trust (later renamed Vanguard 500), the first stock index fund for individual investors, which is now one of the largest mutual funds in the world, and with it launched a seminal market trend toward passive investment generally and indexing in particular (the Vanguard argument for indexing is here). Although the idea took root slowly, passively managed funds (including ETFs, which are growing rapidly in popularity) now control in excess of 25% of all domestic equity fund assets, according to the Investment Company Institute

This trend makes sense.  Even the strongest advocate of active management must concede that, as a matter of simple arithmetic, the universe of active managers will underperform the universe of passive managers.  Costs matter and passive management is a much cheaper endeavor.  As Morningstar discovered, in every single time period and data point tested, low-cost funds beat high-cost funds. Factor in the added tax efficiency of passive investing (much longer holding periods and far fewer transactions in general) and it is clear that active management bears a difficult burden in the race to earn the business of investors. 

Perhaps even more tellingly, active managers generally fail to beat their benchmark indices.  Indeed, in 2010, only about 25% of active managers outperformed.  And those few that do have a very hard time keeping up the good work. 

These obvious problems demonstrate that the case for passive management is a pretty easy one to make and that the trend in that direction is readily understandable.  But I still think there is a good case for active management to be made.

As professionals are well aware, passive investing is predicated upon the efficient markets hypothesis.  To oversimplify, that hypothesis asserts that because asset prices reflect all relevant information and that investors act rationally on it, it is impossible to “beat the market” over time except by being extremely lucky.  In reality, however, there is an abundance of evidence that markets are less than perfectly efficient.

There is no such thing as perfect information.  Information can be and routinely is biased, erroneous, flawed and incomplete.  Don’t forget about disinformation either.  More significantly, as individuals and in the aggregate, the idea that we can somehow rationally interpret all that information is – frankly – ludicrous. Behavioral economics teaches us at least that much.

Every year, Dalbar’s Quantitative Analysis of Investor Behavior demonstrates just how irrational investors are. Not surprisingly, active investors expect to outperform.  However, over the past 20 years the S&P 500 has returned 9.14% annually while the average equity investor has earned only 3.83% per annum, demonstrating how unsuccessful we are at controlling our emotions.  We routinely buy high and sell low.  It is thus clear that markets are adaptive and people are plainly and predictably irrational – individually and in the aggregate.  That said, this data also evidences a related point.  People find that exploiting the market’s inefficiencies is, at minimum, extremely difficult (partially due to those very same emotional factors).  While the efficient market hypothesis is easy enough to falsify, indexing as an investment approach remains excruciatingly difficult to beat.

Active management outperformance can only be predicated upon two things – market timing and/or security selection. Since there is no evidence that market timing works1 (nobody can foresee the future), we’re left with security selection.

Unfortunately, most “actively managed” funds are actually highly diversified and thus cannot be expected to outperform.  The more stocks a portfolio holds, the more closely it resembles an index.  The average number of stocks held in actively managed funds is up roughly 100% since 1980, according to data from the Center for Research in Security Prices. See Pollet & Wilson, “How Does Size Affect Mutual Fund Behavior?” Journal of Finance, Vol. LXIII, No. 6, p. 2948 (December 2008). Large numbers of positions coupled with average turnover in excess of 100% (per William Harding of Morningstar) effectively undermines the idea that such funds could be anything but a “closest index.”

Properly used, diversification is a means to smooth returns and to mitigate risk.  Excessive diversification, on the other hand, is merely (in Warren Buffett’s words), “protection against ignorance.”  I prefer taking active risk with vehicles that offer me the best chances to outperform, which means investments that are concentrated and unrestrained.  It makes no sense to incur excess costs and to suffer tax inefficiencies to purchase an investment that, in effect, is a closet index.

Numerous studies show that funds which are truly actively managed, and thus more concentrated, outperform indices and do so with persistence.  See, e.g., Kacperczyk, Sialm & Zheng, “Unobserved Actions of Mutual Funds” (2005); Cohen, Polk & Silli, “Best Ideas” (2010); Wermers, “Is Money Really ‘Smart’? New Evidence on the Relation Between Mutual Fund Flows, Manager Behavior, and Performance Persistence” (2003); Brands, Brown & Gallagher, “Portfolio Concentration and Investment Manager Performance” (2005); and Cremers & Petajisto, “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” (2007).  As summarized by Cremers and Petajisto:

“Funds with the highest Active Share [most active management] outperform their benchmarks both before and after expenses, while funds with the lowest Active Share underperform after expenses …. The best performers are concentrated stock pickers ….We also find strong evidence for performance persistence for the funds with the highest Active Share, even after controlling for momentum. From an investor’s point of view, funds with the highest Active Share, smallest assets, and best one-year performance seem very attractive, outperforming their benchmarks by 6.5% per year net of fees and expenses.”

Accordingly, it is possible to earn higher rates of return with less risk (particularly since risk and volatility are decidedly different things – more on that below) via active management. By combining a group of securities carefully selected for their limited downside (think “margin of safety”) and high potential return (think “low valuation” or, better yet, “cheap”), the skilled active manager has a real opportunity to stand out by outperforming passive strategies.  This approach has practical benefits too in that the resources devoted to the analysis (original and ongoing) of each specific investment varies inversely with the number of investments in the portfolio. 

I wish to re-emphasize, however, that success in this arena is extremely hard to achieve.  That’s why I prefer an approach that mixes active and passive strategies and sets up a variety of quantitative and structural safeguards designed to protect against our inherent irrationality.  I want to be most active in and focus upon those areas where I am most likely to succeed.  I also want to be careful to seek non-correlated assets (to the extent possible) in order to try to smooth returns over time and to mitigate drawdown risk. 

In the large cap space, markets are relatively efficient and thus alpha-constrained.  The mid and small cap sectors provide more opportunities but liquidity constraints can create difficulties.  International equities tend to provide the best opportunities due to the wide dispersion of returns across sectors, currencies and countries.  Indeed, the SPIVA Scorecard demonstrates that a large percentage of international small-cap funds continue to outperform benchmarks, “suggesting that active management opportunities are still present in this space.”  Moreover, managers running value strategies outperform and do so persistently, in multiple sectors, especially over longer time periods.  I focus my active investments in these areas.

Active management is not merely predicated upon outperformance.  It can also be predicated upon risk mitigation.  Yet defining risk can be quite difficult.  Traditional quantitative finance equates risk with volatility.  By that definition, broad diversification lowers risk because it lowers volatility.  I look at risk more practically, however.  For me, risk relates more to my chances of losing money – perhaps a great deal of money – over time than the volatility of my portfolio. 

For a deep value investor (and I try to be one), purchasing a stock that has been beaten up and trades at low multiples for its fundamental value may have high volatility but not be all that risky due to a significant “margin of safety.” Grouping such stocks together in a carefully concentrated fashion provides the best opportunity I am aware of to outperform while mitigating risk.  As Warren Buffett put it, “a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.” 

Even so, the best and most successful investors make mistakes and have down periods – which can last a significant period of time.  That’s why the money manager I referenced above was so willing simply to mimic the index.  He knew that performance which was close to his benchmark would allow him to retain assets while significant underperformance could cause investors to head for the hills (just ask Bruce Berkowitz). Being willing to stand out is perhaps as hard as achieving the actual outperformance. That’s why so many money managers remain perfectly willing to act like index investors and hope for roughly index-like returns.  It’s a matter of survival.

Surviving in this business can be a major challenge.  Actually to succeed by providing clients with real value is that much more difficult.  It demands the bravery to incur much greater risk – but career and reputation risk rather than investment risk.

How brave are you?


1 As I note in the link, a possible exception exists with respect to very disciplined trend followers.  There is evidence that some of them can execute market timing strategies successfully.  Quality managed futures traders fall into that category, for example.


4 thoughts on “The Indexing Dilemma

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