Indexing, or passive investment management, is one of the more prominent investment strategies. In this paper, we discuss why indexing has become so popular, the challenges of indexing, and when indexing is useful (and not useful) for private clients.
The Rise of the Index
An index is simply an aggregation of a group of stocks that represents a particular market. For example, the S&P 500 Index acts as a proxy for large, corporate America. Index funds and Exchange Traded Funds (ETFs), meanwhile, are designed to track an index.
Originally, the index was not intended as a template for portfolio managers to mimic; rather, it was a way to describe or gauge the market in general terms. Back in 1971, the year that the first index fund was launched, the founders of indexing had three goals in mind:
- Lower fees;
- Lower turnover and market impact (or cost) associated with information-less trades and rational behaviour; and
- Broad diversification.
Of course, a burgeoning institutional investor market, dominated by growing pension plans, found the idea attractive. Pension plans were represented by objective third-party committees with prescribed mandates and infinite time horizons, and the market clearly needed an alternative to the random stock-picking regime of the day.
At the same time, investment managers began to run increasingly greater institutional assets (with all the inherent liquidity problems that came with it). And given such a bulky asset base, it was becoming more and more difficult for large managers to beat the market. But, then came the 1990s.
The 1990s marked an almost aberrational period of investing history. Nine out of 10 years brought positive returns for the largest, most liquid index in the world, the S&P 500 Index. Moreover, eight of those nine years were double-digit returns (the average annual return for the decade being18.9%). Investment management firms were having difficulty with the “perfect storm” of constraining asset growth and runaway market performance. And through this period, many managers became closet-indexers. After all, if the bogey was the index and if money managers were hamstrung by large assets, why wouldn’t investors create portfolios that took only small bets against the indices themselves? There was little business risk in this. And since pension consultants’ and clients’ success was predicated on long-term benchmark returns, everyone was happy.
Indexing: Penny Wise, But Pound Foolish?
Forgotten in all of this excitement, as indices peeled through their historical averages, was that markets are not always rational. The pendulum swings between fear and greed, but rarely lies in balance. As with any investment, there are some companies you want to own, and others, based on research, that you wouldn’t touch with the proverbial 10-foot pole. Unfortunately, indexing does not discriminate between the good, the bad, and the ugly.
By way of example, in 1998, the S&P 500 posted 28.6% for the year; when the 50 largest stocks were removed, however, the return was only 2%. The S&P 500 is arguably the world’s best index in that it is efficient, diversified, and liquid. Yet, its performance here represented anything but diversification or efficiency. In 1999, it became even more concentrated: only 18 issues accounted for all of the S&P 500’s 5.0% return in the first three months and, despite new index highs, most stocks declined. Over the most recent six-year period, the S&P 500 simply has not worked, returning 0.5% per year, on average. In Canadian dollars, it has been a negative return. But, in 1999, everyone wanted the S&P 500 Index.
Coincidentally, what often drives markets is what is fashionable. Markets that have risen are the ones that get the most attention—thus, investment. And investment creates congestion. In the case of Canada, where liquidity, diversification, and efficiency are issues, we have seen two extremely concentrated markets in less than seven years. In the late 1990s, telecom and technology drove market returns. One stock, Nortel, and its related company, BCE, accounted for over 30% of the market. Today, energy makes up almost 30% of the market, from a weighting of less than 15% only three years ago. As the S&P/TSX have caught the attention of the global market, billions have plowed into the commodities and energy, pushing valuations even higher and creating unintentional concentration.
Index returns for developed equity markets have been remarkably homogenous over long periods of time. The long-term average returns for the S&P 500 and the TSX are 13% and 12%, respectively, over the last 70 years. The real challenge is that any one-, three- and five-year returns can vary wildly from the long-term average. The following table shows several index returns, in various timeframes, for the period ending December 31, 2005:
One of the key lessons in this chart is that responsibility for—and attention to—asset allocation is critical. Timing really is everything.
It should be noted, too, that return to the investor purchasing index funds is not actually the return of the index. An index’s performance assumes neither fees nor transaction costs. Generally, fees are quite reasonable for index funds; the most liquid index funds can run as low as 15 basis points, with the more esoteric funds costing upwards of 1%. The biggest impact to actual returns comes from transaction costs. Even though the indices themselves usually experience low turnover relative to many active managers, the index’s turnover and the index fund’s turnover can be quite different. Therefore, an index fund is impacted not only by changes to the index itself, but also by the buying and selling activity of its investors.
The greatest evidence of this impact is the return variability of index funds with the exact same mandates. The Globefund S&P/TSX Composite Index Funds group average for the one-year period ending September 30, 2006, was a full 2.5% less than the index return. For three years, the peer group average lagged the index by 2.7% per year. Even the 10-year period average was 1.2% less than the index.
Indexing and the Individual Investor
For the individual investor, the issues become even more profound. After all, what is important to individual investors, both psychologically and financially, is what happens in the short and intermediate periods. Unlike institutional investors, individuals do not have infinite time horizons. They make decisions neither in the retrospect of a lifetime nor in 15-, 20- or 25-year timeframes. Most often, they make decisions based on their own experiences from year to year.
As such, private clients generally do not define risk in mathematical terms (such as standard deviation) but by their ability to withstand losses over time. Research shows that individuals are loathe to experience loss. Similarly, our own observations at KJ Harrison would bear that individuals are “relative return” investors when markets are strong and “absolute return” when markets turn south. We would also add that institutional investors find periods of sustained or large loss psychologically and financially difficult to handle. In fact, the losses in the earlier part of this decade still weigh heavily on the minds and actions of many pension plans today.
Why and When to Index
So, given the above information, is there a role for indexing in one’s portfolio? We believe that indexing or ETFs could be advocated in the following conditions:
- You can neither find nor access an investment manager who is able to add value or alpha worthy of the additional fees, but you want exposure to the particular asset class or market. This scenario usually results from a lack of information or the absence of the “home advantage” (of being in the local market). A good example is Asian or European market exposure. In this instance, ETFs provide access to the market in a cost-efficient manner. And, since the strategy does not represent the core of your assets, you can generally afford the volatility associated with investing in these markets—without jeopardizing your overall program.
- You are unconcerned about periods of poor absolute returns. If you can absorb longer periods of relatively little to no returns, ETFs can provide specific exposure in a cost-effective manner. Despite the returns in the earlier chart, there can be long stretches where an index simply does not work. These instances are usually preceded by periods where indices are no longer adequately diversified and returns are representative of levered bets, such as the TSX in its current state. A good example is the most recent period for the S&P 500 (1999–2005): the index returned 0.5% on average per year. The fact is that indexing presupposes the emotional and intellectual fortitude to withstand short- and intermediate-term deviations from the average.
- Your existing strategy is over-diversified, with the end result being an index-like portfolio with high fees. A recent McKinsey & Company study showed a dramatic shift over the last three years as to where asset growth is occurring. The study captured a polarized movement to both quantitative strategies, including indexing (also known as “cheap beta”), and highly focused investment strategies. Together, these strategies accounted for more than 50% of institutional assets under management in 2005—roughly double the share observed in the McKinsey survey only two years prior. Everything in between saw a significant decline in asset growth, as investors no longer needed to pay active fees for index-like performance.
In the end, what is underscored is the need for index investors to remain active in the rebalancing of any index funds they might own. Given that asset classes, currencies, and sectors experience periodic overvaluation, and the associated volatility, there exists the need for skillful active asset class, currency, and sector selection. And timing this is often more difficult than successfully picking securities. Time and again, unfortunately, individual investors have shown themselves to be poor at picking inflection points. Instead, they repeatedly buy high and sell low.
Why Active Management?
There are several cornerstones to active investing. These include the following:
- Markets are not entirely rational;
- There exist inefficiencies, both temporal and long-term, that can be profitably exploited;
- You must be prepared to accept periods of short-term underperformance relative to the index for long-term outperformance; and
- Risk can be managed thoughtfully, appropriately, and in an absolute sense.
And given the efficiency of the general market, active management that is worth the fees must have an articulate and differentiated strategy, as well as an identifiable structural advantage against the market.
At KJ Harrison, we manage our portfolios in a way that minimizes risk and maximizes returns, without regard for the index. If, after fees, we can deliver the return of the index with considerably less volatility, we believe we are ahead of an index strategy. We know that adding even a few percentage points to the index over a long period can have a tremendous impact on an investor’s bottom line. That is, every 1% of additional return on $1 million over 20 years generates over $1.2 million pre-tax for an investor.
Therefore, at KJ Harrison, we endeavour to add value and manage risk by:
- Concentrating our positions. We focus our investments in securities that have attractive valuation characteristics—in those companies that, even in the absence of a market for the shares, are ones in which we would invest.
- Buying asymmetric opportunities. By concentrating our investments in important companies trading as inexpensively as ever, assuming little downside and asymmetric upside, we consequently and continually de-risk the portfolio.
- Vigorously protecting our scale and size. This protects our ability to add value without assuming undue risk. We can buy multi-cap securities and adjust our portfolio exposure quickly—which is a key competitive advantage. Size is the biggest handicap that most managers face; it is also the reason why so many have become closet indexers.
- Ignoring indices. Outperforming an index is an outcome, not a portfolio strategy. We pay no attention to what an index is doing along the way. Simply put, if oils are 30% of an index but ridiculously expensive, oils should be ignored.
So, we continue to apply our efforts, skills, and energy to exploit those anomalistic securities that are not rationally priced. After all, as Buffett so succinctly put it, “the sillier the market’s behavior, the greater the opportunity for the business-like investor.”
This document is provided for information purposes only and should not be considered a recommendation to purchase, sell or hold any security.