Jump to content

Will indexers be dissapointed...


tede02
 Share

Recommended Posts

The Wall Street Journal is running a series on the migration towards passive investing.  Unfortunately I think there is a high probability that many people and institutions plowing into index strategies will be disappointed over the coming decade.  I don’t think indexing is a bad strategy, but the vast majority of those abandoning active management seem to have concluded that because actively managed mutual funds and hedge funds have underperformed over the past 5 or so years, this proves it is impossible to out-perform.  What they should be asking is why passive strategies have outperformed. 

 

Generally speaking, people seem oblivious to the underlying market forces which certainly are responsible for a significant amount of the asset price appreciation we’ve experienced since the recession.  Those factors of-course include zero interest rate policy and QE. 

 

Jeffrey Gundlach has been talking a lot about this recently and showing a similar chart as below.  Look at the amazing correlation between the expansion of the Fed’s balance sheet and the appreciation of the S&P500.  It’s remarkable: 

 

http://www.zerohedge.com/sites/default/files/images/user5/imageroot/2016/01-overflow/fed%20balance%20sheet%20vs%20es%20DB_0.jpg

 

Again, I have nothing against indexing as a strategy.  Frankly, its what the majority of people probably should do.  But, I think those that are running to it today are doing so for the wrong reasons.  The bottom line is they are chasing returns and not understanding the greater context of the market environment we’ve been living in.

 

Link to comment
Share on other sites

If someone is willing to hold through a bear market or two and keep investing passively and dollar-cost average through those times, then the person will probably be better off staying in passive. What I envision is people abandoning ship at the bottom and try to chase active management in order to "make up" for lose ground.

 

Personally, I always recommend passive for my own family (and half of my own portfolio is passive) but I constantly remind them do keep buying and to stay the course even while the markets are going down.

 

 

 

 

Link to comment
Share on other sites

I've always recommended passive for family as well.  Most of the time it's a spot on recommendation, most family members don't pay attention and don't care.

 

With my mom I recommended a European index fund, a TSM index and a small cap index.  I have heard a few quips about how terrible her portfolio has done mostly because of Europe and small caps.

 

I helped my co-founder find index funds in his 401k, although after a few years he grew started to lose hope.  He kept seeing things like "Russia Double Levered Exchange Fund" grow by 200% whereas his funds went up by 7%.  He chased some performance for a while, then went to Betterment this year.  Now he's on autopilot, this is how it should be.

 

If I ever have to rollout a 401k I will do Betterment or something similar.  To me a plan like that is the prudent thing to do for employees.

Link to comment
Share on other sites

If someone is willing to hold through a bear market or two and keep investing passively and dollar-cost average through those times, then the person will probably be better off staying in passive. What I envision is people abandoning ship at the bottom and try to chase active management in order to "make up" for lose ground.

 

I absolutely agree with this.  I work on the retail side and see people buy high and sell low regularly.  Eventually active strategies will have their day and the same people who ran into passive strategies will go back the other way (at what will likely be the worst possible time).   

Link to comment
Share on other sites

Tede02

 

I agree with your broad point that many market participants are chasing performance, though that kind of seems akin to saying I woke up this morning. Most won't stick with indexing. They will be on to the next strategy that looks good in the rear-view mirror. Most simply do today what they should have done 3-5 years ago with perfect hindsight.

 

To what extent one should be invested in stocks is one question. How one chooses to access the capital markets given their skills, temperament, etc. is another.

 

I'm totally with you on the point that investors are usually their own worst enemy.

 

Link to comment
Share on other sites

If someone is willing to hold through a bear market or two and keep investing passively and dollar-cost average through those times, then the person will probably be better off staying in passive. What I envision is people abandoning ship at the bottom and try to chase active management in order to "make up" for lose ground.

 

I absolutely agree with this.  I work on the retail side and see people buy high and sell low regularly.  Eventually active strategies will have their day and the same people who ran into passive strategies will go back the other way (at what will likely be the worst possible time). 

 

 

I see institutional clients and their investment consultants doing the same thing. It's incredibly frustrating.

 

Link to comment
Share on other sites

If someone is willing to hold through a bear market or two and keep investing passively and dollar-cost average through those times, then the person will probably be better off staying in passive. What I envision is people abandoning ship at the bottom and try to chase active management in order to "make up" for lose ground.

 

I absolutely agree with this.  I work on the retail side and see people buy high and sell low regularly.  Eventually active strategies will have their day and the same people who ran into passive strategies will go back the other way (at what will likely be the worst possible time). 

 

 

I see institutional clients and their investment consultants doing the same thing. It's incredibly frustrating.

 

 

Those investment consultants are for sure not worth their fee. Discussing indexing without also having investment time horizon in mind makes no sense to me.

Link to comment
Share on other sites

If someone is willing to hold through a bear market or two and keep investing passively and dollar-cost average through those times, then the person will probably be better off staying in passive. What I envision is people abandoning ship at the bottom and try to chase active management in order to "make up" for lose ground.

 

I absolutely agree with this.  I work on the retail side and see people buy high and sell low regularly.  Eventually active strategies will have their day and the same people who ran into passive strategies will go back the other way (at what will likely be the worst possible time). 

 

 

I see institutional clients and their investment consultants doing the same thing. It's incredibly frustrating.

 

 

"I see institutional clients and their investment consultants doing the same thing. It's incredibly frustrating."

 

I dont find it frustrating - its profitable for us.

 

To anyone who hasn't paid off their mortgage that is what I recommend.  To those who have, a good index will suffice.  My MIL is sitting on a pile of cash.  The family wanted me to invest it and I begged off.  The timelines and comprehension just are not there.  She is 82 and her health is okay but not great.  I don't want to be unwinding it under pressure during a bear market.  I suggested she give most of what she doesn't need away to her kids and a little to her grandchildren.  She has always lived below her means, and still does: As in her OAS, CPP, dead husbands pension, and dividends from Imperial Oil stock, way more than cover her expenses.  Its great to live in a country with long term stable government. 

Link to comment
Share on other sites

Well if this continues any stocks on the exchanges will continue to go up in value and you will have two classes: The popular index stocks and the unpopular stocks which don't trade on indexes. Any stock not trading in a popular index will tend to have a very low valuation.

 

The natural arbitrage would be for popular index companies to issue stock and use the issued stock to buy up these unpopular companies. Of course right now that isn't happening...instead companies are buying back shares.

 

You would expect that given index dynamics a stock which made up a huge portion of the exchange like Apple might self generate its own buying pressure....when the stock goes up, indexes are forced to buy it which increases it value, thereby forcing even more buying which create more buying pressure. But this does not seem to have happened.

Link to comment
Share on other sites

I think they will be -

 

There was an article I read about this earlier, but can't seem to re-locate.

 

It mentioned that when indices first started, they tracked the underlying movement in the stocks they traded; however, they've grown so large and so ubiquitous that the concern now is that underlying stocks are going up simply because people are passively plowing money into the index (i.e. tail wagging the dog).

 

I don't view straight passive, "set-it and forget it" as being an intelligent option simply because if everyone did it then it would be a disaster for markets (indiscriminate buying of equities just b/c they're in the index as opposed to any fundamental reasoning/value anchor attached).

 

I think in normal times when you have both active and passive investors, passive CAN be a decent option simply due to avoiding the fees; however, if everyone goes passive - I'd want to be the guy with the only active fund.

 

 

Link to comment
Share on other sites

Passive will crush active over the long term because of fees.  It is simple mathematics. 

 

Market returns are a zero sum game.  If the market returns 8% and you return 10%, someone will have to earn 6%, so the net market return is always the average market return.  When you pay 1-2% for active management then you are guaranteed to have low returns relative to the market.  Due to career risk, fund managers don't see outperformance but relative performance. 

 

How many active managers beat the index over 30 years?  The answer is less than you have fingers on your left hand. 

Link to comment
Share on other sites

...when the stock goes up, indexes are forced to buy it which increases it value, thereby forcing even more buying which create more buying pressure. But this does not seem to have happened.

 

I've heard this idea several times but it's not really true. When a stock goes up, generally market-cap-weighted indexes don't have to buy any more -- the value of the shares they already hold goes up too to maintain the greater weight in the index. Equal-weight indexes will actually create selling pressure as a stock goes up.

Link to comment
Share on other sites

Passive will crush active over the long term because of fees.  It is simple mathematics. 

 

Market returns are a zero sum game.  If the market returns 8% and you return 10%, someone will have to earn 6%, so the net market return is always the average market return.  When you pay 1-2% for active management then you are guaranteed to have low returns relative to the market.  Due to career risk, fund managers don't see outperformance but relative performance. 

 

How many active managers beat the index over 30 years?  The answer is less than you have fingers on your left hand. 

 

This, unfortunately is the basic truth of the matter.

Link to comment
Share on other sites

Guest longinvestor

Passive will crush active over the long term because of fees.  It is simple mathematics. 

 

Market returns are a zero sum game.  If the market returns 8% and you return 10%, someone will have to earn 6%, so the net market return is always the average market return.  When you pay 1-2% for active management then you are guaranteed to have low returns relative to the market.  Due to career risk, fund managers don't see outperformance but relative performance. 

 

How many active managers beat the index over 30 years?  The answer is less than you have fingers on your left hand. 

 

This, unfortunately is the basic truth of the matter.

 

+1

 

While much crocodile tears are being shed over the ordinary investors' imagined suffering someday when active management "will have it's day", the real hit job would be if this message of the utter improbability of active management ever working were to be spread with megaphones at the country clubs (or other places where the wealthy hang around) where this is really sold. Over there is where the real suckers are.

Link to comment
Share on other sites

I don’t think indexing is a bad strategy, but the vast majority of those abandoning active management seem to have concluded that because actively managed mutual funds and hedge funds have underperformed over the past 5 or so years, this proves it is impossible to out-perform. 

 

I would change one thing in my original post.  The last 8 words in the quoted sentence would be better put, "this proves that indexing always out-performs." 

 

Williams406 basically summed up my entire point in a few sentences.  The bottom line is people chase returns. 

 

As many others have pointed out, indexing is surely the best strategy for the majority of investors because of costs.  What saddens me however is many of those going in this direction are doing so for the wrong reasons.  I really fear that as soon as another deep bear market returns (or we even suffer a period of stagnant equity returns), those who wrongly believed indexing is somehow less risky and always out-performs will abandon the strategy at the worst possible time. 

Link to comment
Share on other sites

I agree that for most people indexing is fine, but I would like to add some points:

- Most active funds underperform because they are almost invested in exactly the same way than the index and then you have to take into account the costs. Usually these are the big institutions where having instead of 10% in oil stocks just 8% is already a big decision.

- 80% of active funds underperform after 5 years are the statistics, but don't forget that 100% of passive funds underperform all the time

- For me it is just impossible to invest in passive strategies that are market weighted indexes.  It is just pure logic: with those strategies you have of the most expensive most and of the least expensive the least, which is contrary to all logic.

- If you accept to have 50% of your assets in Japan in 1990 or 50% in Dotcom in 2000 or 35% in banks in 2007 then you should invest passively.  But I can't accept this. I just believe it is stupid.

- So even if you just perform in line with the index after 20 years, but have been able to avoid those big bubbles, you have done a good job...and slept much better.

- Last point: the more popular the passive investing is becoming, the more worried you should be.  Go elsewhere to find bargains, because all the large caps, heavy weights will become very expensive compared to the rest of the market.

Link to comment
Share on other sites

- For me it is just impossible to invest in passive strategies that are market weighted indexes.  It is just pure logic: with those strategies you have of the most expensive most and of the least expensive the least, which is contrary to all logic.

 

Oh really?

 

Let's have an example:

Company A: P/E 1, market cap 1B

Company B: P/E 100, market cap 1M

 

Market cap weighted index of A and B has "most expensive most and of the least expensive the least"?

 

Seriously?

 

I'm rather amazed on the number of false claims in this thread. Just not worth getting involved...

Link to comment
Share on other sites

- For me it is just impossible to invest in passive strategies that are market weighted indexes.  It is just pure logic: with those strategies you have of the most expensive most and of the least expensive the least, which is contrary to all logic.

 

Oh really?

 

Let's have an example:

Company A: P/E 1, market cap 1B

Company B: P/E 100, market cap 1M

 

Market cap weighted index of A and B has "most expensive most and of the least expensive the least"?

 

Seriously?

 

I'm rather amazed on the number of false claims in this thread. Just not worth getting involved...

 

In theory your argument could be true, but in practice you know as well as anybody on this thread how things work.  Exactly 10 years ago in the top 10 of highest market cap companies you had 3 banks and 5 oil companies , today there are no banks left and just 1 oil company.  The most popular sectors, the most favourite stocks are always well represented at the top of the index.  What is less popular is less represented.

And maybe, yes maybe, there is a very cheap huge company at the top of the ranking, but in general you have of the most expensive most and of the least expensive less.

 

Link to comment
Share on other sites

And maybe, yes maybe, there is a very cheap huge company at the top of the ranking, but in general you have of the most expensive most and of the least expensive less.

 

Yeah, like AAPL, for example.  8)

 

So according to your arguments it should be trivial to outperform market cap based index. Just buy the cheap stuff and don't buy expensive stuff. Can you explain then why pretty much nobody outperforms market cap based indexes for 5-10-15-20 years? Are you going to be the one who outperforms?

Link to comment
Share on other sites

And maybe, yes maybe, there is a very cheap huge company at the top of the ranking, but in general you have of the most expensive most and of the least expensive less.

 

Yeah, like AAPL, for example.  8)

 

So according to your arguments it should be trivial to outperform market cap based index. Just buy the cheap stuff and don't buy expensive stuff. Can you explain then why pretty much nobody outperforms market cap based indexes for 5-10-15-20 years? Are you going to be the one who outperforms?

 

Well I manage a billion dollar equity fund since 2003, so almost 14 years and have outperformed by 2,5% on average annually. This is after costs and compared to an index without costs. And I can tell you that I am really not a genius, that many people on this board seem to have much more knowledge than me.  I started in 1995 and though I just managed private portfolios then (so I can't proof it) my outperformance was of the same magnitude before 2003.  I just do the simple things: buy good companies, keep them for the long run, always look at the downside risks and avoid the bubbles.  And of course dare to be a bit contrarian and keep your costs reasonable.

There are quite a few managers who have wonderful performances. I even know a 10 billion fund which has outperformed by 6% per year since 1990.  My belief is that this debate about 'passive management outperforming' is just getting too popular and that everybody just accepts those statistics.

I would like to see statistics of active mangers who are no 'index huggers', because of course by including all 'index huggers' with costs you automatically get underperformance.

I just found this article which is quite interesting:

http://www.marketwatch.com/story/index-funds-beat-active-90-of-the-time-really-2014-08-01

Link to comment
Share on other sites

I agree that for most people indexing is fine, but I would like to add some points:

- Most active funds underperform because they are almost invested in exactly the same way than the index and then you have to take into account the costs. Usually these are the big institutions where having instead of 10% in oil stocks just 8% is already a big decision.

- 80% of active funds underperform after 5 years are the statistics, but don't forget that 100% of passive funds underperform all the time

- For me it is just impossible to invest in passive strategies that are market weighted indexes.  It is just pure logic: with those strategies you have of the most expensive most and of the least expensive the least, which is contrary to all logic.

- If you accept to have 50% of your assets in Japan in 1990 or 50% in Dotcom in 2000 or 35% in banks in 2007 then you should invest passively.  But I can't accept this. I just believe it is stupid.

- So even if you just perform in line with the index after 20 years, but have been able to avoid those big bubbles, you have done a good job...and slept much better.

- Last point: the more popular the passive investing is becoming, the more worried you should be.  Go elsewhere to find bargains, because all the large caps, heavy weights will become very expensive compared to the rest of the market.

 

Superb post.  I also think long term indexing is probably right for most people, but each and every one of these points is relevant and means that those who choose to invest a lot of time in it can do better than indexing.

Link to comment
Share on other sites

If someone is willing to hold through a bear market or two and keep investing passively and dollar-cost average through those times, then the person will probably be better off staying in passive. What I envision is people abandoning ship at the bottom and try to chase active management in order to "make up" for lose ground.

 

Personally, I always recommend passive for my own family (and half of my own portfolio is passive) but I constantly remind them do keep buying and to stay the course even while the markets are going down.

 

Aren't people taking this for granted? If you had 'indexed' in the late 20s it would have taken you several decades before you end up with the same purchasing power as when you started, even if they held through the drawdowns.

Link to comment
Share on other sites

Well I manage a billion dollar equity fund since 2003, so almost 14 years and have outperformed by 2,5% on average annually. This is after costs and compared to an index without costs. And I can tell you that I am really not a genius, that many people on this board seem to have much more knowledge than me.  I started in 1995 and though I just managed private portfolios then (so I can't proof it) my outperformance was of the same magnitude before 2003.  I just do the simple things: buy good companies, keep them for the long run, always look at the downside risks and avoid the bubbles.  And of course dare to be a bit contrarian and keep your costs reasonable.

There are quite a few managers who have wonderful performances. I even know a 10 billion fund which has outperformed by 6% per year since 1990.  My belief is that this debate about 'passive management outperforming' is just getting too popular and that everybody just accepts those statistics.

I would like to see statistics of active mangers who are no 'index huggers', because of course by including all 'index huggers' with costs you automatically get underperformance.

I just found this article which is quite interesting:

http://www.marketwatch.com/story/index-funds-beat-active-90-of-the-time-really-2014-08-01

 

Good for you. Care to name your fund? Or the 10B fund you know? I'm fine with private message if you don't want to make the names public. Honestly, I've been looking for active funds into which I'd comfortably invest and I have found zero that have long term outperformance and consistent management/strategy/etc. Well, apart of Sequoia, which blew up.

 

I think the comments to the article are possibly more interesting than the article. In particular, I really question their results. If there are 35%+ mutual funds outperforming SP500 over 10-15 year basis, can you tell me where they are hiding? Somehow when you read Barron's or look at Morningstar, you don't see them.

 

Edit: I ran the Morningstar screener and there are good news and bad news: the good news apparently there's a bunch of funds beating SP500 over 10 years. Bad news: Morningstar basic screener seems to be broken. Some of the restrictions I put in are ignored (e.g. I asked that the fund would beat SP500 over 5 and 10 years, but results show funds that lag SP500 over 5 years). I'll try to play around and get back to the thread if I get a real result.

Link to comment
Share on other sites

Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account in our community. It's easy!

Register a new account

Sign in

Already have an account? Sign in here.

Sign In Now
 Share

×
×
  • Create New...