Here’s a pithy marketing one-liner for you: ‘Most active fund managers underperform the index’. Combine the argument with the removal or mitigation of structural biases towards fee-paying products, and a massive business has emerged in index funds and index ETFs.
The promise of diversification, a low cost and access to overseas markets are the top three reasons for the popularity of index funds, but their growth and popularity belies the fact that broadly diversified cap-weighted equity index funds guarantee ‘average’ returns for a generation of investors.
As passive index investing becomes ever more popular, the arguments that justify the switch from active to passive management weaken and then break down. Retail investors are none-the-wiser, and trust those recommending this approach because it’s cheap.
Tellingly, they are cheap
Index investing, in particular when it is directed to cap-weighted equity indices, is dumb investing. When Warren Buffett recommended index investing to the masses, he made the point that it suits the 'know-nothing investor'. That is, the investor who has no interest in understanding a business or valuing it.
If you are reading Cuffelinks, you are not a know-nothing investor. And if you are an advisor, your clients are relying on you and paying you to be a ‘know-something investor'. There are plenty of reasons to avoid index investing and the ETF structures used to promote them, but those reasons haven’t hampered their growth.
ASX-listed ETFs are at a record high of over $17 billion and according to a January 2015 'Australian ETF Review', ETF trading activity also broke the record for the largest month-on-month gain in funds under management as growth reached $955 million. Meanwhile, the number of exchange-traded products trading on the ASX exceeds 100 and the number of ETF investors in Australia grew by 46% in the 12 months to October 2014, to 146,000. More than 180,000 investors are expected to have adopted the structures by the end of calendar 2015. Meanwhile the number of financial advisers employing ETFs has reached the record level of 7,000.
Of course strong market performance is having a significant impact on index investing’s popularity. The adoption rate can reasonably be expected to be highest when the market is at a crest and lowest when the market is on its knees – precisely the opposite of a successful investment strategy.
While exchange-traded and index funds have been heralded as one of the most important financial innovations during the last decade, promoters fail to warn investors of their limitations.
Dangers of popularity
As index investing grows in popularity, so does the blind purchase and sale of large baskets of shares with no regard for their underlying fundamentals. How such an approach to equity investing can be recommended to an investor requires careful examination. Most dangerously, as index investing grows in popularity so too does the divergence between stock prices and fundamental values.
Three risks for index investors increase – the risk of permanent capital impairment, volatility, and the certainty of average performance.
Index investing is justified on the basis that the market is efficient and stock prices always reflect fair values. Therefore index investors ride the coat-tails of analysts who have done the work to determine values and disseminate that information. As the number of index investors increases, so does the amount of blind buying and selling. This ‘squeezes out’ sensible value-based investing and reduces the influence of the narrowing pool of analysts required to establish the valuations the efficient-market-index-investing proponents rely on.
More frequent periods of greater divergence between price and fundamental value will occur, and in those periods, active managers have the opportunity to make much larger returns for their clients.
As index investing grows in size so does the ability for marginalised active managers to outperform. The argument that passive beats active – the reason for the migration to passive forms of investing – weakens.
In the long run, sensible investing beats blind investing
I have frequently used the following example to make the case for smart active investing.
In 1919 Coca Cola listed on the NYSE at US$40 per share. A year later the stock was trading at $19.50, the result of rising sugar prices and a perpetual contract Coca-Cola had with its bottlers to supply syrup for $1 per gallon. What would have happened if a single share of Coca-Cola was purchased in 1919 at $40 and held through all of the frightening subsequent economic and financial developments, including the subsequent decline to $19.50 in 1920, then through the great crash of 1929, the subsequent depression of the 1930s, World War II, a baby boom, dozens of other wars and skirmishes, an oil crisis, assassinations, the fall of the Berlin Wall, innumerable recessions, booms, busts and scandals, as well as a war in Vietnam, two in Iraq and the market crashes of 1974, 1987, 2000 and the Global Financial Crisis?
Holding that single share, accepting all of the subsequent stock splits and reinvesting all dividends, would now equate to over 252,000 shares and the investment would have a market value, at $US40 per share, of over US$10 million.
It goes without saying that there would have been many periods and windows where the S&P500, the Russell 2000 and the Dow Jones indices outperformed the share price of Coca Cola. Indeed over the last two years the S&P500 has returned 35%, while Coca Cola has returned negative 5%. And over the last five years, the S&P500 has returned more than 72%, while Coca Cola has returned 50%.
But over the very long run - the period over which investing in a slice of a business makes perfect sense - sensible value investing in quality businesses will beat an index. The index is forced to be in both high and low quality companies. A $40 investment in the S&P500 index in 1919, is now worth just $540,000, compared to the $10 million for Coca Cola.
Australia is replete with businesses generating poor returns
Many advisers and commentators despair that the S&P/ASX 200 price index remains below its all time high, some eight years later. And yet, without thinking about why this is the case, they advocate index investing.
The reason the index remains below its high despite an unprecedented amount of artificial, and temporary, support from low interest rates, is that the index is dominated by businesses generating poor returns on shareholders’ equity capital. Mediocre businesses generate mediocre returns on shareholders’ equity, and over time, share prices reflect this, ensuring small minority shareholders receive a return similar to that of a 100% owner of the business.
As an example, I have previously explained the terrible performance of Virgin Australia over the last decade. It has required massive capital injections, holds $1.7 billion of debt and the share price is a quarter of its level ten years ago. An investor in Virgin shares would have experienced a proportional economic calamity over a decade to the individual who owned the entire business. Every large cap Australian index fund has paid the consequences of this poor investment.
But airlines aren’t the exception. A cursory examination of share price performances for many so-called ‘blue chips’ reveals many equally disappointing performances. Companies like AMP, NAB, Boral, Leighton, Lend Lease, BHP, Rio and Telstra might have paid dividends but their capital return has been disappointingly flat to negative over a number of years, even over a decade or more in some cases.
These blue chips make up the major cap-weighted stock indices and it is the blind buying of these diversified and cheap indices through index funds that will ensure their investors receive similarly mediocre returns.
Final thoughts
The blind buying of mountains of stocks simply because they are in an index will drive mispricing that active managers can rely on to outperform the same index. As more investors flock to the index, the argument trotted out that most active fund managers fail to beat the index will become less true, if not false. The hitherto reason for investing in the index breaks down, just as active managers reward their investors with greater outperformance over the long run.
And keep in mind that it isn’t true that most managers underperform their benchmarks after fees. In Australia the vast majority of active small cap managers beat their index. Their index is full of junior mining exploration companies that lose money or dilute, with frequent capital raisings, the ownership of the company for incumbent shareholders. Simply exclude those companies from a portfolio, buy the rest, and hey presto, you’re beating the index over the long-run!
Poor quality companies aren’t the exclusive domain of small cap indices. There are rubbish companies in every index. Cap-weighted indices are constructed by aggregating the performance of companies based usually on their size or on what they do. They aren’t selected because they are highly profitable at what they do. And they aren’t selected because they are expected to produce strong share price performances over the long term for their investors.
Indices were not originally designed as investments but simply as a measure of the market's activity. A cap-weighted index is not constructed with the intention of producing a solid long-term return for investors.
Roger Montgomery is the Chief Investment Officer of The Montgomery Fund. This article is for general education purposes and does not address the specific circumstances of any individual.