Tuesday, 9 September 2014

Multiple Indexes

The always charming and eloquent Matthew had a comment on the Passive Index v Active Managed stocks debate:
Dear Padrino,
I have been enjoying the dialogue between yourself and your avid blog readers regarding the prudence of index tracker investing. You will find one particularly vociferous group who will disagree with you regarding the peerless nature of this type of investing. The group being comprised of course by the acolytes of Neil Woodford. These bastions of middle England will take great pleasure in telling you how Mr Woodford's Invesco Perpetual Income fund under his tenure outperformed the FTSE All Share handsomely for 20 years.
This leads me to the question of how do you feel about the practice of dividend hunting portfolios with say a once a year reallocation and automatic dividend reinvestment? Is a diverse, high yield portfolio of large caps strictly managed able to squeeze more juice from the index tracking approach? Both methods will of course be often investing in similar companies effectively but with an added filter. This is something the amateur, thanks to discount brokers, can indulge in himself and costs are very manageable if you balance infrequently. These portfolios often contain the same faces year after year so balancing is not too arduous.
I look forward to hearing your thoughts on the matter.
Based on his impressive education and a career background in financial trading, I suspect that Matthew knows far more than I do about these things, so my thoughts and opinions are very much from the man-in-the-street who accepts that others on the inside of the financial world will always know far more than he does about these things, and whose philosophy is thus to keep it simple - invest frequently and consistently in a number of diverse index funds, keeping costs to a minimum.

For those who have not read every single Green All Over post, and shame on you if you haven’t for it is an illuminating read, one of my best financial decisions was to start trading futures and options. It opened up a whole new world of investment possibilities, and I learned a great deal about trading and entry points and lot sizes and the like, but sadly it turned out that others in the world knew more about the price of pork bellies and orange juice than did I, which led to another excellent financial decision, which was to stop trading futures and options.

I dabbled a little in day-trading stocks part-time in the early 2000s but was always aware that however timely my information was, it wasn’t timely enough, and that professionals whose waking hours were spent studying, analysing and dissecting markets, sectors and individual companies would always know far more than me, and rather like trying to trade in court-sider infested markets today, if I can buy or sell at a certain price, it is because the insiders / experts are offering that price to me, and they are not offering me that price out of generosity to me.

In simple terms, stock mutual funds are typically for growth, for income, or a blend of the two. Growth mutual funds tend to focus on capital appreciation, i.e they buy stock in a company with the expectancy that the stock price will increase, while value or income based funds tend to invest in companies that pay dividends. Comparing an Income fund with an all-share index is not comparing like with like. The relevant comparison would be to compare Inveso Perpetual Income Fund with a benchmark for Income Funds.

The major indexes are based on the top companies listed in the relevant country’s stock exchange, for example the FTSE 100 is comprised of the 100 companies listed on the London Stock Exchange with the highest market capitalisation.

Similarly, the DJIA (Dow Jones Industrial Average) is made up of 30 companies, and the industrial is a relic from a bygone age, but the S&P 500 (made up of 500 leading companies trading on the US exchanges) is a better representation of the U.S. stock market, and for the US economy.

The question Matthew asks confuses me slightly, since there isn’t just one ("the") index to beat. Each mutual fund is of a certain type, and each have their own indexes against which they are compared.

Growth funds are measured against an index for growth funds, and an income fund against an income index, and again I would say that the man in the street is unlikely in the long-term, to consistently beat the appropriate index. The "dividend hunting portfolio" should be measured against a similar benchmark.

How one should allocate investment funds is dependent upon factors such as ones age and risk tolerance of course, but it’s not meaningful to compare an income portfolio approach with anything but an income index.

And for the record, I am a big fan of DRIPs (Dividend Re-Investment Plans). They are generally a low cost (commission free) way of buying more stock.

As for annual rebalancing / reallocating, this seems perfectly sensible, although I question the wisdom of rebalancing at the end of the calendar year when everyone else is doing the same. It seems to me that if you are tracking an index, and are light in one company for example, then others will be too, and if everyone goes chasing at the same time, the price you pay will be more than had you re-allocated earlier in the year. There’s a similar issue when a major Index drops a company and replaces it with another. Most Indexes make changes frequently; in June this year the FTSE 100 added 3i Group and dropped Melrose Industries and Intu Properties replaced (coincidentally, given the nature of this blog) our dear old friend William Hill.

Prabhat doesn't know when he's beaten, and returned to comment:
I'm slightly puzzled, my comment explicitly stated that the average person (or fund) won't 'beat the market'. My point was that a) if someone wished to be excellent it's possible.
Yes Prabhat, I have conceded that it is possible (to beat the market long-term), but it's highly unlikely and you have not offered any reason why my assertion, backed by mounting evidence, is not true. Not wishing to believe it isn't evidence. There's also the question of, not only transaction costs, but the cost of the time your cunning plan to beat the odds is going to take. One imagines that would be quite significant.

Emp continues:
You keep saying the average person has no self control etc., and here we are on common ground. I agree entirely that the average person lacks discipline, self-control and other attributes necessary to succeed. My point was if someone has those attributes or wishes to cultivate them, they have options better than an index fund. For that matter, judging by track records you yourself (not to imply you are average) would have done better investing in your football selections than the market.
What options are better than an index fund? That is the crux of the debate, which is not about comparing one investment type with another, (another day perhaps) but about having decided to invest in stocks, what is the best way to invest in them.

Marty chipped in:
When asked I always advise people to invest in low cost index funds and to drip feed investment, so I generally agree with Cassini's practice.
I disagree with this though:
"The S&P 500 last year (2013) was up 32.42% ... ask your friends from outside the financial world... not many would be close to that."
If they're holding US blue chips (a very common investment approach) then lots of them will likely have beaten the S&P, because they're holding the stocks the S&P is made up of and a fair proportion of stocks in that index will have outperformed the index.
The S&P 500 is actually considered a blue chip index, as is the DJIA, so it all depends on how blue you want your chips. The broader index actually beat the narrower one anyway, although neither matched the technology heavy Nasdaq Composite which gained more than 38% in 2013. The Nasdaq is made up of 3,000 components, which suggests that sticking to blue chips rather than a broader basket was a better bet. The Russell 3000 was up 31%.
"The Dow industrials DJIA, -0.15% rose 72.37 points, or 0.4%, to end at 16,576.66, its 52nd record close of the year. The blue chips ended 2013 with an annual rise of 26.5%, the largest since 1995."
With 2014 2/3rds done, the S&P 500 is up a "mere" 8.4%, and I'm glad I looked at the Yahoo Finance page for that tidbit, because what do I find but yet another excellent and well-researched article that is most timely (you may feel that you have heard some of the common objections before):
I'm not going to make you wait for the punch line. Your single biggest investment mistake is owning any actively managed funds. That's where the fund manager, through stock picking and market timing, attempts to beat the returns of a designated benchmark, like the Standard & Poor's 500 index.

I started writing books and blogs about investing in 2006. At that time, only a very small minority of people invested in index funds. Jim Cramer was at the height of his popularity.
I struggled with different ways to communicate to investors that the only intelligent and responsible way to invest was to capture the returns of the global market. This meant investors should avoid stock picking, reject market timing and not engage in the fruitless attempt to pick the next "hot" mutual fund manager. The general reception to this message was about the same as you would expect watching a vegetarian lecture to a cattlemen's convention. The common objections were:
-- "I don't want to settle for 'average' returns."
-- "My broker and I can 'beat the market.'"
-- "I only invest in companies I know."
-- "I can beat the market using dividend-paying stocks."
-- "If you are right, that means everyone making predictions in the financial media is wrong."
Though these assertions may have surface appeal, none of them withstand scrutiny, despite the messages pushed by the mutual fund industry and much of the financial media. The passage of time has been accompanied by a seismic shift in investor attitudes. The dismal track record of actively managed funds has caused even leading proponents of active management to throw in the towel.
Morningstar describes itself as a leading provider of independent investment research. One of its best-known products is its star rating system, which rates mutual funds from one to five stars, based on how well they performed (after adjusting for risk and accounting for all sales charges in comparison with similar funds).
Although Morningstar has cautioned investors to make expense ratios (the management fees charged by mutual funds) a "primary test in fund selection," many investors ignore this advice and use star ratings instead. The mutual fund industry encourages this practice by touting the star ratings of its best-performing funds.
Given Morningstar's pre-eminent position as a provider of information about actively managed funds, it was startling to read the views of John Rekenthaler, the company's vice president of research. In his blog post, Rekenthaler reviewed net sales over the past 12 months for all exchange-traded funds, passive mutual funds and active mutual funds. He found 68 percent of those sales went to passive investment products. Rekenthaler concluded that passive investing is now the mainstream approach and that "active managers have become the periphery."
The message that actively managed funds typically do not add value to investors is resonating globally. A report issued by the Pensions Institute in June 2014, "New Evidence on Mutual Fund Performance: A Comparison of Alternative Bootstrap Methods," based at the Cass Business School of City University in London, reached some startling conclusions.
Researchers examined the returns of 516 stock funds based in the United Kingdom for the period from 1998 through 2008. They found only 1 percent of fund managers produced returns sufficient to cover trading and operating expenses.
In my prior experience, even this data may not dissuade many investors. They would tell me that, with the assistance of their broker, they had the ability to select and purchase that tiny percentage of outperforming actively managed funds. The report by the Pensions Institute dealt a death blow to this claim.
First, it found that prospectively identifying the minuscule number of outperforming fund managers is "incredibly hard."
Second, the report noted it takes 22 years of performance data to have a high degree of confidence that a fund manager's out-performance is a product of skill rather than luck.
Third, it found the tiny group of "star" fund managers able to generate superior performance in excess of operating and trading costs were the sole beneficiaries of their skill. They extracted "the whole of this superior performance for themselves via their fees, leaving nothing for investors."
Perhaps the cruelest cut was that researchers concluded the vast majority of under-performing fund managers were "genuinely unskilled," not simply unlucky. Here's the good news. It's disarmingly simple to avoid making this critical investment mistake. The first step is replacing your actively managed funds with low management fee, comparable stock and bond index funds, passively managed funds or ETFs.
Note that the article references the Cass Business School of City University, London, and not the Prab Business School, which may be a stock-picker sponsored private organisation who are no doubt busy working on a rebuttal article to the growing body of evidence that, while it's nice to think you're above average, the chances are you're not, unless you're the Sultan. I suspect the finished, peer-reviewed, article will be a long time coming. Another comment may not be quite so long in the making, but I hope it has a little more substance that just saying "in theory, I can beat the casino" and then offering no evidence for how this dream might realistically be realised.


Matthew Trenhaile said...

Grazie Saggio Cassini,

Once again you provide a thorough and enjoyable analysis. Looking at it again I am rather comparing apples with oranges. I think my main intent was to compare different methods of allocating savings for the retail investor for long term prosperity. When you are making decisions regarding your pension, stocks and shares NISA or SIPP you are often faced with a bewildering array of funds and of every conceivable strategy. Income funds are invariably included in your pension prospectus and yet the description seems incongruous with the concept of allocating money with which you are unable to touch till you retire.

Ultimately we want to make the most money possible and if it comes from a DRIP income fund or from a passive managed index tracker is of little consequence. I am a huge fan of the low cost index trackers but simply question whether sometimes an attempt to separate the best of breed from a large index via yield evaluation might beat the returns of the tracker for the self same index. Obviously it would have to beat the additional management fees to make the exercise worthwhile.

So can a DRIP income style fund outperform an index tracker fund from an ROC perspective over the longterm? They are both called upon to perform the same role if you agree with the fund prospectus from your pension, NISA or SIPP IFA advisor. As you rightly say there is not just one index but if an investor currently holds a FTSE All Share tracker and a Russell 2000 small cap tracker and he is currently beating the performance of the actively managed funds benchmarked against the performance of the same indices he should not necessarily sit back and think that he has maximised the return on his capital.

Those who have purchased your draw selections and Graeme's TFA selections are investing in football bets but generated from different strategies. Much as they would love to simply compare your selections to other draw backing strategies and Graeme's 7-22 to other H/A backing strategies I am sure they are looking at the ROC of both and wondering which deserves the finite capital more. Of course there could just be a desire for diversification.

I feel I have rather gone off track now. As for re-allocation if one was to try and execute an income style fund strategy oneself there are of course timing issues regarding the buying and selling stock but they are certainly navigable by the retail investor. Finally a note on my education and knowledge as a financial trader. My education simply taught me to always read more, any institution that gets this message across has in my view done well by its students and it does not matter what name is on the building. As for my knowledge on financial trading I am sure I can find the back of a small envelope to put down all I know to pass on to you.



Prabhat said...

Pardon me for not recognizing the universal truth that I'm 'beat' whenever you say so!

In the first place, there's no reason to skip the issue of 'having decided to invest in stocks'. If all one is concerned with is maximizing return (while considering risk) than one should be open to all asset classes, and my earlier posts mentioned commodities, currencies and other classes that average Joe views with suspicion, but excellent traders and hedge fund managers don't.

If you acknowledge it's possible to out-perform, that's all I need. No academic study is going to reveal exactly how likely or unlikely it is. I've already said multiple times, amateurs will probably fail, so I would really appreciate it if you misrepresenting me. There's no way I can 'show you how to beat the market' except to point at the records of excellent managers (never mutual funds). You will then claim they 'got lucky', and so on.

Whenever long bull runs happen, these index funds become the majority and everyone rings the death-knell for using one's brain. Try including a bear market in the sample size, before concluding this is the best strategy ever? I said that in my last post and you conveniently ignored it. Index funds are just an embedded bullish bet, and that has very real risks that look non-existent during an extended bull market (like now).

Ultimately, your own data shows that 99% of managers fail because they lack skill. Obviously then, those with skill will do well, and if finding them (or being them) is 'incredibly hard', it's also incredibly worth it. 99% of every profession is pretty average, and the most desired ones are incredibly difficult to even get into; that doesn't prove that aspiring to be excellent is stupid.

If you really believe all this stuff about index-funds being so great, I dare you to visit the topic annually? Embedded bullishness doesn't do so grandly in a bear-market, and there's certainly one coming in the next year or two.