Saturday, August 12, 2006

The Paradox of Indexed Investing

Recently I have been reading a lot on the theory of trading and hedge funds and musing about what trends in investment strategies mean for the future of returns on different forms of investment and trading. The following thoughts are hypotheses rather than any worked out kind of theory.

In a world where everyone is an active investor (and investing on the long side only) trying to exploit valuation anomalies perhaps the market index reflects the average of their returns. Therefore, if you hire a manager, the average manager will return to you less than the index return once you pay their fees. The best managers will also migrate to the hedge fund world where they can charge larger fees leaving the average mutual fund manager making less than the index even before fees.

Hedge fund managers can also exploit opportunities on the short side and therefore even after their fees do better than long-only mutual fund managers - at least the better hedge fund managers do.

In comes passive indexed investment. What is the point of paying for an active manager if they earn less than the index say investors? So they put their money in index funds, ETFs, futures etc.

That is about where the investing world was at a few years ago.

The potential paradox is this - all the investors who are putting their money into indexed products are no longer pursuing valuation anomalies except to the extent to which they do this is when losing stocks are dropped from the index and winning stocks added. These market participants are no longer contributing to making the market efficient. This means that the remaining active investors have more opportunities to exploit as some of their competition is removed! The bigger indexing gets the more it will again underperform active management.

In recent years actively managed funds have outperformed the index in the US markets. I blogged before that this was likely because we were no longer in the strongly trending markets of the 1980s and 1990s. This is probably true but could indexation also be a factor?

We could even envisage long term cycles of active and passive management being more and less popular. Any thoughts?

4 comments:

jay said...

The potential paradox is this - all the investors who are putting their money into indexed products are no longer pursuing valuation anomalies except to the extent to which they do this is when losing stocks are dropped from the index and winning stocks added. These market participants are no longer contributing to making the market efficient. This means that the remaining active investors have more opportunities to exploit as some of their competition is removed! The bigger indexing gets the more it will again underperform active management.

It doesn't take much to keep the market efficient. With all the active funds out there I don't see why this is a cause for concern. Even more so in this day in age where news travels in mere seconds and computers can constantly analyze data. I imagine things are even more efficient.

In recent years actively managed funds have outperformed the index in the US markets.

How can everybody outperform the market? That is mathematically impossible. Stealing Taylor Larimore's post from the Morningstar forums:

Each quarter Standard & Poor's publishes a "Standard & Poor's Indices Versus Active Funds Scorecard" for domestic stock funds. For the first time Standard and Poor's has also included comparative figures for international and fixed income funds vs. their benchmark indexes.

Here are five year results (the longest period shown):

PERCENTAGE OF EQUITY FUNDS OUTPERFORMED BY INDEX:
67% Large Cap
84% Mid Cap
79% Small Cap

PERCENTAGE OF INTERNATIONAL FUNDS OUTPERFORMED BY INDEX:
65% Global
80% International
88% Emerging Markets

PERCENTAGE OF FIXED INCOME FUNDS OUTPERFORMED BY INDEX:
75% Government Intermediate
84% Government Short
73% General Intermediate
88% General Short
84% High Yield
89% Mortgage-Backed Securities

I want to thank Barry Barnitz who sent me this link to
the full 29 page report:

Standard & Poor's Indices Versus Active Funds Scorecard
http://www2.standardandpoors.com/spf/pdf/index/SPIVA_2006_q2.pdf

mOOm said...

Thanks for dropping by. I didn't say everyone would beat the market just that more passive investing would leave more "alpha" on the table for the remaining active investors. And it is not a "concern" I am trying to point out that there are opportunities for active investors. I will check out that report - I saw an earlier version that seemed to point in the opposite direction. As well as this article. Passive investing is good for people who are not interested in or have the resources to be active investors. I also think that hedge fund type investments will on average outperform long-only mutual fund type investments for a given level of volatility.

mOOm said...

OK - checked out the report now. The data in the report do show as I had previously seen that in recent years there was something of a trend towards more active mutual funds outperforming the index. But the second quarter of 2006 was generally very poor for active funds and the trend to better performance as a result was partially reversed. Does this mean that the improving trend was an anomaly? Or that Q2 2006 is an anomaly? I don't know.

makingourway said...

mOOm, it looks like one of those issues where time will tell.
however, i have fairly strong confidence in historical long term trends which leads me to side closer with Bernstein on fairly predictable active management underperforming indexes.
Jay's point about the instant availability of information and the sheer mass of active funds still out there - there's so many left, keeps me thinking that there are still too many active hands in the pot!
Hope all goes well and the trades are profitable,
regards,
makingourway
www.makingourwayblog.com