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Sunday, 22 February 2009

Don’t Give Index Trackers the Bird

Shoe Fetish

You want to buy a pair of shoes but due to the Great Shoe Shop Recession of ’09 there are only two outlets left to choose from, right next to each other. To the left you have a simple, dressed down stand. To the right there’s a glitzy emporium, covered in flashy signs. The former sells cheap shoes that last for years. The latter sells expensive, fashionable footware that falls apart in months. If all that concerned you was to be well-shod for a low price for a long time, which would you choose?

Irrational Sprinters

In the world of investing the answer for most people is, of course, the shoddy but fashionable and expensive sneakers. Welcome to the bizarrely inverted world of fund management where the simple outperforming Index Tracker is outsold by the expensive underperforming Active Fund. It’s like watching a sprinter win the hundred metres and backing them for the marathon. Is that rational?

John Bogle invented the index tracker – a passive fund that attempts to faithfully track some chosen benchmark – in 1976 when he launched what later became the Vanguard 500 Index Fund. Amusingly, at the time, he was accused of being ‘unAmerican’ for doing so. Presumably the idea is that it’s every American’s duty, no matter how poor, to ensure fund managers are well provided for; “trickle-up” economics in action.

Since then the index tracking industry has mushroomed and the index trackers have consistently outperformed the majority of actively managed funds over every time period. According to Mr. Bogle, between 1980 and 2005 the average inflation adjusted return on a $1000 investment in an active fund would have resulted in an end fund of $3,270, a return of just 4.9% a year. In contrast the same investment in the Vanguard 500 would have yielded $7,160, a return of 8.2% (remember that these returns are adjusted for inflation: 8.2% over inflation is a damn good performance).

Passive Resistance

Most research backs this up – Kenneth French’s 2008 paper (1) on the costs of active investing supports Bogle’s contention, although it puts the cost differential at a rather lower level. No matter, the conclusion is the same: active funds reduce your returns compared to passive funds and make you take on more risk to do so. Of course, you may strike lucky and end up with an outperforming active fund, but unless you’re unusually talented that’s a gamble, not an investment. And if you’ve that much talent why are you bothering giving your money to someone else to manage?

In fact the outperformance of index trackers is even greater if you take into consideration that most of the worst performing active funds are quietly wound up or merged with other funds and promptly disappear from the comparative records. It’s magic, a perfect piece of misdirection – while you’re looking at the box waiting for the lady to reappear the magician is making off with the takings.

Free Lunches

So what causes the difference in returns? It’s a combination of factors but primarily to do with costs – good index funds are as close to frictionless in cost terms as it’s possible to get, while active funds have to cover the expenses of managers, greater advertising costs, more dealing fees and so on. Apparently insignificant differences compound up over significant periods to destroy investor returns. For the average investor looking for a simple and safe way of investing over a lifetime the index tracker is as close to a free lunch as you’ll ever get.

The survival of the actively managed fund industry, then, ought to be a genuine source of wonder. In a perfectly capitalist world such funds should be extinct, outcompeted by their passive brethren. Yet this clearly isn’t so and that should tell us something very interesting about both human nature and the purpose of the investment fund industry. Capitalism doesn’t quite work the way the economists think it should – that’s why salesmen retire at 40 and live in shorts for the rest of their lives while economists wear suits and work till they drop.

Fashionable Investing

Remember our shoe shops? The shop selling poorer quality products at higher prices makes higher margins and uses this to invest in its sales channels and advertising while staying up to date with fashion. Mining companies did well last year? OK, let’s start a mining fund. Soft commodities in fashion? Set up an agriculture vehicle. Behind this are a welter of basic psychological triggers used to persuade us to do what’s not in our interests. That’s the essence of the super-salesman and active fund managers are past masters of the use of our psychological pressure points to deprive us of our hard-earned capital.

Just as in the rest of the world fashion, advertising and smooth sales patter are potent methods of persuading people to do something that’s against their best interests. In some areas of life this doesn’t matter too much but when it comes to retirement savings going for the glitzy shoes will see you wearing rags on your feet and living in a cardboard box before you’re done. Remember – the securities industry is a machine devoted to extracting money from the public and has myriad means of doing so, tithing the unwary investor over and over.

The Least Bad Option

I’m a fan of index trackers, but only in a curiously muted way. Index trackers are the least bad way of an investor avoiding the psychological traps that await the unprepared investor. Behind the index tracker is a technical issue that ensures that their design is curiously inefficient. That’s a topic that’ll have to await a future post but consider this: an index tracker needs to track its index so when people were buying dotcom stocks at stupid valuations in 1999 so were the index trackers, ditto commodity stocks in 2008.

Buying overvalued stocks at the top of the market is classic amateur investor behaviour, so having index trackers do this would seem, at least, to be non-optimal. Yet even with this inbuilt disadvantage broad based index trackers still outperform activist funds which could, if they so chose, simply sit out the more stupid phases of the market. I find that astonishing.

Beware the ETF

Of course, the clever and many tentacled securities industry won’t ever leave a good idea alone. So we’ve seen the rise of new sorts of passive funds - the sector specific and sub-sector specific index trackers, defining ever more narrowly specific industries or geographies. Closely related to these are Exchange Traded Funds (ETF’s) with even lower charges and often even more targeted remits. In fact not all index trackers actually track a market directly, they often use derivatives, increasingly more exotic ones, to simulate index tracking or rely on other indirect means to achieve equivalent exposure.

Caveat emptor - buyer beware. Specialised passive funds are for sophisticated investors not the likes of me (you, I don’t know about but definitely not me). If you don’t understand what any of the above means without resorting to a frantic search of Google and much elbow rubbing then don’t buy them. Look for a well known index tracker with no initial fee, a low total expense ratio (or TER – no more than 0.75%) and a low tracking error (which measures how closely the fund succeeds in tracking the target index – less than 0.15% over a reasonable period of years). And invest regularly to ensure you get the benefit of buying when markets are caught in one of their depressive “sell at all costs” moods. In stockmarket investment sometimes – nearly always, in fact – simple is best.

(1) French, Kenneth R.,The Cost of Active Investing(April 9, 2008). Available at SSRN:

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