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Overselling the Case for Indexing

by: Index Universe July 15, 2008    
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By Jim Wiandt

Matt Hougan - do you really believe 0.6%?

I'm sure the authors of the paper have used all of the right caveats on assumptions to distance themselves to some degree from taking full responsibility for their statement that 0.6% of active managers are beating the market with genuine skill, but such a pronouncement surely defies logic.

I think taking anything that comes out favorably to our position and parroting it does a disservice to ourselves and our readers: Hougan the demagogue ... and he seems so mild mannered. I mean, honestly, are the markets really so efficient that only 0.6% of professional active managers are able to beat the dollar-cost-averaging masses? And I'm saying this as a true index investor who doesn't own a SINGLE actively managed fund.

It all boils down the fact that on some level, you can make the numbers say whatever you want them to (though it is hard to imagine someone having the gall to try to come out with a study purporting, say, that 0.6% of index managers outperform the average active manager).

This is along the lines of those famous asset allocation studies (starting with Brinson) that purported that 80%, or 90% or 98% ... and then in one case over 100% (when the cat was out of the bag on what the numbers actually meant) of performance variation was based on your asset allocation. Try to tell me there's not single-stock risk or timing variation of sectors or subsectors that is possible in an individual portfolio. In effect, it can become a battle of semantics. But as a close friend of mine told me of an embarrassing incident he had when he was a young lawyer, telling a senior partner something was "just semantics."

"(In law) SEMANTICS IS PRETTY *#@&! IMPORTANT!)

Well I think semantics is pretty important in general, and something that is positioned deceptively but with watertight methodology, is nearly as false (and can be so in a more powerful way) as an outright lie.

So that is my initial reaction to 0.6% without even reviewing the research, though what IS interesting to me is that the percentage has gone down in recent years. Maybe I'm wrong on the big-picture issue about the 0.6%, but I doubt it.

I'm absolutely convinced that there are plenty of people out there who are nimble and smart enough to beat the market and to do it with relative consistency, but I think they are a diminishing minority, and that the hurdles they have to overcome in terms of cost and inefficiency are very large indeed. But 0.6%? We'll KNOW something's up if the next study around, the researchers tell us a NEGATIVE percentage of active managers have the genuine skill to beat the market.

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This article has 11 comments:

  •  
    Jul 15 08:51 AM
    Even as an indexer, i welcome your skepticism. Isnt it hard to have a market if people aren't over and underperforming the benchmark? Why has indexing become so cult? The Vanguard Diehards forum reads like an AA meeting.

    cheers,
    john
    Reply
  •  
    Jul 15 09:10 AM
    I think one reason for confusion among small investors is that there are investing strategies that work, but only at small scale. So money managers with positive performance become victims of their own success.

    These studies are not an argument for the end of active management, but I think they probably make a good case that management fees need to fall.
    Reply
  •  
    Jul 15 09:25 AM
    Active managers performs an important asset allocation function in modern economies. Buy side analysts and portfolio managers along with other market participants digest market information and translate it into the impetus behind the invisible hand of the market. Indexing is a free-riding mechanism that misallocates the true cost of the necessary asset allocation function.

    I agree that it is not efficient to have every member of society repeating the same investment analysis in every home and workplace. However indexers are not paying their fair share of the significant cost of producing the actionable results of investment analysis. Its a free lunch in that they get the answers to the exam from the inherent transparency in security prices without having to study or pay for it.

    Indexing is good or not based on the quality of aggregate market knowledge.

    The balance in the mix of information producers and free-riding indexers has been affected to a great extent by information technology and the resultant cost of information.

    If 100% indexing was the case, then asset allocation would be random. Try running a business making random decisions.
    Reply
  •  
    Jul 15 12:09 PM
    ETFnerd - you have a bit of a reductio ad absurdum there. 100% indexing? Come on now. The balance of active and passive investing is subject to the law of supply and demand too. If we went overboard on the indexing (which there's little danger of right now - people love paying fees and trying out new mutual funds), we would reach a situation where there was an oversupply of index options and undersupply of active options (again, I'm not too worried about the latter). There would also be less demand for the unknown but fundamentally strong companies, and more demand for momentum plays.

    As a result, prices became less accurate, less information-driven, more volatile, chaotic, and momentum-driven. At that point, more active managers would be able to beat this market, either by out-trading it or practicing good analysis and a buy-and-hold strategy. The minority of investors who actually pay attention would notice and shift their assets from indexing to these managers, and we would move towards equilibrium again.

    The other thing you need to remember is that mutual funds aren't the whole world. A well-diversifed portfolio of stocks, chosen rationally and held for expense and tax efficiency, can absolutely beat the index: the problem for active managers isn't that they're completely clueless, it's that investors pay them high fees regardless of whether they make any profit, and pay high taxes due to their frequent trading. So even if mutual fund investors figured out that indexing beats most current AMFs and shifted assets accordingly, you would still see wealthy individuals and institutions building rational stock portfolios and providing value information to the market. You also would see some of the best AMF managers lower costs to try to beat the market and retain assets.

    As to the specific study, it seems like the researchers found some percentage of active managers who have beaten the market return, then used some statistics to attempt to figure out a margin of market-beating that is "statistically significant" (which is never as scientific as it sounds), then counted what percentage beat this hurdle. I think there's some merit to this approach, but it can lead to over-stating results. I wonder if they counted what percentage of managers have market-beating skills but didn't beat the market due to random variance, or only applied the statistics in one direction?
    Reply
  •  
    Jul 15 12:35 PM
    najdorf, I don't know what you are talking about. What is an active option?

    I think that you completely misunderstand my post. There can be no indexing if there is no active management. Active managers in modern economies perform the asset allocation function. Individual active managers can underperform or outperform the market. So what? In aggregate they must return the market rate of return.

    Without them you'd be left with technical analysts, speculators and market timers, so how would they allocate capital properly in the economy without doing fundamental research.

    Read Bill Sharpe's article here if you still don't understand:
    www.stanford.edu/~wfsharpe/art/active/...
    Reply
  •  
    Jul 15 12:37 PM
    www.stanford.edu/~wfsharpe/art/active/...
    Reply
  •  
    Jul 15 12:37 PM
    "www.stanford.edu/~wfsharpe/art/active/...
    Reply
  •  
    Jul 15 12:38 PM
    stanford.edu/~wfsharpe/art/active/...
    Reply
  •  
    Jul 15 12:38 PM
    sorry, can't get the link to show up correctly.
    Reply
  •  
    Jul 15 12:39 PM
    google: "The Arithmetic of Active Management
    William F. Sharpe"
    Reply
  •  
    Jul 16 10:08 AM
    You might want to try tinyurl for posting links from now on - you will probably be able to show the entire url this way.
    Reply
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