| Rusty's article
is also available in a printable PDF format (see below).
February 2007
Active Management versus Index Funds
Index mutual funds, which attempt to match a particular benchmark’s
returns (less expenses) instead of trying to beat it, are fine investment
vehicles. They tend to provide steady market exposures and at low costs.
Many prominent investment professionals use or at least recommend index funds
to some degree, and we agree that style purity and cost control are extremely
important investment considerations.
However, what often gets lost in a discussion of the benefits of index funds
is that they are still vulnerable to a problem that can be a lot bigger than
any cost efficiencies: performance chasing. In addition, we also feel that
not enough respect is paid to additional important investment considerations
such as a disciplined investment process and dedicated quality research.
The Value of Research
Warren Buffett, who is widely considered to be the best American investor
in recent decades, recommends that most individual investors use index
funds. David Swensen, the Yale University Chief Investment Officer, and
considered by many to be the premier multi-asset portfolio manager, also
recommends that individual investors use index funds.
Yet, both use active management themselves.
Why? We would like to think that they recognize the value of dedicated quality
research. Given that many mutual fund investors spend less time picking mutual
funds and managing portfolios than they do figuring out which television
or automobile that they might buy, is it any surprise that the typical investor
doesn’t come close to matching benchmark returns? Quality research
is about having the time, tools, and talent to make value-added active investment
decisions.
At Kobren Insight Management, where our core competency is money manager
due diligence and mutual fund research, we have a track record that our research
engine can consistently select above-average mutual funds. The purest way
to gauge our fund selection skills is to examine the track record of our
in-house buy lists, which we call “Research Portfolios.”
We currently have eleven Research portfolios that cover the various equity,
fixed income and alternative asset classes. Since we introduced the Research
Portfolios back in March 2001, each of these Research Portfolios has bettered
their respective peer groups. (Past performance does not guarantee future
performance). In mutual fund investing, research matters.
The Value of “Value”
Since we already invoked the name of Warren Buffett earlier in the article,
we might as well drag him into the discussion again. When defending active
management, Buffett made a memorable presentation to Columbia University
in 1984 commemorating the fiftieth anniversary of the investing textbook “Security
Analysis”, written by Benjamin Graham and David Dodd. The presentation
was called “The Superinvestors of Graham-and-Doddsville”.
In short, Buffett rebutted one of the classic index fund arguments that
it is just randomness and luck that some money managers have superior long-term
track records. In other words, given enough mutual funds, it is inevitable
that some funds will consistently rank near the top of the list. “If
orangutans had engaged in a similar exercise, the results would be much the
same” is how the argument goes.
Buffett’s rebuttal:
“
I would argue, however, that there are some important differences in the
examples I am going to present. For one thing, if (a) you had taken 225 million
orangutans distributed roughly as the U.S. population is; if (b) 215 winners
were left after 20 days; and if (c) you found that 40 came from a particular
zoo in Omaha, you would be pretty sure you were on to something. So you would
probably go out and ask the zookeeper about what he’s feeding them,
whether they had special exercises, what books they read, and who knows what
else. That is, if you found any really extraordinary concentrations of success,
you might want to see if you could identify concentrations of unusual characteristics
that might be causal factors.
Scientific inquiry naturally follows such a pattern. If you were trying
to analyze possible causes of a rare type of cancer — with, say, 1,500
cases a year in the United States — and you found that 400 of them
occurred in some little mining town in Montana, you would get very interested
in the water there, or the occupation of those afflicted, or other variables.
You know it’s not random chance that 400 come from a small area. You
would not necessarily know the causal factors, but you would know where to
search.
I submit to you that there are ways of defining an origin other than geography.
In addition to geographical origins, there can be what I call an intellectual
origin. I think you will find that a disproportionate number of successful
coin-flippers in the investment world came from a very small intellectual
village that could be called Graham-and-Doddsville. A concentration of winners
that simply cannot be explained by chance can be traced to this particular
intellectual village.”
What is this intellectual village? To perhaps oversimplify, it is “value
investing”, which can be defined as buying securities that can be purchased
for less than their intrinsic value. It is about a disciplined, unemotional
approach to buying securities with fundamentals and valuations in mind. It
is not about chasing rising prices, but often buying securities after they
have been marked down in price.
Value investing can apply to mutual fund investing as well. To understand
how a value orientation can work with mutual funds, a couple of assumptions
need to be laid out first.
First, value investing assumes that security pricing will eventually revert
back to a mean value. Security pricing is cyclical. In other words, absolute
valuations of securities continue to rotate back and forth from high to low
levels. Some investors, ourselves included, also assume that relative valuations
also display reversion to mean properties.
Another key assumption is that most mutual funds are managed at least somewhat
consistently due to little change (at least over short time periods) in investment
personnel, philosophy, or process. As a result of this assumption, mutual
funds tend to display somewhat similar portfolio characteristics (such as
sector exposures, market cap distributions, interest rate sensitivity, non-dollar
exposure, portfolio valuations, risk characteristics, and so on and so forth)
over time. As a result, relative portfolio characteristic differences between
funds tend to persist.
So, assuming funds tend to have somewhat consistent exposures and characteristics
relative to peers and benchmarks, and assuming the broad market is cycling
through which market segments are being rewarded and which ones are being
punished, then it’s logical to believe that funds with consistent approaches
will outperform during some market cycles and underperform during other periods.
In this case, an oversimplified example of a “value” buy in
the mutual fund world would be buying a mutual fund that has consistent investment
management and process, but has underperformed in recent years due to the
markets favoring other types of exposures. Conversely, it would not be a “value” buy
if one purchased a fund after it had already had a very strong period of
relative performance due to the market favoring those sorts of funds. Most
mutual fund investors do the opposite of these transactions, however, including
index fund investors.
In mutual fund investing, a disciplined value-oriented approach matters.
Fund Returns versus Investor Returns
Fans of index funds believe that most investors can’t beat the market,
so they are better off investing in an index fund(s) to at least earn market
(benchmark) returns. If you accept the claim that you can’t beat the
market (and we don’t) this sounds like a solid strategy.
There is just one small problem: in practice, it doesn’t seem to work.
It is true that the total returns of index funds closely match their benchmarks
(less expenses), however, it turns out that the average investor in index
funds ends up earning less.
Why?
Human nature: As with any investment, individuals have difficulty keeping
emotion out of their choices. When a particular market area is hot, investors
rush to buy the index funds that track that area, and when that area goes
cold, investors are quick to sell those same index funds.
In short, the average index fund investor does not experience the full return
of the index fund over time. This can be seen by comparing the difference
between the “Investor Return” (as measured by Morningstar) and
the funds’ “Total Return”. Investor Return (IR) captures
the actual investor experience in a fund by weighting that fund’s returns
by the actual dollars invested in the fund over that time period. Total Return
(TR), the way fund returns are generally reported, is time-weighted, meaning
it equally weights returns for each time period regardless of the asset levels
of the fund.
The table below examines the 481 equity index funds in the Morningstar Principia
database (as of 10/31/06) that reported both a 12-month Investor Return and
a Total Return. Over the past year, in 68% of the index funds, investors
earned less than the funds’ total returns. The average shortfall for
investors in those funds over the year was 0.71%. (In other words, if the
average fund had a total return of say 5%, the average investor in those
funds earned 0.71% less or 4.29%.
Over the last 10-years, the data isn’t any better. Again, in 68% of
the equity index funds, investors earned less than the total returns of the
funds, with the average shortfall increasing to 1.15%.
If we examine the most popular index funds over the last ten years, the
difference between the Investor Return and the Total Return tends to be
even greater than the average listed above. For example, the Vanguard 500
Index
fund has an annualized return over the last ten years of 8.56%. However,
based off how money was actually invested in the fund over that time frame,
the average client experience, as expressed by the investor return, was
only 7.11% — 1.45 basis points lower!
So while index fund investors may be able to save a bit on expense ratios,
they still appear to be chasing performance and wasting the benefit from
the lower expenses.
When Comparing Expenses Make Sure it is “Apples
to Apples”
We are not going to argue that the typical index is not cheaper than the
typical actively-managed mutual fund. They are cheaper. What I want to
point out is the “apples to oranges” comparison that many pro-indexers
take when discussing relative expense ratios.
They often point out that the average actively-managed equity mutual fund
has an expense ratio of around 1.45%, while one can buy a domestic equity
index fund for only 0.1% or less. The E*TRADE S&P 500 Index has an expense
ratio of just 0.09% for example. While that statement is true, it exaggerates
the true difference in expense ratios, by comparing the average actively-managed
expense ratio to the cheapest index fund expense ratio.
If we compare the equal-weighted audited expense ratio average (source:
October 31st Morningstar Principia) of equity non-index funds to the equal-weighted
average of equity index funds, the comparison is 1.45% to 0.69%. This is
still a significant difference, but the gap is not nearly as large as is
often claimed.
An even better way of examining “average” expense ratios is
to use the asset-weighted average. Asset-weighting more closely reflects
what the typical investor actually pays in expenses. Also, larger funds of
all types tend to have lower expense ratios because they can attain economies
of scale through their larger fund size. The asset-weighted audited expense
ratio average of equity non-index funds to the asset-weighted average of
equity index funds is 0.94% to 0.25%. Again, this is still a significant
difference, but it basically cuts the initial perceived cost difference in
half.
While an investor could still buy an index fund for 0.1% or less, they could
also buy an actively-managed fund with no load or transaction costs for not
much over 0.5%. There are several fund families that offer funds with expense
ratios this low, including Fidelity.
In sum, while index funds do have lower expenses than non-index funds, many
people may perceive the differences to be greater than they are.
Summary
Index funds are worthy investment products, and if you don’t have the
time to do dedicated quality mutual fund research (or have an advisor do
it for you), investing in a well-constructed portfolio of index funds makes
some sense. Of course the rub on this is that the portfolio still needs to
be constructed properly and be managed with a disciplined approach that emphasizes
a value orientation and minimizes emotional reactions.
Sincerely,
Rusty Vanneman, CFA
Director of Research
Co-Portfolio
Manager
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