Tag Archives: investing ideas

What If Everyone Indexed?

People generally think that more indexing will make the markets function less efficiently. I don’t think this is true at all. The fact that most index funds and ETFs are more tax- and fee-efficient than mutual funds does not mean they are necessarily less “active”. Most passive investing means there will be greater demand for active managers in the form of market makers and arbitrageurs. If everyone indexed, then that much more active market making would be required. I see this question more and more as indexing grows in popularity. People generally think that more indexing will make the markets function less efficiently. I don’t think this is true at all. Unfortunately, the question and its answers are usually shrouded in misunderstandings about how assets are priced and myths about what it means to invest “passively”. So, let’s think about this from an operational perspective. An index fund is not really an “index”. They are portfolios managed every day trying to track an index. These funds are managed actively, and involve hundreds, if not thousands, of decisions every year. The simplest example is the modern-day ETF, which is essentially a real-time version of what most people think of as an index fund. When you buy shares in an ETF, there is someone who is actively managing the allocation of funds (the same is true for an index mutual fund, though it’s less apparent in real-time, since the fund is not traded on an exchange). For instance, if the market price of an ETF were to deviate from the intraday indicative value, then the market makers would either buy/sell the ETF or buy/sell the underlying securities. So, while there doesn’t appear to be much activity on the surface, the very act of buying an index fund could actually force some active management in the underlying securities markets. In other words, your “passive” investment is the other side of the active management of the market maker or fund administrator.¹ It’s not a coincidence that high-frequency trading firms and big banks are making huge gobs of money during the rise of passive indexing. After all, passive indexing means that there is a greater need for those alternative forms of what is nothing more than “active” management. Unfortunately, the studies blasting active management usually include mutual fund managers and not the most active managers of them all – market makers and HFT firms. And make no mistake – these “active” operations are hugely profitable because they are essentially making “passive” portfolios available.² The kicker here is that index funds really aren’t passive at all. When you look at the underlying components of how the funds are actually managed, you realize that there’s a lot of activity in all of this. The fact that most index funds and ETFs are more tax- and fee-efficient than mutual funds does not mean they are necessarily less “active”, though. People misuse the term “passive indexing” on a near-daily basis now. And it’s the result of this desire to create a black-and-white view of the world, which is usually nothing more than a marketing pitch (something along the lines of – “We’re passive, so invest with us, because the misleading academic studies show that ‘active’ managers are dopes.”). The reality, however, is that there is really only active management and its varying degrees. Literally no one replicates a pre-fee and pre-tax index. Not a single investor. And your purchase and maintenance of a “passive” strategy will require a good deal of active upkeep. The bottom line is, most passive investing means there will be greater demand for active managers in the form of market makers and arbitrageurs. The ease of passive investing is made possible thanks to these active underlying elements. And that’s great, because it’s a win-win. Indexers get a low-fee and easy way to access markets. But they also bear the cost of their laziness (in numerous unseen ways), which is why making markets in index funds is hugely profitable. So, if everyone indexed, then that much more active market making would be required. End of story. ¹ – Read this fun paper on how ETFs work. ² – E.g., ever wonder how a big bank like Bank of America (NYSE: BAC ) can be profitable on 100% of its trading days in a quarter ? It’s thanks, in part, to passive indexers like me! “During the three months ended March 31, 2013, positive trading-related revenue was recorded for 100 percent, or 60 trading days, of which 97 percent (58 days) were daily trading gains of over $25 million.” (click to enlarge) Related: The Myth of Passive Investing

Greenblatt On Value Investing

Earlier this year Wharton released a video where Howard Marks interviewed Joel Greenblatt . It was a short interview packed with wisdom from the two value investors. Greenblatt first came across value investing after reading Ben Graham, which offered him a new perspective on investing. He defines value investing perfectly: Figure out what something is worth, pay a lot less, leaving a large margin of safety. He repeated this definition several times during the interview. Most people never get past the first part, but he offers two guarantees to those that do the work. “If they do good valuation work, the market will agree with them. I just don’t tell them when.” “In 90% of the cases for an individual stock, two or three years is enough for the market to recognize the value they see if they’ve done good work.” So good work and the conviction to wait a few years is required. This is why most people fail before they get started. Bad behavior creeps in. They expect too much, too soon, and quit before they get rewarded. The hardest part about investing is waiting. Indeed, Greenblatt’s students regularly tell him – but it was easier to make money when you started then it is today. He has two responses to this. The first is for special situations (Greenblatt literally wrote the book on special situations, titled You Can Be A Stock Market Genius – the worst title ever according to the author). These special situations are built for the small investor because most situations are too small to move the needle for large investors. People who get very good at analyzing businesses with special situations make a lot of money. Because of that, they get too big to play in that obscure area of the market, making room for new investors. His second response is toward technology and why value investing still works in an “efficient market”: Let’s go look at the most followed market in the world. That would be the United States. And let’s go look at the most followed stocks in the most followed market. That would be the S&P 500 stocks to a large extent…Take a look at the S&P 500. From 1996 to 2000, it doubled. From 2000 to 2002, it halved. From 2002 to 2007, it doubled. From 2007 to 2009, it halved. From 2009 till today, it’s basically tripled. That’s my way of saying people are still crazy. And that’s really an unfair thing to say because the S&P 500 is an average of 500 stocks. There’s huge dispersion going on within that average between stocks that are in favor, that people love emotionally, and stocks that people hate. So it’s really much worse than what I just described. There’s a huge dichotomy between things people like, people don’t, things that are out of favor…All this noise is going on within that average. That average is smoothing things . The S&P 500 offers a nice measure of “the market”. But we can’t forget it’s only a small subset of the total market, and mostly representative of large cap stocks. Being too reliant on the bigger picture, means you overlook everything not included in the index and miss what’s really going on in the market. Investing seems as though it’s harder today than the past, but investing was never easy. Investors’ behavior is the same as it ever was. If anything, technology has only made it easier to add a new layer of complexity to strategies and it definitely compounds the short-term mindset driving the market. If anything, that combination should make it easier for the most disciplined investors. Marks added this gem at the end to put it all into perspective: If you want to be exceptional as an investor you have to dare to be great…But to be great, you have to be different because if you think the same as everybody else you’ll take the same actions. If you take the same actions, you’ll have the same performance. You certainly can’t be exceptional if you follow the common course. So to be exceptional, you have to be different. You also have to dare to be wrong.

Why Hasn’t Active Investing Outperformed Passive Investing In Recent Years?

By Jason Voss, CFA Over the last several months, I’ve explored why active investing has been unable to outperform passive investing in recent years. My series is called Alpha Wounds, and so far, the issues covered are the unintended consequences of benchmarks on active management, the poor measurement techniques of investment industry adjuncts, and the lack of diversity in the human resources portfolio . In this week’s CFA Institute Financial NewsBrief , we decided to ask our readers their explanation for the lack of active management outperformance. Rare for our polls, we included a large number of options to try and capture a wide swathe of opinions. The options provided appear to have successfully reflected the broad range of views, as 90% of the 743 respondents selected one of the specific choices rather than “other”. Because it is difficult to know the precise reason for choosing the “other” category, it makes sense to recalculate the percentages without including “other”. These modified results are the ones listed in parentheses below. Note: We did receive one e-mailed response from a reader who opted for “other”. The reader explained, “I marked ‘other’ [because] the market is illogical, so trying to apply logic is bound to fail.” Why has active investing been unable to outperform passive investing in recent years? (click to enlarge) Active Managers Can Do Nothing to Outperform About 24% (27%) of respondents believe that the reason for active management’s underperformance is the deleterious effects of high fees on net performance . This is not surprising, given the large number of studies highlighting this fact. Many asset management firms are, in fact, trying to reduce their expenses to mitigate this alpha drag. Another 15% (16.5%) believe that individual investment managers cannot compete with the wisdom of financial markets. Combined, this means that about 40% (43.5%) believe that no matter what active managers do, they cannot beat passive investment strategies. Active Managers Can Do Something to Outperform Of the remaining five options, 10% (10.8%) believe that the concentration of top stocks in indices detracts from the success of active managers. For those not familiar with the argument, it recognizes that indices have built in momentum effects because many of them are market capitalization-weighted. Indices are, effectively, “must buy” lists of securities that create demand, not because of fundamentals, but because passive strategists must buy the securities in order to closely track their index. Controlling for these momentum effects is outside the specific capabilities of active managers as security prices advance. When indices fall, however, active managers not invested intimately with the securities in the index should be able to avoid some of the downside. What hope do active managers have of beating passive strategies? Together, the four remaining options provide some insight. Most importantly, according to 18% (20.2%) of respondents, active managers should minimize their use of benchmarking, style boxes, and tracking error, which lead to a sameness of results. Next, 13% (14.7%) believe that active managers are guilty of short-termism and need to change their investment time horizon and lower turnover. Incidentally, lowering turnover reduces trading costs and will reduce the expense ratio of active funds. Increasing diversity of opinion in active management is believed by about one in 20 respondents (5.5%) to be critical for improving success. Lastly, approximately 5% (5.2%) of those polled think that active managers should improve their due diligence to better compete with passive strategies. Active vs. Passive Tug-of-War Taken together, the above four tactics, all well within the purview of active management, represent about 46% of total responses as compared with the roughly 44% of responses from those who believe active strategies can never beat passive ones. This result indicates a tug-of-war between camps and, to my mind, reflects the conversation occurring in the financial community in the long-running active vs. passive debate. Disclaimer: All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.