Tuesday, May 16, 2017

Musings on Passive Investing via Index Funds

The Basic Proposition

As per Buffett and Munger, Indexing makes sense if you do not know what you are doing. In aggregate, active managers cannot achieve a result better than the index. In fact, given the extreme skewness of the stockmarket, it is virtually guaranteed that over a long period of time, a majority of active managers will never do better than the index, especially after deduction of significant fees. Given that all long term records of stockmarkets show an upward trend, it makes sense to be invested in the whole market rather than betting on its discrete elements, especially if the attendant costs/fees involved are much lower.

The Problems

The first problem with indexing is that the market is self-correcting, and too much of a good thing becomes a crowded trade. Indexing becomes a problem when too much money is chasing after it. If this happens, prices are no longer tethered to values, and you will have a situation where asset prices rise purely because they are rising and vice versa. This means that asset prices no longer reflect actual business performance, which is unsustainable. Conceptually, index funds are intended to passively track the index. However, if too much funds are involved, the fund inflows by themselves will have a significant effect on the index levels. Index funds will no longer be passively tracking the index, rather, they would be a major factor affecting the index.

The second problem with indexing is the wide sweeping assumption that everything tends to average. An often used marketing angle of index funds is that a majority of fund managers cannot beat the market.  This is true, but it fails to address the main issue of how to select a fund manager who is capable of beating the market. A system with average values will often have wide non-random variability between its system participants. There are persistent winners, and there are persistent losers. Try to remember the kid that always comes first in class over your entire experience of primary and secondary school. And don’t forget the one that comes consistently last. We ask ourselves why? In every field of endeavour, there is a pecking order which is inviolate, and the top and bottom can often be identified very early in advance. Proponents of indexing sweep this away under the carpet.

The third problem with indexing lies with its basic proposition that equity markets inevitably rise over time, ostensibly at a steady rate of 7% per annum. This is true over a truly long time span, say 60-100 years. The reality is that market returns in discrete periods fluctuates greatly. The following are US Equity returns during the Post-War period:
1946-2012 6.4%
1946-1965 10%
1966-1981 -0.4%
1982-1999 13.6%
2000-2012 -0.1%

An investor invested in index funds in the year 2000 would have had made a loss over the next 12 years. The critical message- unless your investment horizon is truly long term over at least 50 years, there is no guarantee that index funds will do well.

The Consequence

Human behaviour and the power of incentives will ensure that so long as investors want salt, they will be sold salt. It is not in the best interest of promoters and managers to sell a single index fund where investors are encouraged to stay invested indefinitely with no churn. If there is no activity and no churn, how are they going to earn their bread? Marketers know the basic behavioural problems of average investors and they will act accordingly, leading to a proliferation of different ETFs.

Investors want choices because each of them believes they are above average investors able to make superior choices than the average punter- hence a proliferation of ETFs will be created to satisfy this demand. If enough people want an ethical ETF which promotes social notions such as gender equality or white supremacy, then the market will surely create this ETF to satisfy demands. Given that the average investor is also unable to sit still and clamor action, there will be plenty of different ETFs to satisfy the need for action.

Investors are also greedy, so leveraged ETFs are created to turbo-charge returns. After all, over the long term, the sharemarket only ever rises.  Investors are also envious creatures. They will not be happy with a steady 7% per annum with a vanilla index fund when their neighbours are raking in 15% from the latest triple leveraged ETFs. Leveraged ETFs will then be in hot demand. 

As investors race up the risk curves, the market will continue to create products to satisfy this demand. Pretty soon, derivatives of ETFs will be created, and then further derivatives. They will all be marketed with great endorsement and validation- virtually assured returns with very little risks involved- whilst the promoters rake in fees and bonuses.

Does this sound familiar to you?  How would all these end?

The Solution?

In the tradition of Fermat, I am nearly finished with my suggested solution, but [insert suitable excuse].

Stay tuned. 

Yours One-Legged


Cameron said...

So how much different are the current 'active managers' who are really just index huggers to ETFs? What is their current relative size?

Peter Phan said...

You need to be more specific. Which managers are you talking about?