Wednesday, April 23rd 2014

Index Versus Active Funds – Avoid Absolute Positions

by Mr Credit Card

Nothing stirs up more debate in the investment arena than the debate of index investing versus active investing. Most people I’ve come across are either for passive investing or active investing.

In the personal finance bloggersphere, quite a few bloggers have taken the position of passive investing.

Passive (Index) Investing Proponents

Free Money Finance is a proponent of index investing and has written quite a few post on this matter. why he likes index funds. Trent from the Simple Dollar also believes in index funds. Blueprint for Financial Prosperity also is invested mainly index funds and has written a post on why he loves index funds.

Bloggers who invest in active funds

The various bloggers have written quite a bit about asset allocation and are mainly invested in actively managed funds. SVB describes her asset allocation. The Sun Financial Diary revealed his asset allocation and active funds to Silicon Valley Blogger.

Pitfalls of Index Funds

We all know the great thing about index funds. They are low cost. But for those investing in index funds, one thing is for sure. Index funds ALWAYS UNDERPERFORM THE MARKET because the match the market’s performance less a nominal fee they charge (0.20% in the case of Vanguard’s funds). For index funds in less liquid sectors like the small cap space, he returns may not really reflect the sector’s returns accurately because of the illiquidity of the sector. Index funds must also recognize that they assume market risk. That means that if a particular index falls 10%, then the index fund should also fall 10% plus the fee.

Risk Adjusted Returns – the missing discussion point

What seems to be missing in this whole passive versus active investing debate is the point about risk adjusted return, With an index funds, you assume market risk. A good active fund manager aims to achieve superior risk adjusted return, ie. achieve similar or better than index returns with lower risk (or volatility). This is a very important point because a fund with better risk adjusted return will outperform in a bear market. When you outperform in a bear market, you will end up ahead in absolute monetary terms (not just fee-adjusted return).

But what are the sophisticated investors doing with index funds?

Despite the “advantages and low costs of index funds”, are the most sophisticated investors jumping on the bandwagen? Well, index funds have certainly grown tremendously over the last few years. Yet, most of the largest funds (endowment funds, pension plans) do not invest solely in index funds. Yes, they do have some portion of their portfolios in index funds. But not 100%. Why?

Index outperform in some years and active managers outperform in others

Why do the largest investors not invest 100% in index funds? It is the exact same reason why investors invest in both growth and value. Growth and value investing are actually negatively correlated. In certain years, growth outperforms and in others value outperforms. The same applies to index versus active investing.

In certain years (like the late 90s), index outperformed. The reason for their out performance was because stocks (especially tech stocks) were overvalued. Active managers simply did not see the rationale for overpaying for expensive stocks. Then from the peak of the S&P and the Dow Jones Industrial index in 1999 to the end of 2006, active managers outperformed the index. In fact, from the peak in 1999, it took seven years for the indices to return to their 1999 peak! That means if you were unlucky enough to invest in an index at the peak of the market in 1999, you would have almost the same amount of money at the end of 2006! You would have lost faith with index funds!

Take the Moderate Position

As with most issues in real life, we should avoid taking extreme and absolute positions in this debate. The largest investors have both active and passive managers. Why should we very mortal pf bloggers argue and take absolute positions in this debate? The only problem with this is that it is not easy for many of us to mix up our portfolio with both active and passive funds. Some are forced to invest in actively managed funds.”>forced to invest in both active and passive funds. Perhaps, this will be a topic for another post.

One Response to “Index Versus Active Funds – Avoid Absolute Positions”

  1. Anon Says:

    “Index funds ALWAYS UNDERPERFORM THE MARKET”

    It is disingenuous to state that without adding this: index investors ALWAYS outperform active investors in the aggregate. This must be so, because both groups attain market-average returns, minus costs. Since index costs are lower, indexing wins.

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