Wealth Intelligence

Put down the spaghetti gun and savour the aroma …

One significant trend that stemmed directly from the GFC was a move by investors (particularly committee driven ones) towards “index” investing*.

Is this daft investing?

Index (or “passive”) investing is simply when you buy a bit of everything in the market proportional to each company’s size (the spaghetti-gun approach: throw a packet of spaghetti against the wall and hope some of it sticks).

On the other hand, “active” investing is when you only buy what you choose from the market (only use the longest, moistest spaghetti to improve your odds).

This trend has been reignited for one principal reason. It is quite understandable that when faced with a “crisis” environment like the 2008-2009 period, indexing would have been appealing to many investors and committees, particularly when a number of active managers did fall short in their hour of need.

“Sense” of lower risk

Ultimately indexing gives a sense of lower risk, that is you are “only” buying the market, and that combined with a lower marketed fee would appear to be logic most unsurpassable!

I can understand how this may feel from a humanistic perspective and appreciate that not all committees and investors are blessed with a deep investment understanding (of course many are).

But, with the benefit of time, it will prove without any doubt to be a very poor investment decision when held up against the performance of an even moderately- skilled active investment process.

Problems

To see why, let’s consider the core problems with an index approach;

1. Concentration risk

The extreme concentration of large stocks in a small number of sectors can magnify risk (not reduce it as conjectured).

For example, in Australia, the main market index, the All Ordinaries, has over 60% of its weight in just two sectors.

All Ords: over 60% in just 2 sectors
Sector % of Index
Materials (e.g. BHP) 26%
Banks 35%
Total 61%

Larger markets (US, Japan, UK, Germany) do not have this problem [1]

2. Being overweight at highest price

With index management, the relatively higher the price of a stock (or sector) the more of it you own.

Most people intuitively know that sales (i.e. when prices are low) are the time to buy.

But with an index approach you are guaranteed to own the most of a company when it is at its most overpriced.

In September 2000, at the peak of the Technology boom, News Corp had a weight of 15% of the Australian market (more than BHP now).

Today its weight is just 1%.

3. Inefficient tax management

Proportional stock indexes don’t optimize for the value of franking credits, and don’t consider tax losses/gains in their decision making.

I would also argue that by managing your tax efficiently you can “save” yourself more than from a lower headline management fee.

Many overseas markets do not have the benefit of franking credits.

4. The (mistaken) belief that index funds match the index.

First Hand Autumn12 graph 1 1280pxW

Simple active approach is better

What we would contend is that even a simple investment approach that

• reduces exposure to highly priced stocks and sectors

• considers the benefits of franking credits and

• effectively manages its tax position

should be able to deliver a superior after-tax and after-fees result over time.

(Which is another reason why performance should be measured after-tax and after-fees.)

As has been seen with our 12-year investment record, this can have a major impact on longer term returns.

Conclusion

It is very important that picking the wrong managers in the past not be compounded by taking on higher risk and lower total returns now simply due to a lack of consideration.

 

* The first index fund started in 1975 and is attributed to John Bogle, the founder of the Vanguard Group.
1. There is a big difference between Australian index investing and international index investing. This is one. See bullet 3 for another. But the overarching difference is that one invests internationally for diversification reasons, not to add value. In the jargon, the investor is buying Beta, not Alpha. Which is why, for our clients that have an international allocation, we use a Vanguard  Indexed Fund.
IMPORTANT NOTICE:  Any advice contained in this document is of a general nature only and has been prepared without taking into account your personal objectives, financial situation or needs.
Because of that, before acting on any advice in this document, you should consider whether the advice is appropriate for you having regard to your personal objectives, financial situation and needs.