WHY DON'T WE JUST BUY AN INDEXED FUND?
We have a few questions of our own in response to the “indexing question”...
- Question: Would you ever hire a manager that's guaranteed to underperform the market when it's headed up and guaranteed to underperform the market when it's headed down?
Answer: The answer from any careful investor is surely, "No!" - but this is essentially what one gets with an index fund.
An index fund, similar to active management, is a real portfolio that is subject to liquidity constraints, transaction costs, management fees and possible fees from intermediaries. On the other hand, an index is a computer generated composite that assumes perfect liquidity, no transaction costs, and no management fees. It is extremely difficult, if not impossible to "match" the market. Therefore, the objective of most index funds is to merely "approximate" the returns of the respective index.
While active management is subject to similar constraints, costs and fees, one does not give up the opportunity to outperform the market on both the upside and the downside.
- Question: Are you a long term investor that is not concerned with short term volatility?
Answer: 2000, 2001 and 2002 were very difficult years for the market. Participants in index funds, which are unmanaged portfolios, experienced the full effect of the decline. Depending on management style, quality active management will emphasize preservation of capital during periods of adverse market conditions.
- Question: Are you taking on more fiduciary liability by using an index fund than by hiring an active manager?
Answer: As with many legal issues, there really is no definitive answer; however, since an index fund is an unmanaged portfolio, it places more responsibility on the purchaser to be aware of the risks associated with these types of funds. If you are in the role of a fiduciary, a decision to index should be compatible with regard to the entity's investment policy goals of capital preservation and diversification.
- Question: Does your investment policy statement allow you to own derivatives, futures, warrants, options?
Answer: It is impossible for an index fund to be 100% invested in stocks at all times. Some portion of the portfolio must be kept in cash for transitional and redemption purposes. Futures and derivatives are used to accommodate for cash positions held. No one in our industry can fully predict how these types of securities will react in volatile market environments.
The following is a sample from a large S&P 500 indexed fund's prospectus:
"Each portfolio of the trust may utilize stock futures contracts, options, warrants, convertible securities and swap agreements to a limited extent. Specifically, each portfolio may enter into futures contracts and options provided that not more than 5% of its assets are required as a margin deposit for futures contracts or options and provided that not more than 20% of a portfolio's assets are invested in futures and options at any time.
"Illiquid securities, in general, may not represent more than 15% of the net assets of a portfolio of the Trust."
- Question: Does the fund invest in accordance with your investment policy statement?
Answer: Does your policy statement allow for:
- The lending of securities
- Use of margin
- Foreign securities
- Question: Can one assume "passive" funds are synonymous with "very low turnover"?
Answer: "Although indexing is considered a form of passive investing, there is plenty of activity, as well as investment decision making involved in managing an index fund. Since the S&P 500 is capitalization weighted, adjustments must be made in an index mutual fund portfolio due to companies being replaced due to a lack of representation or bankruptcy. In addition, whenever there are significant changes in the component stocks' shares outstanding triggered by stock offerings, repurchase programs, shares issued in conjunction with mergers, or even the occasional forced conversion of a bond or preferred stock, changes must be made.
"Depending on the size of the fund, several hundred odd-lot purchases and sales might be required to immediately create a perfect match to rebalance to the S&P 500. The fund manager must consider the effects of all transaction costs on the portfolio's total return as well as how to purchase or sell the required shares at the best possible prices." - S&P 500 Directory
- Question: Is the S&P 500 an appropriate benchmark? Is there a perfect index?
Answer: Is there such a thing as a perfect index, one which precisely reflects the market's performance? Hardly. Indexes can be constructed with large cap stocks, small cap stocks, value stocks, growth stocks and anything in between. Each "style" segment of the market reacts differently to the overall market at different times. One style is popular while another is not, and vice versa. The same is true of industry segments. Trying to gauge market performance using a single index can be a confounding process. It becomes even more difficult when we attempt to identify a single benchmark to measure an active manager's performance with perfection.
It is no longer appropriate for an investment management firm simply to claim that it beat the S&P 500. The firm must use a benchmark that parallels the risk of the investment style the client's portfolio is expected to track. Active management takes into account risk tolerance, time horizon, tax considerations, performance expectations and the overall appropriateness of the investment portfolio based specifically on that investor's unique goals and objectives. With index funds, one size fits all.
Capitalization and structure of the S&P 500 index
Most actively managed portfolios are diversified in a manner more similar to the equal weighted Value Line Geometric Index, which is a much better proxy for the market than the S&P 500 or the Dow Jones Industrial Average. With the S&P 500, the largest capitalization stocks have a disproportionate effect on the performance of the index. At the height of the last bull market, the 75 largest companies in the S&P 500 (15% of the constituents) represented 70% of capitalization. Fifteen stocks accounted for 75% of the performance of the S&P 500. Led by stocks such as Dell Computer, Lucent Technologies, Cisco Systems and Microsoft, the technology sector of the S&P 500 grew from 7% in 1990 to over 33% by decade's end. Active managers do not weight portfolios in such a concentrated manner. Portfolios that were not overweighted in these and a handful of other issues were hard pressed to compete with the S&P. Greater concentration, however, in any economic sector, industry group or individual stock implies greater risk. The primary reason for diversification through active management is to reduce risk. Do personal investment philosophy or investment guidelines allow for such large sector concentration? Investors should be aware of how their index fund is structured before unpleasantness occurs.
Source: Bloomberg, Standard and Poors
Tax consequences
Investors making an initial investment in index or traditional mutual funds should be aware most funds have unrealized short and long term gains. Should gains be realized, investors may face a tax bill irrespective of how long they have been invested in the fund. These "phantom" profits are taxable even if the investors' N.A.V. becomes a negative number.
In contrast, while separately managed portfolios are also taxable, an individual is taxed only on income and capital gains actually experienced in their own personal portfolio. An active manager can take into consideration a client's tax status and lifestyle in making investment decisions to minimize taxes. Investors are not buying into a possible deferred tax liability as is the case with index or other commingled funds.
Putting things into perspective
- The methodology used to construct indexes is completely different than that used by active managers
- An index measures the aggregate value of a universe of stocks through a sampling technique
- Active managers invest away from the benchmark; that's why performance moves in cycles vs. the index
- Vanguard, the most widely regarded index manager, offers over 30 actively managed equity funds with total assets doubling the size of its S&P 500 Index Fund
Suggested Reading
Behaviorial Finance: Past Battles and Future Engagements
by Meir Statman
Financial Analysts Journal,
vol.55, no.6 (November/December 1999): 18-27
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