Index Funds: Who’s Sorry Now?

There are lots of reasons for using high-quality index funds, including low fees, high transparency and a clear mandate on the strategic goal. There’s also the remorse factor to consider.

One benefit of indexing is never having to say you’re sorry, a feature that comes to mind after reading about the brouhaha over Vanguard’s “tardy” firing of AllianceBernstein as a co-subadvisor. As Investment News reports:

The Vanguard Group Inc.’s decision last month to fire AllianceBernstein LP as co-subadviser of its U.S. Growth Fund after nine years has caused a number of fund observers, including Vanguard founder John Bogle, to question why it took so long.

The move came after the fund underperformed its category for the past one-, three-, and five-year periods during AllianceBernstein’s tenure, and for the 10- and 15-year periods encompassing that tenure, according to Morningstar Inc….

Some advisers said that Vanguard’s unwillingness to fire Alliance even though it was clear that the firm wasn’t turning around its performance might be an indication that Vanguard should stick to passive management.

“Why is this firm in active management at all?” asked Doug Flynn, co-founder of Flynn Zito Capital Management LLC, which has $265 million in assets under management. “And if they are going to do active management, I need to understand what kind of system and process they have in place that requires you to take this long to fire an underperforming manager.”

The debate over why Vanguard waited so long to fire an active manager is a bit odd, considering that Vanguard is primarily an indexing shop, and a successful one at that. Nonetheless, the firm does run a few actively managed funds, although the challenges are no less vexing for one of the largest financial firms on the planet.

Evaluating and monitoring active managers is no easy task. Even if you have deep pockets and lots of smart analysts under your roof, there’s still no assurance that you’ll excel in distinguishing true talent from luck, or recognize when a gifted manager has lost his touch rather than merely suffering from a temporary slump.

Much of what’s known about skill (or what appears to be skill) in conventional equity strategies is based on analysis of factors. The leading equity factors, for instance, are bound up with the degree of emphasis (for or against) market cap (small vs. big), style (value vs. growth), and short-term price momentum. It’s fairly easy to run a factor analysis to figure out if, say, a dedicated value manager is worth his expense ratio. The answer turns out to be “no” enough of the time to inspire using a low-cost value equity index fund.

What happens if you’re evaluating an active manager who’s a style timer? That’s a tougher nut to crack. Let’s say you’re considering a mutual fund run by a manager who opportunistically tilts the portfolio back and forth between large and small caps, and value and growth stocks. At certain times, he may decide that small-cap growth offers the superior risk/reward profile; a year later, he thinks it’s time to tilt the portfolio to large-cap value stocks.

The problem here for investors is that evaluating the presence (or absence) of style-timing skill is much more challenging vs. assessing a manager committed to a single style factor. Can it be done? Yes, but it demands a certain amount of finesse and quite a lot more effort—and data. That’s hardly a surprise. Over the past two decades, financial economists have been pointing out the challenges of identifying style-timing talent. So-called estimation errors, for instance, are one problem, advises a 1986 study (“Assessing the Market Training Performance of Managed Portfolios,” by Ravi Jagannathan and Robert A. Korajczyk, Journal of Business). Even when above-average performance is genuine, it’s turns out to be fleeting a fair amount of the time (“Short-Term Persistence in Mutual Fund Performance,” by Nicolas P. B. Bollen and Jeffrey A. Busse, 2004, Review of Financial Studies). And that only scratches the surface of the potential pitfalls.

Index funds are an easier alternative. By using superior indexing products, you can reliably capture 50% to 80% of the target factor, depending on the asset class, the index fund, and the prevailing market conditions. Actively managed products can do better, of course, but they can also do worse. And since it’s difficult to have a high degree of confidence that you’ve chosen the right active manager, it’s important to recognize the additional layer of risk that accompanies the quest to tap alpha.

Beta, by contrast, is more reliable. In fact, the case for indexing is especially strong for managing a multi-asset class portfolio. Imagine that your asset allocation is divided up into, say, 15 corners of the capital and commodity markets. The odds are fairly low for continually choosing superior active managers in each bucket over the long haul, at least for most investors without deep analytical resources and a full-time commitment to the task. Those who attempt to beat the odds all too often end up with average results. In other words, they’re paying high fees for mediocre results.

It’s often preferable to stick with index funds from the start and cut the fees to the bone. That leaves you with a free hand to focus on what’s really important: designing and managing the asset allocation. In fact, you still have to do that if you use a mix of active managers, but you have the added burden of evaluating managers on an ongoing basis. Index funds cut out that extra step, and save you money in the process.

Remember, too, that there are some simple, forecast-free strategies for enhancing the pasive return of a multi-asset class portfolio. A basic rebalancing strategy for a broad array of asset classes, for instance, has a history of boosting return by 50 to 100 basis points over time.

Bottom line: using index funds to manage asset allocation is easier, less costly, and likely to deliver 50% to 80% of the return you’d achieve in the best-case scenario with active managers. Indexing, quite simply, means never having to say you’re sorry.

About James Picerno 894 Articles

James Picerno is a financial journalist who has been writing about finance and investment theory for more than twenty years. He writes for trade magazines read by financial professionals and financial advisers.

Over the years, he’s written for the Wall Street Journal, Barron’s, Bloomberg, Dow Jones, Reuters.

Visit: The Capital Spectator

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