Is it getting easier to beat the market?
Consistently beating the market is clearly not an easy thing to do. Analysis of fund manager performance typically shows that a large proportion of them do not add enough value to cover their fees.
Some of them – admittedly – may not be trying all that hard. A manager who has accumulated many billions of dollars of funds under management (FUM) over the years potentially has a lot to lose from trying to beat the index, and maybe not much to gain.
A really bad run of performance could see them lose much of that hard-won FUM, and so a safer course of action may be to stick close to the index. This is likely to result in modest underperformance after fees, but those hard-won investors will probably stick around for another year.
As an interesting aside, analysis of fund manager performance tends to show that the newer managers – the ones who don’t yet have many billions under management – tend to deliver better investment performance than the more established players.
Over time, however, slightly anaemic performance from large sections of the funds management community has prompted investors to move more of their capital into index funds. The idea is that you won’t beat the index, but at least you won’t have to pay active management fees for the privilege of not beating the index. This idea makes perfectly good sense: if you don’t know how to choose a “good” fund manager, there is logic in going for the low cost option with a more certain outcome.
If, however, you are an active investor (or you know how to choose a good fund manager), there is some good news to hand: the shift towards index investments is well advanced in various parts of the world, but is particularly strong in Australia, where the size of the Exchange Traded Fund (ETF) industry is now setting new records.
Why is that good news? Put simply, more money going into index products means less money seeking out high quality, undervalued equities. In other words: less competition and more opportunity for active managers.
Beating the market just got that little bit easier. Yay.
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Sue POLSON
:
Yay. I agree. Let the others follow the “herd”.
Carl Poingdestre
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I’m happy with your performance and am in for the long haul. Keep up the great work guys.
james-cruz-5473
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I totally agree with your sentiments but what happens when Montgomery Investment holds a Billion in funds? As a trusted financial planner with clients best interests in mind, I believe that the index allocation is still sound as it covers off for the longer term. What is the better alternative?
Roger Montgomery
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There’s another very good reason not to follow the index: It’s very reason for being is not aligned with investor’s goals. If you read Standard & poors document entitled: S&P/ASX Australian Indices Methodology, you will find; “The aim is not to replicate a fixed percentage of the market capitalization, but to design a highly liquid and tradable index whose total market capitalization is large enough to approximate the market segment it is capturing while keeping the number of stocks at a minimum. This creates a highly cost-effective, easily replicable trading instrument that provides an appropriate barometer of the market’s performance” AND “Listed companies place immense significance on their membership in the S&P/ASX 200 index. Inclusion in the index generates significant institutional interest for constituents, and proliferates widespread media and buy/sell side analytical coverage.” The same document for the US Dow Jones reads; “S&P Dow Jones’ U.S. Indices are designed to be liquid, so as to support investment products such as index mutual funds, exchange traded funds, index portfolios, index futures and options.” And “An index is not exactly the same as a portfolio…some corporate actions that cause changes in the market value of the stocks in an index should not be reflected in the index level. Adjustments are made to the divisor to eliminate the impact of these corporate actions.” In essence the index is constructed to accurately reflect activity in the stocks that comprise it.
Nowhere in any of the S&P index methodology documents will you find words to this effect: “the index is constructed to ensure investors wealth is allocated to those companies best able to add economic value, generate high rates of return on capital and ensure safety of capital over the long term.” WHile that is obviously asking too much from an index, it is what investors are looking for to securely fund their retirement and lifestyle. Therefore there is a fundamental misalignment.
An index constructed to ‘track changes’, ‘provide for trading’, reflect activity’ etc etc is simply not aligned with investors goals. Sure a massive industry has grown up to offer a cheap/non-thinking option that has make billionaires of their founders but the bottom line is the S&P/ASX 200 is at the same level it was in November 2006! I can understand why index investing is so cheap; why pay a premium to be permanently invested in mediocre companies? This is not in our clients’ best interests is it?