Tuesday, March 14, 2006

indexing the index

March 14,2006

Hello,

For the last several years the debate has raged on as too weather it is better to index or seek active managers ,the current common wisdom is that indexes are cheaper ,more tax efficient and out perform most active funds most of the time. Although I do think indexing is an important tool for investors I am not so sure I am sold on the idea that the indexes are always “better argument”. First; of coarse they out perform most actively managed funds, yes true but there are over 8000 mutual funds so I am not sure that is such a big deal. The top 200 funds every year outperform the bottom 7800, yippee! I mean how many all-star baseball players are there in a given year compared to the total amount of players? That seems kind of obvious don’t you think? The amount of quality funds is probably less that 800 out of 8000 anyway. Indexes go on forever, but fund managers especially the good ones retire in style so long term comparisons are difficult and there is a tendency for fund performance to decline as the fund size grows however this process does not seem to apply to index funds. Secondly Outperforming Funds seldom continue to out perform when a market cycle changes. Long term investors realize that the trend of today may not be the trend of tomorrow. A perfect example are funds that specialize in gold or energy, they haven’t out performed since the 1970’s, now they are on fire again. Technology out performed in the late 1990’s but now most of the large cap tech funds have just treaded water. Latin American funds and Asian funds did very well in the early 1990’s now they are hot again. Each new market cycle brings winners and losers; does anyone really think the S&P 500 out performed energy stocks last year? Thirdly large cap funds that have large asset bases and are very limited to what stocks they can actually buy, so most of the time big funds buy all the same stocks and can only buy the biggest stocks in an Index, making these funds mirrors of the index. So for many of the behemoth large cap funds what an investor gets is an index fund with management fees. Beside does anyone think the largest capitalization stocks are often the best performers? Not too often I suspect. Four ; when it comes to smaller and mid cap stocks managers seem to out perform the indexes anyway because often these markets are not that liquid ,investment risk is high and it takes a lot of tire kicking to figure out which end is up. Fifth like most market cycles the late 1990’s and the “nifty fifty mentality” of that era came to an end ,with heavy inflows of cash ,lots of liquidity and easy profits it is easy to see why so many indexes beat actively managed funds. The market environment of the time created the indexing phenomenon .In that environment of it only goes up who needs a manager, but now with the indexes are lagging most managers the last 5 years, it appears that stock picking has gotten back in style. One of the other problems I have with indexing is that the performance is often compared to non correlated investments, yes index funds out performed gold funds in the 1990’s but often this evaluation is thrown around with little regard type of class. The index is also often compared out of context to other investment choices for example Valero was the number one stock in the S&P 500 but does that mean your investments were a failure because your portfolio did not equal the return of Valero? The indexes are often market Cap weighted which makes them far less diverse than you would suspect ie…at one time the top 10 stocks of the S&P 500 accounted for 97% of the move of that index. The other issue is that the out performance of the S&P 500 in the latter part of the 1990’s skews the calculations of total return for a long time to come, that’s why most investors don’t realize the S&P 500 index has underperformed the last 5 years. Do I think indexes are not good, no not really many of the exchange traded indexes like the spiders (S&P 500) are easy to buy and offer lots of liquidity. I think to be successful most investors need to look long term ,use dollar cost averaging and use common sense in rotating sectors and investment styles. And always remember as a rule of thumb it is that an investment declines at twice the rate and speed that it goes up, so for example it takes a month for a stock to go up 50%, it usually takes less than two weeks to decline that same amount. I also think a good money manager is often more measured by protecting you on the down side another words protecting you against loss.

James

www.jamesfoytlin.com

3 comments:

Anonymous said...

James,

How the heck are you?

Lets get a beer soon to catch up!

rjp

Anonymous said...

Can I make a suggestion - Can you change the font? - I just can't read it in the present form . Very tiring for the eyes

Anonymous said...

Hi. So whats new with Martha?