Bylo rebuts: Index funds have their dark side, too
Larry Sarbit The Globe and Mail Friday, May 12, 2000

Index funds have been enormously successful in this bull market for one good reason -- they've beaten the stuffing out the majority of active portfolio managers.

Comment: Can't argue with that!

But what happens in a bear market?

Over the long term, active portfolio managers have been outdistanced by stock indexes 75 to 90 per cent of the time. So, it shouldn't come as any big surprise that many have concluded that the world would be a better place without the existence of active portfolio managers.

The concept of indexing grew out of the school of thought that the market is efficient and any changes affecting a business are immediately reflected in the stock price. Stock prices, according to these proponents, always reflect their true value. Therefore, it is a waste of time to try to look for inefficiencies between price and true value because none exists.

Their response: Surrender to this sad reality. Diversification over a broad range of stocks across all sectors, they surmise, is in the clients' best interests. Better to own a representation of the market than to try to do the impossible.

Indexes are the practical expression of these beliefs.

Index funds have some positive aspects in their design. For example, the folks who construct the index practice a "buy and hold" approach. The result is little stock trading and therefore low brokerage fees. This also produces little in the way of realized capital gains for the holder while the index is owned. And, because no active investment decisions need to be made, management fees tend to be lower compared with those charged by active money managers.

Comment: So why would anyone consider anything else? Indeed Mr. Sarbit extolls the virtues of indexing so eloquently that one wonders why he hasn't been able to make a persuasive case to the board of AIC that they launch a series of index funds.

But index funds carry their dark side -- most we have not witnessed because of this long, seemingly unending bull market.

Comment: Oh, oh. Here it comes...

New cash coming into index funds is appropriated according to weightings of stocks in the fund at the time. The largest companies receive the greatest portion of the incoming money. Since these companies receive the lion's share of the proceeds, there's upward price pressure on the big firms' stocks, while businesses with smaller weightings experience little or no impact on their stock prices. In fact, what happens is that the index behaves as a form of momentum investing, pushing rising stocks even higher.

Rebuttal: Even in the US, where index funds have the greatest market penetration, they represent less than 10% of all mutual fund investments. So who buys the stocks that comprise the other 90+%? And why don't their much larger purchases not also drive up the prices of their chosen stocks, which presumably have lower weightings, to an even greater extent?

So, what do investors really own when they buy these so-called "representative" indexes? The TSE 300 is dominated by just one stock, Nortel Networks, which makes up 25 per cent of the index. Nortel is trading at about 75 times this year's average estimate of earnings, a number that is extremely high. In my humble opinion, this isn't the balanced, diversified product that investors are looking for when they buy into an index.

The S&P 500, which is widely held as the representative of U.S. business, has 25 per cent of its index in just 10 companies. And the average price-to-earnings ratio of these is a whopping 50 times. These are expensive prices to pay for businesses in any environment. And the objective of diversification that the original designers had in mind is no longer there.

Rebuttal: According to AIC's 1999 annual report their flagship fund, Advantage, invests more than half of its assets in financial stocks. In my, not so humble opinion, this isn't the balanced, diversified product that investors should be looking for either. Why does this even greater lack of diversification not concern Mr. Sarbit?

Additionally, when a stock is added or deleted to an index, the funds replicating the index must respond by selling or buying the stock, usually driving the stock up or down dramatically. In other words, they pay top dollar to get in and bail out on the way down -- not exactly the behaviour of a prudent investor.

Rebuttals:

1. Usually the stocks that enter or leave an index fund are the smallest by market capitalization. Hence this buying or selling activity has a negligible impact on the value of the total assets of the fund.

2. When a stock market analyst upgrades or downgrades a stock many people, including presumably many active fund managers, rush like lemmings to buy or sell that stock. This too has a dramatic impact on the stock's price. (Witness the effect of last weekend's negative article in Barron's on shares of Cisco.) If active managers like Mr. Sarbit can resist such "madness" then why aren't they generally successful in exploiting everyone else's weakness?

3. Indexers can easily avoid this situation altogether. They simply buy only those funds that track entire market indexes like the Wilshire 5000 instead of more focused ones like the S&P 500 or NASDAQ 100.

What's more, index funds carry no cash -- they are supposed to be fully invested at all times.

Rebuttals:

1. So what's wrong with that? Properly diversified portfolios consist of several asset classes, usually including a few percent in cash. If an investor holds cash at say ING Direct, where it earns 4.5% with no fees, why would that investor want to pay Mr. Sarbit an MER of 2.5% -- more than half the pretax return of cash! -- to hold it in an equity mutual fund?

2. Equity mutual funds may at any time hold from zero to as much as 1/3 (a few hold even more!) of their assets in cash. Why would an investor with a carefully crafted strategic asset allocation leave such large cash positions to the discretion of multiple fund managers?

3. Active fund managers often justify holding large cash positions on the pretext that it buffers the fund in a market downturn. They conveniently forget to mention that this also constrains the fund in an up market. Since, over the long run, stocks prices rise, why would investors want to be "buffered" by all this cash? Moreover historical evidence suggests that index funds generally drop less in a market correction than their "buffered" counterparts.

This is great on the upside of a market, but when stock prices are headed south, the only way indexes can meet redemptions is to sell shares of the stocks they hold. And they sell in the fashion that they buy -- dumping the shares proportionally to their representation in the index. This liquidation can exacerbate the decline in the index itself.

Rebuttals:

1. When stock markets correct people often panic and redeem their investments. When this happens active fund managers too must sell assets to meet those redemptions.

2. The experience of Vanguard, the world's largest retail index fund management company, is that indexers are less prone to panic and sell in a downturn. After all, people who buy index funds tend to be sophisticated, buy-and-hold investors who neither chase the hot fund du jour nor dump it the moment it suffers a setback. Indeed, in the last broad US stock market correction in 1998, Vanguard reported net cash inflows into their flagship S&P 500 index fund.

3. According to AIC's annual financial statements dated December 31, 1999 Advantage holds virually no cash. So if one accepts Mr. Sarbit's point, shouldn't one then be concerned about how Advantage will weather the next down market without selling any of its holdings?

Finally, the selection process makes no distinction between terrific or poor companies. But with 300 or 500 companies, it's guaranteed there will be both. In the end, with this hodgepodge of companies, an index fund, in terms of quality ends up being a mediocre investment.

Rebuttal: Why does this disturb Mr. Sarbit if by his own reckoning "active portfolio managers have been outdistanced by stock indexes 75 to 90 per cent of the time"? Who wouldn't be thankful for such "mediocre" investments if they so consistently outperform their supposedly higher quality alternatives?

There is another way that is not particularly popular today: the "Ben Graham/Warren Buffett" approach. Under this strategy, look for excellent businesses selling at significant discounts, or "margins of safety," relative to their prices. And, hold for the long term. The investor gets many of the benefits of an index fund: Low brokerage costs, delayed capital gains recognition and, over the long term, superior results to the average business, which is what indexes really are. If this straightforward discipline is followed, the results will be well worth the extra management fees paid by the investor.

Rebuttal: One can invest directly in Bershire Hathaway stock and derive the full benefits of Mr. Buffett's talent for an effective MER of 0.01%. Contrast this with AIC's 250 times higher fees.

Larry Sarbit is a Winnipeg-based fund manager and senior vice-president of AIC Ltd. of Burlington, Ont. Guest Appearance is an occasional series of solicited articles from investment professionals.

Rebuttal: Bylo Selhi is a Toronto-based fund industry gadfly and proprietor of a website for smart Canadian mutual fund investors. Bylo Rebuts is an occasional series of articles that debunk misguided investment professionals.

 

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