The Wrong Way To Use An Index Tracker

Sedate and Inept

Index tracking is supposed to be a sedate affair, a quiet contemplation of the tempestuous dynamics of market forces from an appropriate distance.  A passive approach to investing, if you will.

Instead it seems that people who use index trackers either don’t understand that they’re simple commodities or simply trade them like any other instrument available to private investors: frequently, ineptly and in a manner calculated to abrogate their inbuilt advantages.  Nothing new there, then.

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Risk := ON

Quantitative Squeezing

As the immediate fears of market immolation have faded the switch in investors’ heads marked “Risk” has moved to the OFF position. All those little signs of uncertainty, the mass synchronisation of share price movements, the endless twittering and wittering about the imminent end of the known world have faded, to replaced by the normal measures of complacency in the face of unimagined dangers.

It’s likely that the relief generated by the Eurozone’s ability to stitch together a patchwork quilt of compromise to keep Greece from defaulting and the general resilience of corporate profits is only temporary. A reckoning must come when quantitative squeezing replaces quantitative easing. Getting this right requires finessing on a grand scale by the lords of finance; not impossible, merely very, very difficult.

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Hubble, Bubble, Index Trouble

Consequences, Consequences

In a world in which our behavioral biases are continually encouraging us to stray into temptation, or at least into the grasping hands of the securities industry, we have to look for whatever small mercies we can find. Not the least amongst these is the humble index tracking fund, an asset type specifically created to minimise the opportunity for self-inflicted mischief.

Yet such is the nature of the financial business that even in the world of the behaviorally inert, passive index tracker we can’t avoid the dead hand of unintended consequences and cognitively induced misadventure. In becoming popular index tracking funds have simultaneously created their own behavioral problems: because whenever too much money imbued with too little intelligence chases too few assets the only possible outcome is a bubble. And we all know what happens with bubbles.

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Why There’s Never Been A More Dangerous Time To Invest

Facing the Big Guns

Tadas Viskanta, who writes and curates the excellent Abnormal Returns, recently penned an equally excellent article entitled There Has Never Been A Better Time To Be An Individual Investor. In this he cogently sets out a list of reasons why investing is cheaper and easier than ever before while caveating that our innate biases work against us when investing.

While agreeing with every word of the article, I think there’s danger for anyone executing anything other than the suggested default option of a low cost, globally diversified, occasionally rebalanced portfolio. Active private investors are engaged in an arm’s race with the securities industry and most of the big guns are facing the wrong way. The problem is that darned scientific method, which is why there's also never been a more dangerous time to invest.

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Intelligence Can Seriously Damage Your Wealth

Cerebral Investors

In most walks of life intellectual superiority is generally viewed as something that gives the possessor an advantage over their fellow humans. Admittedly measuring intelligence is a pastime fraught with difficulty and hedged in contradiction but, even so, there are a few easy ways in which we can distinguish people who have better than average analytic abilities. Whether that’s the same as being clever is another matter, but it’ll have to do for the current considerations.

As investing itself is often viewed as a cerebral occupation, an area where the spoils fall to the smartest, we ought to expect to find a good correlation between intellect and returns. After all the calculation of alphas, betas, coupons, coefficients, efficient frontiers, adjusted earnings and the rest of the paraphernalia beloved of market gurus is pretty complex stuff. Of course this is a myth: simply being smart isn’t anywhere near sufficient to succeed in stocks.

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Index Tracking At The Omega Point

Stick or Twist?

We’re hearing the clarion call of market timing ever more loudly. It’s unsurprising that this is the case – in times of almost unprecedented market volatility many people have suffered a horrible rude awakening about the true nature of stockmarket risk. By some measures markets have now returned the square root of bugger all for the best part of four decades.

Despite this we need to be careful that the alluring song of the naysaying sirens doesn’t blind us to the real meaning of risk. While passive investment can clearly be outperformed by people with time and money it’s not necessarily the safest way of proceeding if you don’t know what you’re doing.

And, to be frank, that’s most of us.

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Real Fortune Telling: Dividend Forecast Indexing

Fallible Analysts, Reliable Dividends

Unfortunately investment analysts are just as prone to the standard behavioural biases as the rest of us and are inevitably more affected by incentives designed to promote short-term outperformance. In particular when market conditions become turbulent most earnings forecasts become slightly less useful than an unsinkable submarine.

Dividends, on the other hand, are less volatile than earnings. Even better, analysts' dividend forecasts are much more reliable than their earnings forecasts. So if dividends are a sign of healthy companies then using analyst dividend forecasts as a forward signalling mechanism may offer a way of obtaining market beating returns at little excess risk. Although, as it turns out, whether this works or not depends on whether your country’s legal system was created by a bunch of Vikings masquerading as French nobles rather than the descendents of Julius Caesar.

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Jack Bogle and the Bogleheads

Bogle's Folly

Back in 1946 Ben Graham, doyen of value investors, opined thus:

"Furthermore, there is nothing to prevent the investor from dealing with his own investment problems on a group basis. There is nothing to prevent the investor from actually buying the Dow-Jones Industrial Average, though I never heard of anybody doing it. It seems to me it would make a great deal of sense if he did."

It was to take another thirty years before Graham’s "great deal of sense" was heeded when Jack Bogle set up the Vanguard Fund tracking the S&P500. Bogle’s contention was that by keeping costs down, avoiding unnecessary transactions and avoiding the behavioural biases associated with active trading an index tracker would outperform the majority of active funds over time.

Unsurprisingly the fund industry labelled Vanguard as “Bogle’s Folly” and "UnAmerican". Funny guys . Who's laughing now?

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Exotic ETFs Are Toxic ETFs

Beware of Enticing Charms

Just as the exotic charms of Cleopatra confounded Julius Caesar, the foreign wiles of Delilah did for Samson and the mystique of Heather Mills’ fake leg ensnared Paul McCartney, so the mysterious allure of the exotic ETF is undermining the original purpose of these investment vehicles. As usual the investment industry has worked its magic and turned a really useful investment tool into a method for speculating in snake oil.

From single country funds with markets no bigger than the market capitalisation of a newly downsized investment bank to Ultra Short ETFs that ensure you have a whole new set of ways to lose money these things are dangerous for private investors. However attractive they may look, beneath the surface they’re toxic waste, not investment gold.

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Arnott: 40 Years of Bonds Beating Equities

Bonds: Why Bother?

Rob Arnott’s paper Bonds: Why Bother? sets out to succinctly punch a few holes in accepted market norms. What he finds should be sobering for investors in shares who believe that they can gain excess returns for taking the excess risk of holding equities over reasonable lengths of time.

Now a lot depends on your definition of a “reasonable length of time” but as the paper shows that someone holding and rolling over 20 year Treasury bonds would have beaten an investor in the S&P 500 over any time frame since 1979 you'd have to have a very long term view indeed to regard equity investment as a safe thing. In fact bonds have actually beaten equities on the same measure over the last forty years.

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Clairvoyant Value

51 Years of Value Beating Growth

It’s a kind of truism in the markets that value stocks outperform growth stocks. However, it’s pretty hard to get demonstrable evidence of this. Arnott, Li and Sherrerd (2008) have come up with an interesting take on the problem. Instead of projecting forward they’ve gone back in time and looked at how companies performed in comparison to their historic earnings multiples.

By looking at this so-called clairvoyant value – analysing in hindsight – they’ve been able to show that the suspicion is correct and value stocks do outperform in terms of actual returns. However they’ve also shown that the market is generally pretty accurate in identifying growth companies – it’s just lousy at valuing them correctly.

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Fundamental Indexing Can’t Save You from Aliens

(But Can Protect You From Nearly Everything Else)

William Bernstein, in The Four Pillars of Investing, states: “About once every generation, the markets go barking mad. If you are unprepared, you’re sure to fail”.

As indices crumble and even experienced investors start to capitulate the stockmarkets are flashing a big message to anyone with an appreciation of stockmarket history and the ability to ride out the storm. Welcome to the test of our generation.

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Don’t Give Index Trackers the Bird

Shoe Fetish

You want to buy a pair of shoes but due to the Great Shoe Shop Recession of ’09 there are only two outlets left to choose from, right next to each other. To the left you have a simple, dressed down stand. To the right there’s a glitzy emporium, covered in flashy signs. The former sells cheap shoes that last for years. The latter sells expensive, fashionable footware that falls apart in months. If all that concerned you was to be well-shod for a low price for a long time, which would you choose?

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