For passive index fund managers – the game is up. Part 2

The ASX/200 has gone nowhere in ten years and nor have the associated ETF’s. “Most fund managers underperform the index’ Why?

returns

This story as we all know is getting a good working over from the press. Investors are not only realising that the they are getting fleeced by index managers but in fact there are alternatives if they’re prepared to do the research. The distractive lure of ‘index performance’, diversification and purported low costs no longer resonates with the astute investor of today. Like the politicians of the world we are sick of the hypocrisy and simply no longer believe them. Why should our portfolio’s shrink in value? With correct risk management settings there is no reason.

The growth of passive investments here in recent years is more a symptom of crowd behavior and lack of alternatives. In the US these index funds are at a much lower cost and also tax deductible. That makes sense but you are still subject to down swings in the market. And as to the growth of the ETF alternative, I’ll come to that shortly. As with many shortsighted investment strategies they are fine when things are going well but when the fat lady sings, carnage sets in.

We need to be educated and as smart as possible, not accept average performance, and think about achieving real returns rather than the distraction of benchmarks and indices. The reality is that the index has gone nowhere for ten years and ETF investing is simply a reflection of an index only it is a listed entity. Just as the heavily laden leader based index has performed poorly so to has the midcap and smaller cap indices. BUT if you had selected your stocks right, like a good active manager should, you would grow your equity. By ignoring the ‘weak’ and focusing on the strong you can generate an absolute positive return year on year. Now that’s the benchmark we want.

Now to ETF’s. Yes they offer a spread of stocks based on a sector or country. It seems a godsend and the cheap ‘answer’. But Richard Montgomery highlighted the reality in this weekend’s Australian of the crime that is an ETF. Take the example of a large market capitalised stock in an index that is an ETF. The provider receives funds that must reflect movements in a basket of stocks. In spite of the fundamental performance of a stock, to reflect the movements in a basket of stocks it must blindly purchase or sell a stock to reflect the fund inflows. So their growth is a self-perpetuating phenomenon as it distorts the price of the underlying stock. Montgomery uses the example of Exxon, which since 2013 has had a revenue decline of 46%, EPS decline of 74%, a debt increase of 129% but as it is included in an S&P index and a variety of specialist ETF’s. It has had a share price increase of 4%. Despite the fundamental structural deterioration of the stock it is unrealistically being propped up because of a weight of money being thrown at an ETF with both good and bad stocks. When the outflow starts the reality will hit and dominos will start to fall. The reverse is also true in that the good will be dragged down by outflows. It will be dependent on the current market ‘whim’.

So ETF and Index investor’s face the risk of permanent capital decay, volatility, average performance and an unrealistic divergence between price and fundamental value giving active managers that play an ‘edge’ a big edge, so to speak. On any level large, midcap or small, accurate stock picking will easily seek out and find outperformance. Index investors will have to be exposed to rubbish stocks but if you exclude those stocks from your portfolio then will you easily outperform and are well on the way to generating positive returns. As Montgomery points out indices were originally designed as a measure of market activity not as investments.

Now just to be extra safe with our active management strategy based on an ‘edge’ and to be confident your capital is safe in times of crises, which at any stage we can be exposed to, a quality risk management process that doesn’t carry drawdowns past say 15% would seem a sensible safety net to include. Some upside may be forsaken to ensure the downside is protected but that’s smart investing.