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Value-Weighted Indexing: The Problem with Active Management

May 15, 2012 | About:


Joel Greenblatt’s rationale for a value-weighted index can be paraphrased as follows:

  • Most investors, pro’s included, can’t beat the index. Therefore, buying an index fund is better than messing it up yourself or getting an active manager to mess it up for you.
  • If you’re going to buy an index, you might as well buy the best one. An index based on the market capitalization-weighted S&P500 will be handily beaten by an equal-weighted index, which will be handily beaten by a fundamentally weighted index, which is in turn handily beaten by a “value-weighted index,” which is what Greenblatt calls his “Magic Formula-weighted index.”
Let’s examine each of these points in some more depth.

Most investors, pro’s included, can’t beat the index.

The most famous argument against active management (at least by mutual funds) is by John Bogle, made before the Senate Subcommittee on Financial Management, the Budget, and International Security on November 3, 2003. Bogle’s testimony was on the then market-timing scandal, but he used the opportunity to speak more broadly on the investment industry.

Bogle argued that the average mutual fund should earn the market’s return less costs, but investors earn even less because they try to time the market:

What has been described as “a pathological mutation” in corporate America has transformed traditional owners capitalism into modern-day managers capitalism. In mutual fund America, the conflict of interest between fund managers and fund owners is an echo, if not an amplification, of that unfortunate, indeed “morally unacceptable”5 transformation. The blessing of our industry’s market-timing scandal—the good for our investors blown by that ill wind—is that it has focused the spotlight on that conflict, and on its even more scandalous manifestations: the level of fund costs, the building of assets of individual funds to levels at which they can no longer differentiate themselves, and the focus on selling funds that make money for managers while far too often losing money—and lots of it—for investors.

The net results of these conflicts of interest is readily measurable by comparing the long-term returns achieved by mutual funds, and by mutual fund shareholders, with the returns earned in the stock market itself. During the period 1984-2002, the U.S. stock market, as measured by the S&P 500 Index, provided an annual rate of return of 12.2%. The return on average mutual fund was 9.3%.6 The reason for that lag is not very complicated: As the trained, experienced investment professionals employed by the industry’s managers compete with one another to pick the best stocks, their results average out. Thus, the average mutual fund should earn the market’s return—before costs. Since all-in fund costs can be estimated at something like 3% per year, the annual lag of 2.9% in after-cost return seems simply to confirm that eminently reasonable hypothesis.

But during that same period, according to a study of mutual fund data provided by mutual fund data collector Dalbar, the average fund shareholder earned a return just 2.6% a year. How could that be? How solid is that number? Can that methodology be justified? I’d like to conclude by examining those issues, for the returns that fund managers actually deliver to fund shareholders serves as the definitive test of whether the fund investor is getting a fair shake.

This makes sense. Large mutual funds are the market, so on average earn returns that equate to the market average less costs. While it’s not directly on point, the huge penalty for timing and selection errors is worth exploring further.

Timing and selection penalties

Timing and selection penalties eat a huge proportion of the return. These costs are the result of investors investing in funds after good performance, and withdrawing from funds after poor performance:

It is reasonable to expect the average mutual fund investor to earn a return that falls well short of the return of the average fund. After all, we know that investors have paid a large timing penalty in their decisions, investing little in equity funds early in the period and huge amounts as the market bubble reached its maximum. During 1984-1988, when the S&P Index was below 300, investors purchased an average of just $11 billion per year of equity funds. They added another $105 billion per year when the Index was still below 1100. But after it topped the 1100 mark in 1998, they added to their holdings at an $218 billion(!) annual rate. Then, during the three quarters before the recent rally, with the Index below 900, equity fund investors actually withdrew $80 billion. Clearly, this perverse market sensitivity ill-served fund investors.

The Dalbar study calculates the returns on these cash flows as if they had been invested in the Standard & Poor’s 500 Index, and it is that simple calculation that produces the 2.6% annual investor return. Of course, it is not entirely fair to compare the return on those periodic investments over the years with initial lump-sum investments in the S&P 500 Stock Index and in the average fund. The gap between those returns and the returns earned by investors, then, is somewhat overstated. More appropriate would be a comparison of regular periodic investments in the market with the irregular (and counterproductive) periodic investments made by fund investors, which would reduce both the market return and the fund return with which the 2.6% return has been compared.

But if the gap is overstated, so is the 2.6% return figure itself. For investors did notselect the S&P 500 Index, as the Dalbar study implies. What they selected was an average fund that lagged the S&P Index by 2.9% per year. So they paid not only a timing penalty, but a selection penalty. Looked at superficially, then, the 2.6% return earned by investors should have been minus 0.3%.

Worse, what fund investors selected was not the average fund. Rather they invested most of their money, not only at the wrong time, but in the wrong funds. The selection penalty is reflected by the eagerness of investors as a group to jump into the “new economy” funds, and in the three years of the boom phase, place some $460 billion in those speculative funds, and pull $100 billion out of old-economy value funds—choices which clearly slashed investor returns.

I can imagine how difficult the investment decision is for mutual fund investors. How else does an investor in a mutual fund differentiate between similar funds other than by using historical return? I wouldn’t select a fund with a poor return. I’d put my money into the better one. Which is what everyone does, and why the average return sucks so bad. How bad? Bogle has calculated it below.

Dollar-weighted returns

The calculation of dollar-weighted returns speaks to the cost of timing and selection penalties:

Now let me give you some dollars-and-cents examples of how pouring money into the hot performers and hot sector funds of the era created a truly astonishing gap between (time-weighted) per-share fund returns and (dollar-weighted) returns that reflect what the funds actually earned for their owners. So let’s examine the astonishing gap between those two figures during the recent stock market boom and subsequent bust.

Consider first the “hot” funds of the day—the twenty funds which turned in the largest gains during the market upsurge. These funds had a compound return of 51% per year(!) in 1996-1999, only to suffer a compound annual loss of –32% during the subsequent three years. For the full period, they earned a net annualized return of 1.5%, and a cumulative gain of 9.2%. Not all that bad! Yet the investors in those funds, pouring tens of billions of dollars of their money in after the performance gains began, earned an annual return of minus 12.2%, losing fully 54% of their money during the period.

Now consider sector funds, specific arenas in which investors can (foolishly, as it turns out) make their bets. The computer, telecommunications, and technology sectors were the favorites of the day, but only until they collapsed. The average annual returns of 53% earned in the bull market by a group of the largest sector funds were followed by returns of minus 31% a year in the bear market, a net annual return of 3% and a cumulative gain of 19.2%. Again, not too bad. Yet sector fund investors, similar to the hot fund investors I described earlier, poured billions of dollars in the funds as they soared, and their annual return averaged –12.1%, a cumulative loss of 54% of their capital, too.

While the six-year annual returns for these funds were hardly horrible, both groups did lag the 4.3% annual return of the stock market, as measured by the largest S&P 500 Index Fund, which provided a 29% cumulative gain. But the investors in that index fund, taking no selection risk, minimized the stock market’s influence on their timing and earned a positive 2.4% return, building their capital by 15% during the challenging period. Index investor +15%; sector fund and hot fund investor –54%. Gap: 69 percentage points. It’s a stunning contrast.

Bogle’s conclusion says it all: Index investor +15%; sector fund and hot fund investor –54%. Gap: 69 percentage points. It’s a stunning contrast.

Tomorrow, why fundamental indexing beats the market.

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