In today’s era of “quantitative easing” – massive liquidity injections and a zero interest rate policy, which had a strong positive effect on asset prices – we continue to see money pouring into equity funds, especially index funds (usually a mutual fund or exchange traded fund) as investors chase returns and can’t bear sitting on cash yielding zero and losing purchasing power every day. Yet what will happen when the Federal Reserve raises interest rates, corporate profit margins decline, or markets start exhibiting more volatility? Is a fully invested index fund really the right place to be? At IVA, we believe some active managers, especially some value investors, can still beat a benchmark over the long-term, with the trick being: pick the right asset manager.
When investing in an index fund – timing matters. We believe that the ability to avoid bubbles is key to long-term outperformance. As a passive investor, you cannot make the decision to be less invested when markets appear to be overvalued or a bubble is brewing, which could lead to significant losses. The following examples illustrate the importance of timing when buying an index fund:
The infamous “dot-com” bubble roughly occurred from 1997 to 2000, peaking on March 10, 2000. If one was able to invest in the S&P 500 Index at the peak through March 31, 2014, one could have earned 4.0%, on an annualized basis, including dividends. Yes, a positive return, however, when inflation is factored in (inflation was 2.3% annualized over that period) the return was only slightly positive in real terms, before fees and taxes on dividends received.
An even better example is the “Japanese bubble” which occurred from 1986 to 1991, peaking on December 29, 1989. In Japanese yen, the Nikkei 225 Index fell -3.90% annualized (yes, annualized, over a generation!) from its peak through March 31, 2014. The Japanese market is still a long way away from the peak of ¥38,957; the Nikkei Index closed at ¥14,827 on March 31, 2014.
If one had the flexibility to avoid these trouble spots and not be fully invested, the road would have been less bumpy.
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