INVESTMENT DISCIPLINE UNDER ATTAck

The

well publicised failure of active management to outperform the market index has wrongly marginalised investment discipline as a valid framework for the management of risk and return.

TAMRIS believes that careful analysis of market dynamics, risk preferences and investment styles actually supports selective use of long term active management disciplines.

The “index fund” is a rationale solution for the majority of investors, advisors and portfolio managers with conventional risk preferences.

Nevertheless, reports over the failure of most mutual funds to out perform the index should not be a revelation.

The majority of investors are unable to out perform the index over the long term because a) the market is efficient in matching demand and supply and, b) most investors at any one point in time are congregated around areas of highest earnings’ certainty and greatest price competition.
Many mutual funds attempt to reduce performance risk by limiting deviations from the index, limiting room for out performance.
In Canada, management expenses can be as high as 2.75% including trailer fees. The S&P 500 was close to 40 times earnings at its peak in 2000 with an earnings yield of 2.5%. At the same time the 10 year treasury was yielding some 6.5%.

The march of the index alternative is not a reason to ditch investment discipline. It is a reason to consider whether a particular allocation component is best housed within an index.

For one, value investors have to be able to buy assets which others are not buying, to undergo periods of relative under performance, to take positions which many investors would consider risky and to tolerate market conditions that may be too much for many investors to stomach .

While a pure and simple index recommendation is sensible it is by no means an optimum framework for the management of risk and return.

By buying the index you are stating aversion to under performing the index and that short term performance is an issue.

Indexes underweight under valued areas and overweight over valued areas and as a result are more expensive than they should be. The major benefit, apart from costs, is that they avoid market timing. Indexes neither sell low nor do they buy high.
Because the index over weights over valued components, the index is not a good risk manager.

The major market indexes are weighted by market cap and by highest relative demand. They are not weighted by value.

Note the overweight position of telecom, technology and media stocks in each market’s domestic index at the end of the 1990s and note the overweight allocation to Japan in global market indexes at the end of the 1980s and vice versa the US at the end of the 1990s.

Areas of lowest market cap, highest equity risk premiums and lowest relative demand; smaller companies, undiscovered growth and value and/or sectors at critical valuation points are under weighted.

This makes value style indexes a competitive alternative, given that value indexes out perform the overall market index over time. Unfortunately since value also under performs the major market index over long periods of time, you need a value discipline to stomach a value allocation .

Style, market cap and ETF sector indexes are worthwhile asset allocation vehicles for those with specific allocation and management discipline and, a lower cost alternative to market timing problems for those without.

If the objective of asset management is to add value then we need to be able to allocate globally. How much and to which index is a problem, since both decisions imply a valuation and allocation decision.

Global indexes amply illustrate the dangers of weighting according to market capitalisation.

Economies at the peak of their economic and market cycles will have the largest index allocation while those in recession and market troughs will have lower allocations.

Additionally, global indexes do not allow you to sell over valued components or retain under valued components. As such global indexes limit return and risk management opportunities. As with domestic market indexes, allocation to higher risk/higher return areas such as smaller companies and emerging markets is also limited.

Care needs to be taken with reference to conclusions drawn from long term performance analysis of component indexes.

For example, note the S&P Value and Growth Indexes. In fact, the top end of the value and the lower end of the growth universe represent the conservative allocation universe. These indexes also do not show the constant recycling of value or growth and the benefits of this recycling on long term performance.

Additionally, to use a simple growth index to validate the long term benefits of growth investing is also open to error. Not all stocks in the growth index are actually growth stocks. Many will be either overvalued or mature growth stocks exposed to a decline in price.