Hans Janssen Daalen General Director DUFAS. Stockholm, May 16, 2011

Transcription

1 Active investing and Index investing Hans Janssen Daalen General Director DUFAS Stockholm, May 16,

2 The vast majority of fund investors suffer from punitive fee structures, overtrading, fund proliferation and closet indexing. The net result is poor performance. Terry Smith, Fundsmith 2

3 The case for index investing Costs of index investing are lower Risk of index investing is lower Index investing is simpler & easier to understand d Scientific research demonstrates t that t active investing cannot beat the benchmark / index 3

4 Are costs of index investing really lower? Expenses are important: they reduce performance Net return is what counts TER total costs of ownership TER of active funds is usually higher a.o. more research, strategy development, embedded distribution costs 4

5 Are costs of index investing really lower? TER total-costs-of-ownership of ownership Reasons for underperformance. TER excludes: transaction costs of the financial instruments which the fund buys and sells dividend withholding tax cost of advice subscription & redemption fees for units of the fund itself 5

6 Are costs of index investing really lower? TER of index fund is typically much lower Transaction costs can go up to 33% of total cost of ownership of index funds Transaction costs are much lower in active fund with buyand-hold strategy Dividend withholding tax reduces real return compared with TER Cost of advice is embedded in management fee of active funds, but normally not in fee of index funds 6

7 Are costs of index investing really lower? If you look at TER only: index funds are cheaper If you look at total costs of ownership: index funds cost approximately the same as active funds 7

8 Is index investing really less riskier? Tracking error (volatility compared to market) really is smaller, but Tracking error excludes market risk Market risk is a major risk for both active funds & index funds Lower correlation with benchmark = higher risk free return Market weighted indices invest in winners of the past (F.i. Greece s government debt weight in Euroland Bond Index) 8

9 Is index investing really less riskier? Tracking error also does not include: Securities lending risks Index arbitrage or index front running Certain types of index funds have higher than normal liquidity idit and tradability risks small ETF -- large investor bond index trackers are just as (il)liquid as active bond funds because of underlying illiquid bond market Leveraged index trackers magnify both profits & losses 9

10 Is index investing really less riskier? Saying index investing is less riskier than active investing is misleading the public 10

11 Is index investing easier to understand? YES: the index tells you which investments are made but Index funds are not always a copy of the index There are many index funds for many markets If you invest in more than one index fund, advice is needed 11

12 Is index investing easier to understand? Index funds are not always a copy of the index: Representative sampling strategy =520% 5-20% of AuM is in derivatives and non-index investments Agressive sampling = very small % of AuM is index investment Synthetic indexing = stock index futures + bonds replicate the performance of the index Enhanced indexing = aimed at outperformance 12

13 Can active investing not beat the benchmark? Efficient Market Hypothesis led to index funds Fund performance literature: statistical analysis of the whole market and a very large selection of active funds to prove EMH Outcome is consistently positive but Confirmation bias: falsification of EMH is easier Outperforming strategies are proprietary and not surrendered to scientists Averages of nearly the whole market are meaningless 13

14 Can active investing not beat the benchmark? Efficient Market Hypothesis states that: an active investor can beat the market but, on average, extra returns will be lower than, or equal to, the extra costs of beating the market (incl. wages, information costs and transaction costs) But empirical research shows EMH cannot explain all phenomena in financial markets... 14

15 Can active investing not beat the benchmark? Empirical research shows EMH cannot explain: Irrational exuberance, bubbles, crashes January effect, July effect, November effect, weekend effect or Monday effect End-of-the-month effect; holiday effect (=returns are higher the day before the holiday starts) Small-cap effect (=small companies generate relatively large returns) Index effect (=when a stock is included in an index, its value immediately goes up significantly, and vice versa) 15

16 Can active investing not beat the benchmark? Empirical research shows EMH cannot explain: Price momentum Earnings surprise Mean reversion Home bias (investors tend to invest close to home) Herding (=investors follow trends rather than anticipate them) Irrational but familiar human behaviour as explained by behavioural finance 16

17 Can active investing not beat the benchmark? Alternative to EMH: the adaptive markets hypothesis Contrasts with EMH which assumes that all stock brokers are identical and their future expectations are homogenous Economically irrational behaviour is consistent with an evolutionary model of individuals who adapt to a changing environment by means of simple rules of thumb 17

18 How to find outperforming active funds? Low cost versus high cost in the case of index trackers, research suggests that the performance/benchmark can be predicted accurately based on expenses research shows no such relation for active funds: there are expensive underperformers and cheap outperformers and vice versa 18

19 How to find outperforming active funds? Look for the source of alpha and how it is related to the historic performance of the investments. Then ask why the active manager expects that particular source of alpha to work in the future. But most retail investors cannot evaluate the answers. 19

20 How to find outperforming active funds? Look at the active share of the fund Cremers & Petajisto: the funds with the highest active share perform better than the benchmark, both before and after expenses Caveat emptor! This method only filters out the closet indexers and reduces the chance of disappointments. i t 20

21 How to find outperforming active funds? Cremers & Petajisto: t Active share predicts performance Higher active share = higher performance 21

22 How to find outperforming active funds? Cremers & Petajisto: active share has declined over time, resulting in too many closet indexers 22

23 How to find outperforming active funds? Cremers & Petajisto: t low-active- share funds (or: index funds) )have a far lower tracking error than active funds 23

24 How to find outperforming active funds? Cremers & Petajisto: it makes sense to weed out the closet indexers from your portfolio 24

25 How to find outperforming active funds? Cremers & Petajisto segment all types of funds by combining active share with tracking error 25

26 Diversified stock pickers outperform other fund segments 26

27 High active share' funds outperform market & index funds 27

28 Active share funds outperform 130/30 funds 28

29 More assets and less active management 29

30 Symbiosis Active investors do fundamental analysis valuation on which stock & bond prices are based Index trackers rely on active investors assessments Index investors are a multiplier to active investors decisions 30

31 DUFAS evenhanded approach Index investing is not superior to active investing Active investing is not superior to index investing Both have a legitimate place in a client s portfolio (core satellite strategies) 31

32 Questions? s 32