Active investing and Index investing. Hans Janssen Daalen General Director DUFAS Stockholm, May 16, 2011

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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 Ladies and gentlemen, this is your wake-up call! A clear message from an active manager, Terry Smith. And many will agree with him. It is very true to say that the competition from alternative investment products is moving on. The competition is not only coming from alternative investment products. In the fund arena itself, index funds and ETF s are becoming a greater threat for active managers that produce UCITS. With the AIFM directive coming into force within a couple of years, also alternative managers will profit from a more harmonized European playground. Like in sports, it is more difficult to maintain your top position, rather than getting there. The success of UCITS has made traditional fund managers lazy. Many fund managers lost the ability to listen to the needs of their clients. Instead of that, they kept on creating new products, new funds, simply because they could. Long time ago, fund investing was meant to be a cheap and simple solution for people, who did not have the means nor the expertise to get investment advice. Therefore, fund managers created easy accessible investment solutions by offering truly risk spreaded, because worldwide investing, funds in equity, fixed income and real estate. People only needed to bother of their asset allocation. Nowadays, we have created in Europe a very diversified fund marketplace, comprised of over 50,000 funds, offering concentrated investments in almost any tiny market or asset class. Fund investors, more and more, became in need of qualified investment advisors, and fund managers started to include the costs of investment advice in their management fees too. The result is what we see in this quote from Terry Smith. No wonder competitors move ahead in our market place, acquiring greater market share day by day. Institutional investors started to find their way to index investing many years ago. But nowadays, even regulators make public pleads for better and cheaper investment solutions, one of which is index investing, the topic I want to address to you today. In my home country, The Netherlands, the regulator started to challenge the fund industry back in 2009, at the aftermath of the credit crisis. Index funds were mentioned as a cheap, default solution for the public. So called active managers where not able to beat their benchmark index anyway, so why pay more for poor performance? DUFAS accepted the challenge from the regulator and conducted a research about the merits from index investing opposite to active investment styles. As one of the results of this research paper, I am standing here today in front of you. Let us find out if our regulators are right. 3

4 The case for index investing according to proponents Costs of index investing are lower Risk of index investing is lower Index investing is simpler & easier to understand Scientific research demonstrates that active investing cannot beat the benchmark / index 4

5 Are costs of index investing really lower? Expenses are important: they reduce performance Net return (risk adjusted after expenses) is what counts TER total costs of ownership TER of active funds is usually higher a.o. due to more research, strategy development, embedded distribution costs 5

6 Are costs of index investing really lower? TER total-costs-of-ownership Reasons for underperformance opposite to the relevant index. TER does not include: transaction costs of the financial instruments which the fund buys and sells: broker commissions dividend withholding tax cost of investment advice subscription & redemption fees for units of the fund itself 6

7 Are costs of index investing really lower? TER of index funds is much lower than the actual costs! Transaction costs can get as high as 33% of total cost of ownership of index funds (some equity funds) Transaction costs are f.i. much lower in active fund with buy-and-hold strategy Dividend withholding tax reduces real return of index tracker, compared with TER Cost of advice is embedded in management fee of active funds, but normally not in fee of index funds 7

8 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! 8

9 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 (the standard) invest in winners of the past (f.i. Greece s government debt weight in Euroland Bond Index) 9

10 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 and tradability risks small ETF -- large investor may cause huge NAV impact 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 10

11 Is index investing really less riskier? Saying index investing is less riskier than active investing is misleading the public! 11

12 Is index investing easier to understand? YES: the index tells you which investments are made but Index funds are not always a replication of the index There are many index funds for many different markets Commercial parties create alternative indices: hybrid active/passive, not based upon market caps Investment advice required to select appropiate index funds, just as in case of active managed funds 12

13 Is index investing easier to understand? Index funds are not always a full replication of the index: Representative sampling strategy = 5-20% of fund portfolio is in derivatives and non-index investments Agressive sampling = very small percentage of portfolio is index investment Synthetic indexing = stock index futures + bonds replicate the performance of the index Enhanced indexing = aimed at outperformance 13

14 Can active investing not beat the benchmark? Keynes: stock exchange casino full of gamblers Fama: 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 14

15 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... 15

16 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) 16

17 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: overconfidence, overreaction, representativeness bias, information bias, loss aversion, anchoring, framing, hyperbolic discounting, the disposition effect and several other predictable human mistakes in reasoning and information processing and biases. 17

18 Can active investing not beat the benchmark? Alternative to EMH: the adaptive markets hypothesis : different people hold different convictions about the future (incl. future developments in financial markets) and people can adapt their beliefs to current developments. 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 18

19 How to find outperforming active funds? Look at the active share of the fund: difference between the weights in the fund portfolio and the benchmark Cremers & Petajisto: the funds with the highest active share perform often 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. No guarantee for outperformance. 19

20 How to find outperforming active funds? Cremers & Petajisto: Active share predicts performance Higher active share = higher performance 20

21 How to find outperforming active funds? Cremers & Petajisto: shift to less active management in the 90, resulting in many closet indexers 21

22 C&P: more AuM and less active management over time 22

23 How to find outperforming active funds? Cremers & Petajisto: low-activeshare funds have a far lower tracking error than high active share 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 C&P: High active share' funds outperform market & (closet) index funds 25

26 C&P: Active share funds outperform 130/30 funds 26

27 How to find outperforming active funds? Cremers & Petajisto segment all types of funds by combining active share with tracking error 27

28 C&P: stock pickers outperform other fund segments 28

29 How to find outperforming active funds? Use active share to identify better-performing funds. Will this hold in the future? Cremers & Petajisto: yes, for two reasons: (1) generating alpha requires deviating from the benchmark, and (2) no data mining in these results. Long run outlook: any easy rule for earning positive alphas in the market is an anomaly which should not exist forever. 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 Apply core satellite strategies But: look for Active Share funds! 31