Passive Investing: Theory vs. Practice. Oliver Murray Brandes Investment Partners & Co.

Transcription

1 Passive Investing: Theory vs. Practice Oliver Murray Brandes Investment Partners & Co.

2 Backgrounder: Passive Investing Passive Investing in Practice Examples from U.S. Equity Markets 2

3 Sample US Equity Indices Very Similar But Which One is the Market? Full Name Abbreviation Focus # of Stocks Method Broad n/a Market cap MSCI US Broad Market MSCI US BM Broad n/a Market cap MSCI US Investable Market 2500 Broad 2500 Market cap MSCI US Prime Market 750 Large/Mid 750 Market cap MSCI US Large Cap 300 Large Cap 300 Market cap NYSE Arca Composite index Broad >2000 Market cap PR Large Cap 100 Market cap Dow Jones Industrial Average Large Cap 30 Price Dow Jones US Large Cap Large Cap n/a Market cap Dow Jones Composite Average Large Cap 65 Price Dow Jones Broad Market cap Broad 2500 Market cap Large Cap 1000 Market cap Broad 3000 Market cap Large Cap 200 Market cap Russell Top 50 Russell Top 50 Large Cap 50 Market cap Large Cap 500 Market cap S&P Composite 1500 Broad 1500 Market cap Large Cap 100 Market cap Large Cap 900 Market cap The Index is often not the market 3

4 US Equity Indices - Despite Similarity, Returns Vary Significantly MSCI US BM MSCI US BM Russell Top Russell Top MSCI US BM Russell Top MSCI US BM Russell Top MSCI US BM MSCI US BM Russell Top Best-Worst Range Average Yearly Difference Over 10 Year Period: 13.2 Source: Index returns from Ibbotson Associates, except returns ( ) from Bloomberg. MSCI US Broad Market and Russell Top 50 returns are provided following their inceptions in 2003 and 2005, respectively. Returns are 1-year total returns, in Canadian dollars, as of December 31 of each year. 4

5 There are many passive strategies tied to each index Market Cap weighted indexing (plain vanilla) Price-weighted indexing Equally-weighted indexing Fundamental indexing Leveraged indexing Inverse Indexing Results will vary 5

6 There are many ways to implement each strategy 1.Direct investment into the securities underlying the index 2.Investment into a basket of securities that best represent the index 3.Use of derivatives to replicate the index 4.Use all the strategies listed above Results will vary 6

7 Tracking Error is Real 2009 US ETF Industry Experience US ETF Industry Absolute Tracking Error by category (bps) 1709 Average Post Expense Tracking Error in 2009 was 125bps Maximum Tracking Error (bps) Fully 83% of US ETFs had Negative Error 1070 Average (Post Expenses) Minimum US Major Market 90% US Dividend 83% US Custom 79% US Asset Allocation 71% US Style 91% US Sector Industry 85% International 82% Global 61% Fixed Income 87% Commodity 87% Currency 100% Percentage of ETFs in category with negative tracking error Source: 2009 Morgan Stanley Report on 563 US domiciled ETFs. 7

8 Tracking Error is Real 2009 US ETF Industry Experience Tracking Error has tended to increase during recoveries Substantial increase in the number of ETFs ( ) 8

9 The Bid-Ask Spread is Real Average Bid-Ask Spread was 20 bps Source: Bloomberg Businessweek 9

10 Conclusion: The index return is never the investor s return Total Cost of Ownership Typical ETF Underperformance 0.48% Average ETF Expense Ratio 0.50% 1.25% Average ETF Tracking Error 2.0% Transaction Costs and/or Dealer/Advisor Compensation Not includedin the ETF Expense Ratio but typically included in the Mutual Fund Expense Ratio Typical ETF Total Cost of Ownership 0.98% % 0.20% 0.50% Average Bid Ask Spread Transaction Costs and/or Dealer/Advisor Compensation 2.0% Typical ETF Underperformance 1.95% % 10

11 Active vs. Passive Debate: 7 Common Analytical Weaknesses Benchmark Misuse Treatment of Fees Confusion of the index with an investment that tracks the index Narrow Universe A Significant Number of US Equity Studies End Date Bias No Recognition for Risk and Tax Consequences Ex-Post Analysis 11

12 The Arithmetic of Passive Investing Active managers play an important role in ensuring market efficiency There is an upper limit to passive investing - there can only be so many free riders Capital cannot be allocated efficiently through passive investment alone. - Should index providers determine capital allocation? Passive Investing cannot exist without active management Active management cannot be rationed efficient level determined by markets All large defined benefit pension plan managers in Canada, including CPPIB, diversify to utilize both active and passive asset selection strategies. 12

13 Active vs. Passive Debate: Conclusions Investor s ultimate goal For individual investors, the relevant question is not whether to choose an active or passive fund but rather how to choose the investment that will maximize the risk adjusted returns of their portfolio subject to the investor s other unique quantitative and qualitative constraints Both passive and active funds will be utilized to answer this question. 13

14 Active vs. Passive Debate: Conclusions An informed investor is a better investor The Canadian Context Concerns regarding: Transparency in the total cost of ownership Historical performance of new funds Regulatory Fairness and a level playing field are key 14

15 Thank You 15