The Case For Passive Investing!

Aswath Damodaran

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 The Mechanics of Indexing!

 Fully indexed fund: An index fund attempts to replicate a market

index. It is relatively simple to create, once the index to be replicated
has been identified. 
1. Identify the index to be replicated. (Example: S & P 500)
2. Estimate the total market values of equity of all firms in that index.
3. Create a market-value weighted portfolio of stocks in the index.
This fund will replicate the index and is self correcting. It will need to
be adjusted only if stocks enter or leave the index.

 Sampled Index fund: Here, you sample an index because the index
contains too many stocks like the Wilshire 5000 or it is too expensive
to index the assets in a fund.

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 The growth of indexing!

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 The Case for Indexing!

 The case for indexing is best made by active investors who try to beat
the market and fail.

 In the following pages, we will consider whether

• Individual investors who are active investors beat the market

• Professional money managers beat the market

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 Individual Investors: The bad news first…!

 The average individual investor does not beat the market, after netting out
trading costs. Between 1991 and 1996, for instance, the annual net (of
transactions costs) return on an S&P 500 index fund was 17.8% whereas the
average investor trading at the brokerage house had a net return of 16.4%.

 The more individual investors trade, the lower their returns tend to be. In fact,
the returns before transactions costs are accounted for are lower for more
active traders than they are for less active traders. After transactions costs are
accounted for, the returns to active trading get worse.

 Pooling the talent and strengths of individual investors into investment clubs
does not result in better returns. Barber and Odean examined the performance
of 166 randomly selected investment clubs that used the discount brokerage
house. Between 1991 and 1996, these investment clubs had a net annual return
of 14.1%, underperforming the S&P 500 (17.8%) and individual investors
(16.4%).

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 And some possible good news…!

 The study by Barber and Odean, quoted in the last page, found that the
top peforming quartile of individual investors do outperform the
market by about 6% a month.

 Building on that theme, other studies of individual investors find that
they generate relatively high returns when they invest in companies
close to their homes compared to the stocks of distant companies, and
that investors with more concentrated portfolios outperform those with
more diversified portfolios.

 Finally a study of 16,668 individual trader accounts at a large discount
brokerage house finds that the top 10% of traders in this group
outperform the bottom 10% by about 8 percent per year over long
period.

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 Professional Money Managers!

 Professional money managers operate as the experts in the field of

investments. They are supposed to be better informed, smarter, have
lower transactions costs and be better investors overall than smaller
investors.

 Studies of mutual funds do not seem to support the proposition that
professional money managers each excess returns.

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 Jensen’s Results!

Figure 13.3: Mutual Fund Performance: 1955-64 - The Jensen Study

-0.08 -0.07 -0.06 -0.05 -0.04 -0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04 0.05 0.06
Intercept (Actual Return - E(R))

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 The same holds true for bond funds as well…!

Lehman Bond Index

300
Active Bond funds

200

100

83 84 85 86 87 88 89 90 91 92

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 Measurement Issue 1: Sensitivity to Risk
Measures!

 The Jensen study used the capital asset pricing model to estimate and
correct for risk.

 The limitations of the CAPM have opened up the question of how
sensitive the conclusions at to different risk and return models.

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 1. Relative to the Market!

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 2. Other Risk Measures!

 : The Sharpe ratio, which is computed by dividing the excess return on

a portfolio by its standard deviation, the Treynor measure, which
divides the excess return by the beta and the appraisal ratio which
divides the alpha from the regression by the standard deviation can be
considered close relatives of Jensen’s alpha. Studies using all three of
these alternative measures conclude that mutual funds continue to
under perform the market.

 In a study that examined the sensitivity of the conclusion to alternative
risk and return models, Lehmann and Modest computed the abnormal
return earned by mutual funds using the arbitrage pricing model for
130 mutual funds from 1969 to 1982. While the magnitude of the
abnormal returns earned is sensitive to alternative specifications of the
model, every specification of the model yields negative abnormal
returns.

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 3. Expanded Proxy Models!

 Studies seem to indicate that risk and return model consistently under
estimate the expected returns for stocks with low price to book ratios,
low market capitalization and price momentum.

 In 1997, Carhart used a four-factor model, including beta, market
capitalization, price to book ratios and price momentum as factors, and
concluded that the average mutual fund still under performed the
market by about 1.80% a year. In other words, you cannot blame
empirical irregularities for the under performance of mutual funds.

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 Measurement Issue 2: Survivor Bias!

 One of the limitations of many studies of mutual funds is that they use only
mutual funds that have data available for a sample period and are in existence
at the end of the sample period. Since the funds that fail are likely to be the
poorest performers, there is likely to be a bias introduced in the returns that we
compute for funds.

 Carhart examined all equity mutual funds (including failed funds) from
January 1962 to December 1995. Over that period, approximately 3.6% of the
funds in existence failed each year and they tend to be smaller and riskier than
the average fund in the sample. In addition, and this is important for the
survivor bias issue, about 80% of the non-surviving funds under perform other
mutual funds in the 5 years preceding their failure. Ignoring them as many
studies do when computing the average annual return from holding mutual
funds results in annual returns being overstated by 0.17% with a one-year
sample period to more than 1% with 20-year time horizons.

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 Performance by Sub-categories!

 Mutual funds adopt a variety of styles. Some are value funds while
others are growth funds. Some buy small-cap stocks whereas others
buy large-cap stocks.

 Mutual funds also come in different sizes. Some funds have tens of
billions to invest whereas others have only a few hundred million to
invest.

 Mutual funds can also be domestic and foreign, load and no-load…

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 1. Categorized by market cap of companies!

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 2. Categorized by Investment Style!

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 But growth investors tend to do better relative
to their indices..!

Figure 13.7: Returns on Growth and Value Funds

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%
1987 1988 1989 1990 1991 1992 1993 1987 - 1993

-10.00%

-20.00%

-30.00%
Year

Growth Funds Growth index Value funds Value Index

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 3. Emerging Market and International Funds!

Figure 13.8: Emerging Market Funds versus Indices

30.00%

25.00%

20.00%

15.00%
Average Fund Return
Return on index

10.00%

5.00%

0.00%
Latin American Diversified Asia- Pacific Asia Excluding Japan Diversified Emerging
Market
Category of fund

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 4. Load versus No-load Funds!

Figure 13.9: Jensen's Alpha: Load versus No-load Funds

0.00%

-0.50%

-1.00%

-1.50%

Load funds
-2.00% No-load funds

-2.50%

-3.00%

-3.50%

-4.00%
Pre-load Return Post-load return

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 5. And fund age…!

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 6. Institutional versus Retail Funds!

Figure 13.11: Institutional versus Retail Funds: Annualized Excess Returns

0.50%

0.00%

-0.50%

-1.00%

-1.50%

-2.00%

-2.50%

-3.00%

-3.50%
Retail funds Big Stand-alone Big Institutional with Small Stand-alone Small Institutional with
Institutional retail mate Insitutional retail mate

Excess Return (CAPM) Excess Return (4-factor model)

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 Performance Continuity!

 Fund managers argue that the average is brought down by poor money
managers. They argue that good managers continue to be good
managers whereas bad managers drag the average down year after
year.

 The evidence indicates otherwise.

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 1. Transition Probabilities!

Quartile ranking next period

Quartile ranking this 1 2 3 4
period
1 26% 24% 23% 27%
2 20% 26% 29% 25%
3 22% 28% 26% 24%
4 32% 22% 22% 24%

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 With an update…!

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 2. The Value of Rankings!

Figure 13.12: Annualized Return based on Morningstar Ratings- 1994-1997

1.00%

0.50%

0.00%

-0.50%
Annualized Excess Return

-1.00%

-1.50%

-2.00%

-2.50%

-3.00%

-3.50%

-4.00%

-4.50%
1 2 3 4 5 6 7 8 9 10
(Highest) (Lowest)
Morningstar Rating Score

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 But ratings have become more informative..!

 Morningstar did revamp its rating system in 2002, making three

changes.

• They broke funds down into 48 smaller subgroups rather than four large
groups, as was the convention prior to 2002.

• They adjusted their risk meaures to more completely capture downside
risk; prior to 2002, a fund was considered risky only if its returns fell
below the treasury bill rate, even if the returns were extremely volatile.

• Funds with multiple share classes were consolidated into one fund rather
than treated as separate funds.

 A study that classified mutual funds into classes based upon these new
ratings in June 2002 and looked at returns over the following three
years (July 2002-June 2005) finds that they do have predictive power
now, with the higher rated funds delivering significantly higher returns
than the lower rated funds.

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 There is some evidence of hot hands..!

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 And the persistence continues.. At both small &
large funds!

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 Why active money managers fail…!

 High Transactions Costs: The costs of collecting and processing

information and trading on stocks is larger than the benefits from the
same.

 High Taxes: Trading exposes investors to much larger tax burdens.

 Too much activity: Activity, by itself, can be damaging as investors
often sell when they should not and buy when they should not.

 Failure to stay fully invested in equities: Since mutual fund managers
are not great market timers, failing to stay fully invested hurts more
than it helps.

 Behavioral factors: All of the behavioral problems that we see with
individual investors apply in spades with institutional investors.

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 1. High Transactions Costs!

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 Turnover Ratios and Returns!

Figure 13.15: Turnover Ratios and Returns: Mutual Funds

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%

-2.00%

-4.00%
1 (Lowest) 2 3 4 5 (Hghest)

Total Return Excess Return

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 Trading Costs and Returns!

Figure 13.16: Trading Costs and Returns: Mutual Funds

16.00%

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%

-2.00%

-4.00%

-6.00%
1 (Lowest) 2 3 4 5 (Highest)
Total Cost Category

Total Return Excess Return

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 2. High Tax Burdens!

Figure 13.17: Tax Effects at Index and Actively Managed Funds

12.00%

10.00%
Average Annual Return - 1997-2001

8.00%

6.00% Pre-tax return

After-tax return

4.00%

2.00%

0.00%
10 largest active funds 5 largest index funds
Type of Fund

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 3. Too Much Activity!

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 4. Failure to stay fully invested!

Index Funds versus Active Funds: Market Downturns

7/17/98- 10/7/97- 6/5/96- 2/2/94- 7/12/90- 8/13/87-

9/4/98 10/27/97 7/24/96 4/20/94 10/11/90 12/3/87
0.00%

-5.00%

-10.00%

-15.00%
Returns

S&P 500
Active Funds
-20.00%

-25.00%

-30.00%

-35.00%
Downturn

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 5. Behavioral Factors!

 Lack of consistency: Brown and Van Harlow examined several

thousand mutual funds from 1991 to 2000 and categorized them based
upon style consistency. They noted that funds that switch styles had
much higher expense ratios and much lower returns than funds that
maintain more consistent styles.

 Herd Behavior: One of the striking aspects of institutional investing is
the degree to which institutions tend to buy or sell the same
investments at the same time.

 Window Dressing: It is a well documented fact that portfolio managers
try to rearrange their portfolios just prior to reporting dates, selling
their losers and buying winners (after the fact). O’Neal, in a paper in
2001, presents evidence that window dressing is most prevalent in
December and that it does impose a significant cost on mutual funds.

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 Alternatives to Indexing!

 Exchange Traded Funds such as SPDRs provide investors with a way

of replicating the index at low cost, while preserving liquidity.

 Index Futures and Options

 Enhanced Index Funds that attempt to deliver the low costs of index
funds with slightly higher returns.

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 Exchange Traded Funds…!

1993 1994 1995 1996 1997 1998 1993-98

SPDR NAV 8.92% 1.15% 37.20% 22.72% 33.06% 28.28% 21.90%
S & P 500 9.19% 1.32% 37.56% 22.97% 33.40% 28.57% 22.17%
Shortfall -0.27% -0.17% -0.36% -0.25% -0.34% -0.29% -0.28%

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 Mechanics of Enhanced Index Funds…!

 In synthetic enhancement strategies, you build on the derivatives

strategies that we described in the last section. Using the whole range
of derivatives – futures, options and swaps- that may be available at
any time on an index, you look for mispricing that you can use to
replicate the index and generate additional returns.

 In stock-based enhancement strategies, you adopt a more conventional
active strategy using either stock selection or allocation to generate the
excess returns.

 In quantitative enhancement strategies, you use the mean-variance
framework that is the foundation of modern portfolio theory to
determine the optimal portfolio in terms of the trade-off between risk
and return.

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 And many active funds are really enhanced
index funds..!

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 Enhanced Index Funds… The Returns
Promise..!

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 Enhanced Index Funds…The Risk!

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 Conclusion!

 There is substantial evidence of irregularities in market behavior,

related to systematic factors such as size, price-earnings ratios and
price book value ratios.

 While these irregularities may be inefficiencies, there is also the
sobering evidence that professional money managers, who are in a
position to exploit these inefficiencies, have a very difficult time
consistently beating financial markets.

 Read together, the persistence of the irregularities and the inability of
money managers to beat the market is testimony to the gap between
empirical tests on paper and real world money management in
some cases, and the failure of the models of risk and return in
others.

 The performance of active money managers provides the best evidence
yet that indexing may be the best strategy for many investors.

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