There are no pure index investors

[November 20, 2014]  By James Saft

(Reuters) - At the heart of every great movement, and index investing is no different, lies a kernel of truth surrounded by a great deal of hooey.

I’d argue that index investing, the practice of eschewing active stock or bond picking in exchange for a cheap and cheerful return close to that of a given index, has done more good for investors over the past 40 years than any other idea.

The big lie about being an index investor, however, is that it is possible to be one in a pure sense, as opposed to an investor who uses indexing as a tool.

There are no pure indexers: everyone, like it or not, is an asset allocator, or asset picker if you prefer.

“The reality is that there is only one true index and that is the index that represents all of the world’s outstanding financial assets. In other words, there is, at the aggregate level, just one portfolio,” Cullen Roache, a money manager at Orcam Financial, writes.

“If you were actually passive you would ‘take what the market gives you’ and you would never deviate from this portfolio. But that’s not what most investors do. Most of us deviate from global cap weighting by necessity, thereby rendering us all asset pickers of some sort,” he adds. (http://pragcap.com/)
 

Think about it: when you choose to put money into a given index fund, you are choosing that index at the expense of all others. Take an S&P 500 fund and you eliminate a huge swath of U.S. publicly traded companies, not to mention everything outside the U.S.

Even for those who try to put together a package of index funds, mixing equity and debt products, the result inevitably makes bets on given asset classes or sub-classes. There may be good reason for this; after all someone who is U.S. dollar based and saving for retirement may wish to hedge their future dollar liabilities by investing heavily in U.S. dollar-denominated assets. That’s a consideration and may well be a wise move, but it is, ultimately, an asset allocation, an active decision.

The most important thing in this context is first to be honest with yourself about what you are actually doing. That’s almost certainly using indexing as a good and low-cost means to achieve a measure of diversified exposure to major asset classes. The second issue, and here is where many go wrong, is to understand what you are paying for.

THE GLOBAL ONE-STOP PORTFOLIO

The good news is that something close to the Platonic ideal for index investing does exist, but only as an idea. Ronald Q. Doeswijk and Trevin Lam of Rabobank and Laurens Swinkels of Norges Bank Investment Management last year published a paper on what they call the Global Multi-Asset Market Portfolio.

In it, the authors weigh up and construct an index based on the investible global assets in the following classes: equities, private equity, listed and unlisted real estate, high-yield bonds, emerging-market debt, investment-grade credits, government bonds and inflation-linked bonds. (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2352932)

Interestingly, as of 2012, equities are only 36.3 percent of global assets, with bonds taking up another 55 percent or so and private equity and real estate the remainder.

The problem, of course, is that it is impossible to get mirror exposure to this global portfolio, though it can be used as a base against which to construct or benchmark your own.

Roache did some tweaks to the global portfolio and backtested it to 1985, getting some fairly impressive results. Compound annual returns were 8.7 percent, not as good as the 9.5 percent from a classic 60/40 stock/bond portfolio, but with considerably better risk characteristics.

Clearly, that beats the heck out of a strategy which has a typical active stock picking fund at its heart. There you are likely to get a closet index, a fund which makes some bets against the index but which charges you fat fees for all of your money rather than something like a risk-adjusted charge for those services actually rendered.

The realization that you can’t just index often drives would-be investors into the arms of financial advisors who charge considerable fees for making those active choices, and often shepherd investors into higher-cost means of executing a given strategy.

Understanding that indexing is a tool rather than a religion is a good first step in avoiding that kind of nonsense.

(At the time of publication James Saft did not own any directinvestments in securities mentioned in this article. He may bean owner indirectly as an investor in a fund. You can email himat [e-mail] and find more columns at http://blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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