There’s a fairly common way to explain why active investors/managers tend to underperform the index: all investors as a whole will earn the index return as an average, and index investors will also get the index return, so the average performance of all active investors is also the index return. However active managers take higher fees so their average falls below the index return.
It turns out that there may be a catch though, which comes in the form of another common active management complaint. I just saw this today thanks to the latest post in a Million Dollar Journey series about identifying good managers. If you follow the averages a bit further it looks different because, as we all know, a lot of fund managers are really just tracking the index to varying degrees. Some are virtually identical while others looks different but have similar performance.
If the average active manager underperforms the index after fees, and a large percentage of funds track the index closely and end up falling in the same range or below, they may be counter-balanced by a category of funds that look different and have better performance. The blog post linked above cites a study which appears to identify such a group, saying “Of the funds that had only 0-20% of their holdings in common with the index, the average fund beat the index.”
This may make sense and might even hold together if there is a large enough group of funds outside this category that counterbalance it with worse returns to maintain the average. However one study is not enough to demonstrate this; it could just be a coincidence in a certain time period or region. It seems more likely that the closet-index funds stay close to the average under-performance and funds that deviate further from the index have a wider range from losing it all to winning big.
As Jeremy Grantham frequently points out under the name of “career risk” this is exactly why there are so many closet-index funds; as long as the manager doesn’t fall too far behind the market their job is safe. The only ones that have a hope of delivering real value are just a few unlucky years away from getting kicked out unless they protect themselves. The series does point to some other ways to identify good fund managers including looking at whether they are committed to their strategy for the long term, but it’s no easy task (in fact it sounds like more work than stock picking). As a simple measure, looking for a fund manager that’s different from the index hasn’t been proven to be enough yet.
Two of the hot investing topics for the last 5 years have been emerging markets and commodities. As we all know, when you buy a Canadian stock index you’re getting a fair bit of commodity exposure. A new post on Canadian Capitalist shows how a little experimenting revealed that Canadian equities have also historically had a correlation to emerging markets (obviously with a few less 100% gains).
I’m not into commodities but for the last couple of years I have at times thought about how I could approach emerging markets and whether they’re worthwhile. In addition to the usual investing risks they feature such fun things as large legal/regulatory risks, different accounting standards, and simply not knowing what’s really there. They also have a history of shutting down stock markets which we haven’t seen in North America. If there is a safer way to profit from them that could be very attractive.
Emerging markets will put up really big gains now and then, but for something with more transparency and less risk you might be surprised to find that a plain old Canadian index can give you exposure! Conversely you shouldn’t think that you’re diversifying by buying the company the drills the oil and the company that burns it.
It’s not hard to write the story for the connection. It could be as simple as saying that growth in emerging markets fuels demand for commodities, which causes Canadian resource stocks to do well. In fact they may be more closely linked to emerging market GDP growth than actual emerging market stocks. For many reasons GDP in a country does not necessarily translate to profits for public corporations in that country but the misconception may has driven many investment decisions.
It’s not all that simple – as the excellent book Debunkery shows even a small difference in correlation can be used to get added returns – but generally informed investors may be making a mistake similar to someone who doesn’t care about their investments and buys 5 funds covering the same market if they aren’t aware of things like this. Of course this is based on historical correlation (and not even over 10 years) so it’s not guaranteed.