The Financial Fortnight That Was - Tuesday 29th January 2008

The sharemarket is the bearpit of capitalism. The sharemarket (and capitalism itself) have proved to be exceptionally resilient - although we have regular setbacks and scares, it seems almost nothing, including the latest sub-prime scare, can knock the sharemarket off its track.

So, why do we insist on investing as though sharemarkets don't work? Why are we always looking for "mispriced" (or undervalued) shares among a market mechanism that has proven itself to be extraordinarily reliable in rewarding investors over time? Why are we always looking to "time" markets - pick and choose when we should be exposed to shares and when not to be - when we know that over the long run sharemarkets have always done outstanding jobs of rewarding investors for the risk they take on?

Active management

What is active management, and why is it investing "against" the market?

The majority of market participants hold a direct portfolio or use a fund manager that has taken positions in a portfolio of stocks they expect will beat the market. Most of these fund managers are engaged in "active management" - taking a position that is different to the average market index in expectation that this will provide a higher return for the investor.

The central principle of all this investing activity is what you might call "investing against the market". It is a form of investing that relies on benefiting from "mispricing" or "undervaluing" of the companies by the market that are selected for the portfolio, and then assumes that these companies will earn a higher future rate of return. One problem with this principle is that it would seem to be extremely difficult among all the fund managers, stock brokers, research analysts and self-directed investors to have some sort of information that would allow any individual to identify an "undervalued" company before anybody else gets the same idea.

The second problem might be called "An Inconvenient Truth", in honour of recent Nobel Peace Prize winner, Al Gore: If the market mechanism does not work perfectly and actually does present undervalued companies, we have to ask ourselves whether there is any guarantee market mechanisms will ultimately work and the company will in due course be properly valued?

The failure of active management

And if the theoretical arguments against "active management" don't immediately convince you then take a look at the evidence! The argument against active management is well supported at a research level. For example we know that:

Actively managed funds have a strong tendency to underperform the average market return. Over the five years to June 30, only three of our 19 largest fund managers beat the index. What's more, the results from our recent managed fund survey is consistent with almost all research on managed fund returns, which found managed funds underperforming the market. (To read the full article, Big-name funds disappoint, click here.)

We know from studies of individual investors that their buying and selling destroys their investment returns. US academics Brad Barber and Terrance Odean have put together a comprehensive data base of individual investor's trades and brokerage accounts. In a paper entitled Trading is Hazardous to Your Wealth, they found that 66,400 US household portfolios earned returns of 11.4%, over a five-year period, where the average market return was 17.9%.

We know that analyst research does not seem to lead to above-average returns for investors. The paper entitled Prophets During Doom and Gloom Downunder by Sarah Azzi and Ron Bird and published in the Global Finance Journal looked at sharemarket analyst recommendations during the period 1994 to 2003. This period was broken into the early strong market up to the year 2000, and then the period of poor returns to early 2003. Their conclusion was that, "overall, analysts' recommendations seemed to provide minimal insight into the better-performing stocks", although the paper did suggest that analysts' recommendation changes might contain some predictive ability.

Dalbar, a US investment firm, produces an annual report that outlines how successful the average managed fund investor in the United States has been. The following graph shows that between 1985 and 2006 the average managed fund investor received a return of 3.90%, against a return of 11.90% from the index. Why is this return so low? Primarily because investors do a terrible job of deciding when to buy into and sell out of asset classes.

When share values are falling, there is a strong tendency for investors to want to sell assets. When share values have risen strongly, the tendency is to want to buy more assets. The results, with the average investor receiving less than one third of the returns on offer from the market, are spectacularly bad! This is another plank in the argument that investors should thoughtfully build an asset allocation and then stick to it!

nManaging to trail the index

How do you invest "with" the market?

The first investment strategy that comes to mind when talking about investing "with" the market is index investing. Index funds simply replicate the market index by holding all the investments in an index in the same proportion as they exist in the index.

This effectively captures the market rate of return for an investor, less some costs. It is my opinion this is the return that every participant in capitalism is entitled to: the market rate of return.

Index investing and the evolution of index funds came out of the body of research broadly entitled "modern portfolio theory", which included contributions by Nobel Prize winners Harry Markowitz and William Sharpe. There is a problem with naming a theory "modern portfolio theory", and that is that the name modern becomes dated very quickly. In truth, modern portfolio theory is based on research that is now 40 years old. Although index funds remain an effective way of capturing the average market return, they are far from perfect. For a start index funds buy "everything" - the good, the bad and the ugly in any index. Moreover, our understanding of how markets work has progressed.

Beyond modern portfolio theory

In the early 1990s University of Chicago Professors Gene Fama and Kenneth French wrote one of the most often referenced papers about sharemarket returns: they showed returns were not only a function of the average market returns; they were also a function of the size of the firm and the "value" characteristics of the firm.

Fama and French's paper showed that small companies had a higher expected return, and "value" companies have a higher expected return.

I have highlighted the term "value". This is because it is a term often used in association with investing referring to companies with low price/earnings multiples, high dividend yields or companies that are deemed to be "out of favour or overlooked and trading at a discount to their true value". In the Fama and French research, value companies were those companies that traded at a price closest to the value of their assets. The three factors that make up the Fama and French model or sharemarket returns are:

The average market return.
The size effect: smaller companies have a higher expected return than large companies.
The value effect: companies with a price closer to the value of their assets have a higher expected return.

This Fama and French research, often referred to as the Three Factor Model, remains the basis of most academic analysis of investment returns. It is the most frequently used model of sharemarket returns that I come across in my reading.

There is more recent research that considers "momentum" as a further source of investment returns. Put simply, momentum is the short-term repeating of performance trends in stocks.

The Three Factor Model applied

Dimensional Fund Advisers is an investment manager that sets itself apart by working with the academic community and apply its research to investments. Dimensional has used the Three Factor Model to build investment strategies that revolve around capturing the excess returns identified by Fama and French that come from holding small and value stocks. The don't try to pick and choose which small and value stocks to invest in, rather they invest broadly in those sections of the market.

The following two graphs show the success of those strategies for the five years to the end of September 2007.

nAustralian

nInternational

Focusing on what matters

When you invest "with" the market - whether through index funds, ETFs or Three Factor strategies - you start to focus on other aspects of investing that are important to having a successful investment experience, including:

Keeping fees low.
Keeping taxes low (our last active managed fund survey showed how much tax was paid from the high levels of income paid).
Having a well diversified portfolio.
Focusing on asset allocation as a key driver of returns.

A commentary on index-style investment options would not be complete without a few comments on their flaws. First, buying into an index fund means that you are buying into a portfolio with capital gains, which is not an ideal solution. And index funds, while having a lower level of trading compared to active managed funds, still have some level of trading as investors come and go from a fund - what we might describe as "liquidity trading".

Nevertheless, the application of the accumulated body of research to investment solutions is worthy of strong consideration as we all search for the "holy grail" of investing: the best risk adjusted returns we can find.