Index funds are a flawed idea and savvy investors can take advantage of the anomaly.
Index funds must buy the pieces of the index regardless of their investment value. Back in the late ’90s, a few Canadian stocks made up a huge share of the index value. Nortel, JDS Uniphase, and Bell could move the index of 300 stocks all by themselves. And did.
In 1998 the index was up 30% but if you took out Bell and Nortel the “TSE 298” was up just 6.5%. That anomaly caused some grief for savvy managers. They could not come close to the index returns and customers were less capable of seeing why. By mid 2000, Nortel represented over 35% of the index value. There is little upside from there. 8 years later it represented 0% of the index value. JDS did little better. Bell has recovered. The managers who owned the TSE 297 in 1999 are back on top.
The lesson is you cannot trust rule-based systems under all conditions. Sometimes the context is outside the span of the rules.
The flaw in the index fund idea is that the fund must buy the pieces. Even if a piece is clearly hyped, they must buy proportionally. As money flows toward index funds, the demand for these stocks becomes artificially high. Nothing to do with value, just hype. The index rises. A bubble if you will.
That is where the savvy investors will do okay. Savvy investors like market inefficiencies. They will not own the overpriced stocks in the index and may even be short. If a stock blows up while in the index, the push from sellers will be artificially large to the same extent as the demand to buy was artificially large. Active managers are not bound to behave in a certain predictable way and they will win even though their costs are a bit higher. You don’t need many big winners or avoided losers to beat the index.
So what to do? Index funds work well enough for the non-savvy investor. The ones who cannot determine a company’s value or who do not understand how the market prices businesses. Index funds, however imperfect, are likely better for them than being left to their own devices. They are emotionless.
Index funds are like autopilot and they work fine most of the time. Sometimes though, an airplane pilot must disengage the autopilot to land or takeoff or because weather conditions are extreme. Or the engines just ingested a flock of geese.
Chesley Sullenberger is required to land a plane in the river. No autopilot can do that. Seasoned managers will beat indexes when clear skies disappear.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
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