KEY POINTS:
One of the key decisions to consider before anyone contemplates an investment plan is whether to use an active or passive investment strategy, or some combination of both.
At the risk of grossly simplifying things, active management involves paying a fund manager to use his or her skills to pick stocks, bonds or whatever with the aim of outperforming the return of the market as a whole.
A passive strategy, in contrast, has a lower annual fee structure and uses a rule-based computer programme to buy the entire market on the basis that the amount of each company you own is determined, most often, by the relative size of the company, bond etc.
For example the TeNZ index fund, which tracks an index of the 10 largest stocks on the NZX, has big weightings in Telecom and Contact because they are the biggest stocks by virtue of their value.
Internationally index funds have grown enormously in popularity in the past five years, especially with the advent of exchange traded funds, or ETFs. An ETF is a managed fund listed on the stock exchange which pays dividends and trades like a stock.
Virtually all ETFs are passive funds and they have been popular in the US and Europe with both institutional and retail investors, frequently appearing as the most traded securities each day on the NYSE.
There are an increasing number of variations of the passive strategy, whereby the weightings to each stock are determined by, among other things, the market value of the company, the value of its sales, dividends, etc.
Besides the broad market trackers, you can just about get exposure to any market niche you like with an ETF from technology stocks with a focus on multimedia networks to blue chips listed on the Austrian stockmarket, to short-dated US government bonds and a lot more.
Whether this specialisation is an advantage or not to mum and dad in light of the benefits from diversifying as widely as possible is debatable.
The theoretical background to indexing by value is that at any point in time the "market" represents the best guesses of all market participants, including insiders like directors, executives and fund managers. As new information becomes available, not necessarily publicly, the market adjusts. For this reason it is hard to "beat the market".
Which approach is best, active or passive, depends upon who you listen to but what is pretty clear is that passive strategies generally have a big advantage by way of lower annual fees, except perhaps in New Zealand where unfortunately some of the more popular index funds have higher annual fees than some actively managed funds overseas.
Not surprisingly active fund managers maintain that they deserve to be paid more because they can beat the market, particularly when shares are falling, as has been the case of late.
This claim, beating the average in a bear market, is one of the key selling propositions of active managers, and it does sound intuitively correct that when an active manager sees that the market is trending down, he or she can move the portfolio to cash or defensive investments.
In contrast, a passive fund must remain fully invested come hell or high water. But as we know, the investment world is full of contradictions. So while common sense might suggest that one strategy would be successful, reality is that the opposite course of action actually works in practice.
In an October 2008 study the world's largest index fund manager, Vanguard of the US, looked at the relative performance of active share fund managers in declining markets. Using a Morningstar database of every equity oriented managed fund in the US and Europe, Vanguard compared the performance of each fund to its relevant benchmark index in six bear markets in the US since 1973 and five bear markets in Europe since 1990.
Vanguard analysts concluded: "Despite the bias towards survivors, we observe that a majority of active managers outperformed the market in just three of six US bear [down] markets and in two of five European bear markets. In each bear market, funds existed that successfully outperformed the broad market. However, these results indicate a lack of consistency with respect to the success of active funds in general."
Let's look a bit closer at the Vanguard study. It found that despite measuring the performance of only those managed funds which stayed in business (one presumes that those that didn't stay in business probably underperformed, thus potentially biasing the results upwards), US managed funds were only able to outperform when the market was falling half of the time. In Europe, managed funds only outperformed in bear markets 40 per cent of the time.
Vanguard then looked at whether those funds that outperformed in one down market did so in other down markets. Alas, success generally did not carry over from one bear market to the next and that, statistically, success in one or two bear markets may have been simply due to luck.
Vanguard analysts then looked at how those fund managers that outperformed in down markets adapted to rising (bull) markets.
The study found that those funds that did well in a bear market did so because they were defensively positioned, which is great news in a bear market, but proved a drag on performance when markets started rising again.
The lesson being that it is hard to call the bottom or the top of the market. So that's the gospel according to St Vanguard.
Back in New Zealand, our choice of locally oriented, low-cost exchange traded index funds is limited not only by what's on offer but also in terms of who buys them.
In two weeks' time we will take a closer look at New Zealand's modest contribution to the ETF revolution and speculate as to why ETFs are big in the US, Europe and the UK but not, so far anyway, in New Zealand .
* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
