Question of the Month

I'm a new subscriber, and am somewhat confused by your views on indexing versus active management. You really don't seem to be in one camp or the other. Could you please explain?

As we like to say, experience has taught us not to be ideologues when it comes to this debate. As a practical matter, our base case view is that, for long-term investors, indexing makes the most sense. Successful active management ultimately comes down to successful forecasting. In turn, this depends on having access to superior private information about a security or asset class, and/or using a superior model to analyze publicly available information. Over a long-period of time, superior sources of private information are hard to sustain, and models lose their effectiveness due to either copying by competitors or changes in the economy that invalidate their assumptions. This is why, as the length of time is extended, a geometrically smaller proportion of active managers have been able to outperform the relevant index fund. There is a reason people like Warren Buffett are so well known: their skills are incredibly rare.

However, there are four important exceptions to our general rule that, for investors with a long time horizon, indexing makes the most sense.

The first exception is that, over the course of an investing lifetime, almost everyone will come into possession of superior private (which is different from illegal) information, that creates the opportunity for an active management success. For example, an investor may be aware of different developments in her industry that lead her to conclude that the market as a whole is underestimating its future growth rate, which should soon accelerate. In this case, she might allocate a portion of her portfolio to an exchange traded fund that tracks the industry, and watch its returns outperform the overall market index over the next year. Of course, this also raises the point that successful active management also requires knowing when to sell, realize one's profits, and reinvest them back into index funds. In essence, two forecasts are involved: one that says it is time to buy, and one that says it is time to sell. Active opportunities like the one just described don't happen very often for most people. In addition, if your superior information is limited to developments at your own company about which the public is unaware, you run the risk of committing the crime of insider trading if you trade your company's shares rather than a broader ETF.

The second exception is one we have frequently written about: bubbles, or, more technically, situations in which one or more asset classes appear extremely overvalued. When these situations occur, and when the asset class in question is well above its target weight in your portfolio, prudent risk management demands that you make an active management decision to reduce your allocation to well-below its target weight.The purpose of our Asset Class Valuation Update section is to help investors make these decisions.

The third exception to our preference for indexing is an asset class (e.g., timber, or, in some regions, foreign currency bonds) where no indexed investment vehicle is yet available.

The fourth exception is the most challenging. We know that in hindsight, it is possible to identify rare human beings like Warren Buffett who are truly skilled active managers. But hindsight is not foresight. We also know that it is next-to-impossible to identify tomorrow's Warren Buffett with any confidence (in the statistical sense of a significant T-Ratio test). Under these difficult circumstances, an investor might still rationally choose to allocate a portion of his portfolio to actively managed funds, based on his subjective evaluation of an active manager's skills. Such evaluations are inherently uncertain, since superior past performance, in most asset classes, has been shown to be of no use in predicting future superior performance (though private equity has, in the past, been an exception to this rule). In addition, these allocations to active management should logically be focused on funds that attempt to deliver returns that are uncorrelated with the returns that can be earned by investing in asset class index funds. Technically, these are funds whose objective is to produce "uncorrelated alpha." In contrast, traditional actively managed funds deliver a mix of overall asset class returns (technically known as "beta") and alpha. However, an investor can obtain the asset class returns more cheaply by buying an index fund. He or she should only pay higher fees for returns that are not only above those on index funds, but also uncorrelated with them (because such returns add the most diversification benefit to a portfolio).

Our target return model portfolios with equity market neutral funds take this exception into account. They allow for an allocation of up to ten percent of the portfolio's assets to investments in equity market neutral funds whose objective is to deliver uncorrelated alpha through superior security selection. As we have discussed in our writing, another approach would be to use so-called "global macro" funds, which attempt to deliver alpha by shifting investment allocations to different asset classes over time.

As you can see, we are definitely not rigid ideologues in the indexing versus active management debate. Rather, our objective is to highlight how each approach can best be used by an investor.

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