August 18, 2009
INDEXING & TIPS: THE SAME OLD STORY
Last week, The Wall Street Journal published a story explaining why Pimco, the behemoth bond fund manager, believes active management is preferable for running a portfolio of TIPS, or inflation-indexed Treasuries. According to the article, "Pacific Investment Management Co….says that while indexing may work wonders in the stock market, with TIPS it often leads to missed opportunities and hidden costs." Meanwhile, you can find Pimco's research paper that inspired the article here.
Some commentators have picked up on the article and announced a variety of revelations to the masses, ranging from the idea that investing in TIPS is somehow different compared with owning conventional bonds and even stocks to allegations that the Journal story highlights a new smoking gun in the case against indexing.
Nonsense. Nothing's changed, even if the article suggests otherwise. Indexing is no more or less persuasive today vs. last year, for TIPS or any other asset class. The evidence begins with the fact that the long-term record speaks for itself, which boils down to the reality that beating the market is still very difficult over time.
Yet let's be clear: In an efficient market, there'll always be winners and losers relative to a germane benchmark. No indexer disputes that. But it's also true that alpha—delivering a return that's something other than the benchmark—sums to zero over time. This is basic fact is immune to debate. In other words, for every investor who beats the market, the index-beating results must come from other active managers who trail the market. There'll always be winners and losers, and in the middle, more or less, is a relevant index.
Professor William F. Sharpe outlined the details in a paper some years ago and The Arithmetic of Active Management remains essential reading for every investor, if only to provide a sober assessment of how money management operates regardless of your personal decisions. Sharpe sums up the lesson this way: "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."
Managing a portfolio of TIPS, or any other portfolio, doesn't jettison the arithmetic of active management. Any one manager may beat the odds, or suffer profoundly at the opposite extreme, but as a general rule Sharpe's arithmetic of active manage is enduring.
The idea that there's something different or special about inflation-indexed Treasuries doesn't stand up to the historical record. As one example, consider that for the five years through the end of last month, there were 25 distinct funds (mutual funds and ETFs) with trailing returns over that stretch, according to Morningstar Principia. The returns ranged from a low of 3.12% to a high of 5.27%. How has one of the leading index funds in the niche fared over that period? About where you'd expect a reasonably designed benchmark to be: in the middle. Actually, the iShares Barclays TIPS ETF (TIP) has delivered a bit better than average, posting a 4.64% average annual return for the five years through July 31, 2009.
Similar stories prevail for each of the major asset classes. The point here isn't that talented active managers don't exist. They do. Nor is our argument that investors should avoid active managers at all times. Pimco and many other investment shops offer valuable services to investors. Yet it's also clear that not all active managers are created equal, and even the good ones can charge excessive fees that take a toll over the long term. In short, using active managers introduces an additional layer of complication. That starts with the devilishly difficult challenge of identifying market-beating managers in advance as a long-run proposition. If you're going to pick an active manager, you'd better have a sound reason for doing so, which generally means doing a fair amount of proprietary research.
In fact, there's an even bigger problem with active management, and it's an issue that's widely overlooked. Namely, buying a mix of active managers to flesh out an asset allocation that approximates a globally diversified multi-asset class portfolio creates a number of hazards that aren't obvious when considering active management piecemeal. We'll be discussing the details in the upcoming September issue of The Beta Investment Report. As a preview, the best-case scenario value proposition for owning one actively managed fund fades as you expand the portfolio into additional asset classes.
Yes, indexing generally offers middling performance in the long run, and there's no escape from that future. For some, that's a reason to avoid index funds. In fact, that's the great strength of indexing, even if the details of why that's so are routinely lost in the story du jour and the rush to identify the market-beating fund in isolation of a broader portfolio strategy.
Indeed, the primary challenge for strategic-minded investors is one of designing and managing a mix of asset classes. You can triumph on that front with active managers, but it takes quite a bit more work than doing the same with index funds. Even more problematic is the risk of picking the wrong active managers. That may not be a challenge for the talented few who excel in asset allocation, but for the rest of us there's reason to wonder if we can manage the asset allocation intelligently and routinely pick an array of market-beating active managers.
Posted by jp at August 18, 2009 11:42 AM