Open Philosophy of Indexing with ETFsPosted 06/19/2009, 12:00 am EST by Will McClatchy from ETFzone.com
Frequently ETFs are criticized for because uneducated investors use them inappropriately. The basis of the charge is undeniable. Some investors misuse ETFs to their own misfortune. But the conclusion is a vast leap in logic. People also misuse cars. Should we revert to the horse and buggy?
ETFs represent an undeniable leap forward in convenience and efficiency, when used appropriately. Rather than trying to turn back time, we think it more helpful to educate investors to select ETFs appropriate to their situation and goals. We advocate an open, but critical-thinking philosophy of indexing.
Indexing is the practice of buying a basket of stocks or bonds to represent an asset class. It avoids picking individual winners and instead buys the market. Passive indexing is a quiet version which buys and holds traditional indexes. Active indexing is a dynamic version which typically involves frequent trading. There are plenty of combinations of the two.
For most busy individual investors, passive indexing is the way to go. For professionals and sophisticated individual investors with time on their hands, active indexing makes more sense.
What unites all indexers (including all ETF investors) is their avoidance of individual company stocks. Competition makes it quite difficult to beat a market by picking stocks within it. Large, publicly traded stocks especially are thoroughly researched and analyzed by tens of thousands of professional investment managers and millions of individual investors. It is the rare individual investor who can consistently outwit professionals using the same publicly available information. While academics may debate theories of how efficient markets may be, no one denies they are competitive.
Repeated studies of actual stock market and fund returns shows that fund performance is overwhelmingly a function of selection of asset classes (i.e., indexes). Performance, whether good or bad, is primarily due to the kinds of stocks chosen (large or small companies, US or foreign, stocks or bonds). It is only marginally due to selection of individual securities within an asset class (Citibank vs. Bank of America).
Other repeated studies have demonstrated that past performance by a stock-picking investment manager gives little indication of future performance. A slight majority of outperforming funds typically continue to outperform the market for a quarter or two, but beyond that only about half do. This is what one would expect if one flipped a coin.
Active indexing typically involves frequent trading and allows higher performance with greater risk. Passive indexing, or buy-and-hold with only occasional rebalancing, ensures middle-of-the road performance and rock bottom costs and effort. While many investors refer to indexing as exclusively passive and individual company stock picking as active, this definition ignores the many investors who trade indexes frequently.
Whether active or passive, every investor should look out for bubbles and act accordingly, in our view. By bubbles we mean historically extreme valuations. Bubbles are easy to spot: price/earnings or price/book value for certain asset classes are far from historical norms, and respected investment managers overwhelmingly warn of overvaluation. Bubbles are never hidden, and all can be avoided by running to cash with only the risk of opportunity cost.
The thoughtful ETF investor, whether active or passive or a bit of both, welcomes ETF investors with other types of philosophies. It is the critical mass of millions of investors which allows ETFs to be traded so easily and to exist at such low cost. Different views are ultimately good for everyone. The goal of the investor, in this open philosophy of indexing, is to pick the most appropriate strategy for their skill and temperament and to deploy it steadily and with common sense.
Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.