As the public grows increasingly familiar with “passive” or “index” investing, it’s becoming easier for individual investors to gain cost-effective exposure to globally diversified market returns. That’s good news! Even better news is that there is a similar approach we employ for our clients that incorporates the many strengths of passive/index investing while eliminating some of its inherent weaknesses. Beyond passive, we call it evidence-based investing or EBPI. More than any other approach, we feel it rigorously incorporates available evidence on how markets have delivered long-term wealth to patient investors.
A Brief History of Indexing
To understand how EBPI works today, it’s helpful to review where it came from. Before there was any form of passive investing, there was active investing. Active investors try to profit by predicting where and when they’re going to experience future gains and losses, and proactively trade in and out of securities, sectors or markets to stay one step ahead. While the idea may seem appealing, there are reams and decades of academic evidence demonstrating that the tactic simply doesn’t reliably work, especially after factoring in costs.
In the early 1970s, the first index funds were formed to offer investors a better choice. As the name implies, an index fund buys and holds the securities tracked by a particular index, which is seeking to reflect the performance of a particular asset class. For example, the earliest index funds tracked the popular S&P 500 Index – which in turn tracks the asset class of U.S. large-company stocks. Over time, additional index funds (and similar Exchange Traded Funds, or ETFs) have emerged to track a host of other indices, representing a wide range of asset classes.
Many index funds are well-suited alternatives to actively managed funds, offering tighter control over the actions that academic evidence indicates are critical to expected outcomes:
Asset allocation – How you allocate your portfolio across various market asset classes plays a far greater role in varying your long-term portfolio performance than does the individual securities you hold.
Global diversification – Through broad and deep diversification, the sum of your whole risk can actually be lower than its individual parts.
Cost control – The less you spend implementing a strategy, the more you get to keep.
Inherent Weaknesses in Index Investing
So far, so good. But there are at least a couple inherent weaknesses to index funds.
Index Dependency – Most index funds are generally cost-effective compared to active strategies. But, by definition, they track an index. Whenever that index “reconstitutes” by changing the underlying stocks it is following, the funds tracking it must do so as well – and quickly. In a classic display of supply-and-demand pricing, this generates a buy high, sell low environment as index fund managers must queue up to simultaneously sell stocks that have been removed from the index and buy stocks that have been added.
Compromised Composition – Asset class investing is based on the premise that particular market asset classes exhibit particular return characteristics over time. For example, academic evidence has demonstrated that the stocks of distressed, small-companies are perceived as riskier than stocks of thriving, large-companies. So investors demand – and have by and large received – a premium return for investing in these riskier factors.
An index seeks to accurately proxy the asset class it is targeting. But it’s still just a proxy. The S&P 500, for example, tracks only 500 U.S. large company stocks out of the more than 16,000 large companies counted in the 2010 U.S. Census. Tracking an index enables pretty good exposure to a targeted asset class, but there’s room for improvement by a fund manager who can capture a larger, more accurate representation of the asset class being targeted.
The Advance of Evidence-Based Investing
It didn’t take long before academically minded innovators from around the globe sought to improve on the best traits of index funds and eliminate their weaknesses. In fact, many of these thought leaders were the same early adapters who introduced index fund investing to begin with. The results are evidence-based investment funds, which offer us several advantages:
Index-independence – EBPI fund managers have freed themselves from tracking popular indexes. Instead, they have established their own parameters for cost-effectively investing in the lion’s share of the securities within the asset class being targeted. This reduces the need to place undesirable trades at inopportune times simply to track an index; it allows them to employ more patient trading strategies and scales of economy to achieve better pricing.
Improved Concentration – Untethering themselves from popular indexes also enables EBPI fund managers to more aggressively pursue targeted risk factors; for example, an EBPI small-cap value fund has more flexibility to hold smaller and more value-tilted holdings than a comparable index fund. This provides us with more refined control as we construct clients’ portfolios according to their individual risk/return goals.
A Final Word: Investor Behavior
In many respects, the most important factor driving your investments has nothing to do with market factors. It has to do with your state of mind. To build or preserve sustainable wealth in ever-volatile markets calls for a disciplined outlook based on: (1) adhering to a long-term plan, (2) managing market risks and (3) minimizing the costs involved.