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Volatility and Indexing
Controlling surprises in turbulent markets
Investing icon Warren Buffett famously said, "You can't tell who's swimming
naked until the tide goes out." That is, the flaws in a portfolio are difficult to spot
in rising markets, but become alarmingly apparent when things go bad. Many
investors were caught naked this summer as some pedigreed professionals —
including hedge fund manager Sowood Capital, bond managers in Bear Stearns
Asset Management, and mortgage giant Countrywide Financial — fell fast and far.
Could this shock and embarrassment have been avoided?
No investment strategy or portfolio is immune to volatility. However, investors
can easily take precautions that can help work to prevent the worst surprises — the
naked on the beach variety. We believe that one of the best protections is the
disciplined use of index investments.
Surprises not included
When you buy an index — as an ETF or mutual fund — you generally get a basket
of securities with some common thread, such as market cap, style, geography,
etc. When you own the Dow Jones Industrial index (DIA), for example, you get
the return on the 30 stocks that comprise the index.
Indexes offer easy diversification, easy trading, and an easy way to match market
performance. But perhaps much more important than what you get with an index
is what you don't get:
- Style drift — Active managers, in search of better performance, can stray
from their stated missions. Value investors may become growth and
momentum players, or vice versa. Even the estimable Bill Miller, manager
of the $10 billion Legg Mason Value Prime Trust (LMVTX) lists Google
and Amazon among his top 10 holdings. Good investments perhaps, but are
they value stocks? Possibly the most egregious example of style drift was
Long Term Capital Management, which started out as a market neutral
hedge fund and ended up as a 100 to 1 leveraged one way long bet on
stocks and bonds (see When Genius Failed by Roger Lowenstein).
- Whiplash and knee jerks — When managers try to rebound from poor
results, they may make radical moves that are even worse. In the money
management race the only thing harder than staying ahead is catching up
when behind. Often, a higher level of risk is adopted to catch up, when
adherence to discipline would be the better choice. Above average portfolio
turnover is an early indicator of a manager susceptible to whiplash.
- Market timing — Indexes are immune to one of the greatest (and least
productive) temptations facing investors and money managers — trying to
buy before the surge, and sell before the plunge.
- Surprises — Indexes are pure WYSWYG. The investment tracks the index,
period.
- Pointless apologies — When performance falls short, active managers will
sometimes express regret to reassure investors, or attempt to explain away the results: "This was a 27 standard deviation event." With indexes, there are no judgment errors to apologize for or explain.
- Black boxes and opinion-based investing — Indexes are transparent,
understandable, rules-based, accountable, and reinforced by market pricing. There's no man (or machine) behind the curtain making subjective
decisions on fund content.
- Tax shock — The minimal movement of stocks in and out of indexes limits
tax consequences, in contrast to active managers who may trigger significant unexpected tax liabilities through frequent buying and selling.
- Needless costs — Low or no turnover means low transaction costs for index
investments.
- Fads — Owning an index eliminates any concern that one's money manager is chasing "the next big thing," which typically isn't.
- Overexposure — As most indexes track hundreds or thousands of securities, they limit exposure to one-company collapses such as Enron.
Be like Harvard
Indexing can be compared to a college dorm with a curfew (continuous mark to
market), rules (the prospectus), lights out (trading on a listed exchange during
market hours), and no funny stuff (the SEC is watching; penalties can include
criminal, not just civil charges). Because of its many benefits, indexing is not just
for individuals. Harvard's endowment, which has preferred access to any
investment vehicle, indexes 30% of its massive $35 billion portfolio, according to
Mohamed El-Arian, president and CEO of Harvard Management Co., the
endowment's manager, as reported by Bloomberg on December 14, 2006.
Keep your suit on
In the months ahead, we expect to see more naked and bewildered swimmers on
the beach. As described above, there are many ways to be surprised when the tide
goes out. Fortunately, we believe indexing mediates or eliminates many of these
unpleasant possibilities.
To be sure, choosing among the 500+ index vehicles demands care and discipline,
with intense attention to asset allocation. Indexing is an important tool in all client
portfolios at Osbon Capital Management — typically representing the majority of
investment assets. My advice to all investors is simple: index a portion of your
portfolio. And relax at the beach.
John Osbon, Chief Investment Officer
October 2007
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