Thursday, 6 September 2007

Index Investing Imperfection

A new blog, Behavioural Investing, by author and investment industry professional James Montier has a worthwhile post titled Something the Bogleheads wouldn't want you to know, or index investing isn't passive. The posting reviews a research article called Index Rebalancing and Long Term Portfolio Performance by Cai and Houge. Montier's provocative headline (are the adherents of John Bogle annoying people and causing others to want to poke holes in their balloon?) states that indices such as the S&P500 and the Russell 2000 are not passive. Well, that turns out to be merely a reflection of the fact that companies are added or dropped from the index on a regular basis. Big deal, that's what an index is. The important point is that better returns and lower risk could have been achieved merely by buying and holding the original members of the index. Montier cites another paper by Siegel and Schwartz, The Long-term Returns on the Original S&P 500 Firms, that finds the same thing as Cai and Houge.

The challenge now is turning that research result into a practical investing strategy. Buy and hold is obviously the core of such a strategy as Montier says at the end of his post. But what exactly to buy and hold? An individual, Warren Buffett aside, cannot buy all 500 stocks in the S&P 500. I haven't come across any Exchange Traded Funds out there that implement the ultimate buy and hold. In the meantime, those index ETFs still seem to be the best available practical investment vehicle. Little is ever perfect, even index investing, which is an encouraging thing since that means there's always room for improvement and it is worth the effort to find those improvements.


Mr. Cheap said...

Interesting post and the link to the new blog (I'm definitely adding him to my reader).

FourPillars said...

Interesting post - and very short by your standards :)

So their research says that keeping the companies that fell off the index is better than switching those companies for the new companies on the index?

Intuitively I have a hard time believing this since companies fall the index for a reason.

On the other hand I suppose there are a certain percentage of new companies on the index which are "up and coming" and end up flaming out. If their data encompassed the dot com era then this might help their conclusions.


Outroupistache said...

Yup, your guess is right FourP. They found that companies entering the index tended to be over-valued while those leaving the index were under-valued, leading to the respective later poor performance that dragged down the index returns for the former and the other way round for the latter.

Yes, dot-com tech companies were among those in the period studied but the paper authors point out (p.19) that the S&P 500 selection committee actually turned down at the time a number of the no-revenue/profit companies with enormous market caps, though some got through.

Here is what they say:
''The underperformance of the continually updated S&P 500 Index is due to the overvaluation of
newly admitted firms, which have been caused by the cyclical fluctuations in investor sentiment and
price pressures exerted by indexers.''

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