Index Investing    A cost effective approach to long term investing ...
                                                                        Table of ContentWork Cited.……………………………………………………………...
                                                                                           Works CitedBogle, J. C. (1997)....
                                                   ‐ 1 ‐ Abstract:In this paper, I will examine the work of some of the mo...
                                                  ‐ 2 ‐ Introduction:       Index investing provides a cost effective way ...
                                                ‐ 3 ‐        There are number of well known economists who have done signi...
                                                 ‐ 4 ‐ Allocation strategies based on market cycles:       One of the skil...
                                                    ‐ 5 ‐ any specified time period, the market return will be a weighted ...
                                                   ‐ 6 ‐ than a quarter of it, leaving less than three-quarters of the ret...
                                                  ‐ 7 ‐        Bogle conducted research on the last 20 years of S&P 500 in...
                                                   ‐ 8 ‐        Turnover refers to the selling and buying of securities by...
                                                 ‐ 9 ‐ consumed an estimated 2.5 percentage points of its annual return, r...
                                                 ‐ 10 ‐        There is another behavioral explanation for active investin...
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Index investing

  1. 1.         Index Investing A cost effective approach to long term investing  Syed Zillur Rehman  
  2. 2.        Table of ContentWork Cited.……………………………………………………………………………………….iAbstract………………...………………………………………………………………………....1Introduction……...……………………………………………………………………………….2Burton Malkiel’s support for Index Funds….....……………………………………………....3Allocation strategies based on market cycles……...…………………………………………...4William Sharpe’s Arithmetic Approach…………..……………………………………………4Bogles’ Cost Matter Hypothesis………..……………………………………………………….5Returns in terms of Real Interest Rate and Compounding Interest………………………….6Performance analysis of Mutual fund vs Index Fund ………………………...………………7Portfolio Turnover……………………………………………………………...………………..8Tax Implications………………………………………………………...……………………….9Behavioral reasons for active investment…………………………..…………………………10Conclusion ……………………………………………………………………………………...10
  3. 3.        Works CitedBogle, J. C. (1997). The First Index Mutual Fund: A History of Vanguard Index Trust and the Vanguard Index Strategy. Retrieved 08 08, 08, from Bogle Financial Market Research Center: http://www.vanguard.com/bogle_site/lib/sp19970401.htmlBogle, J. C. (2004). As The Index Fund Moves from Heresy to Dogma...What More Do We Need To Know? Retrieved 08 08, 2008, from Bogle Financial Markets Research Center: http://www.vanguard.com/bogle_site/sp20040413.htmlBogle, J. C. (2005). In Investing, You Get What You Dont Pay For. Retrieved 08 08, 2008, from Bogle Financial Market Research Center: http://www.vanguard.com/bogle_site/sp20050202.htmBogle, J. C. (2005). The Relentless Rules of Humble Arithmetic . Retrieved 08 08, 2008, from Bogle Financial Markets Research Center: http://www.vanguard.com/bogle_site/sp20060101.htmBogle, J. C. (2007). The Little Book of Common Sense Investing. Hoboken: John Wiley & Sons.French, K. (2008). Kenneth R. French - Home Page. Retrieved 07 31, 2008, from Social Science Research Network: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1105775French, K. R. (2008). The Cost of Active Investing. Journal of Indexes , 50.Malkiel, B. (2003). A Random Walk Down Wall Street. New York: W. W. Norton & Company, Inc.Sharpe, W. F. (1991). The Arithmetic of Active Management. Retrieved 08 08, 08, from Stanford University: http://www.stanford.edu/~wfsharpe/art/active/active.htmSharpe, W. F. (2002). Indexed Investing: A Prosaic Way to Beat the Average Investor. Retrieved 08 08, 08, from Stanford University: http://www.standford.edu/~wfsharpe/art/talks/indexed_investing.htm
  4. 4.   ‐ 1 ‐ Abstract:In this paper, I will examine the work of some of the most notable and leading economists insupport of index based investing, also knows as passive investing. I would like to point out thatthis paper is intended for average investors but, the logic is equally applicable to anyone withlong term investment objectives. I will define the meaning and the origination of index funds, itstransformation from a simple theory to an efficient investment vehicle, and its lower costimplication in comparison to mutual funds. Subsequently, I will analyze the validity of thisstrategy using arithmetic approach as presented by William Sharpe. In light of John Bogle andKenneth French’s research papers, where they have tracked the performance of index funds andthe effects of various costs on a portfolio, I would highlight some of the incentives reaped frompassive investing. Finally, I will discuss some of the behavioral reasons such as overconfidenceand prestige that can be attributed to active management.
  5. 5.   ‐ 2 ‐ Introduction: Index investing provides a cost effective way to earn market return by matching thesecurities within a given index proportionally. This idea is based on the principle that investorscan not beat the market on a regular basis and therefore, it is futile to continuously chase higherreturns. There are number of cost elements that significantly offset gains received by higherturnover portfolios. In case of a mutual fund, investors not only pay explicit cost such as management feesbut also implicit costs that includes turn-over cost and realized capital gain taxes. Furthermore,if an investor is managing their own portfolio, one has to account for the unrecognized cost forthe time spent in researching and tracking performance of companies within a portfolio. Studiesshow that once the number of stocks in a given portfolio exceeds 6, it becomes very difficult tomanage their individual progress. Upon quantifying all of these factors, we find that they take upa big chunk out of investors’ overall return. Essentially, index funds are designed to combat highcosts that investors pay without even realizing its impact on the overall return. The discussion of return is incomplete without considering the risk factor thataccompanies it. By efficiently diversifying, we strive to build portfolios that yield maximumreturn yet minimize the risk exposure. In this pursuit, fund managers pick securities that are notoptimally correlated. However, when mutual fund managers make adjustments to the portfolio,they introduce new securities that drift away from the optimal correlation that initially existed.Additionally, this portfolio calibration is sometimes subjected to capital gain taxes even if itresults in the net loss for the investor. In comparison, index funds’ composition does not changeas frequently, therefore investors are protected from higher turn-over cost and capital gain taxes.
  6. 6.   ‐ 3 ‐  There are number of well known economists who have done significant amount ofresearch in support of index investing, including Paul Samuelson, Charles Ellis, and Al Ehrbar.In addition, Burton Malkiel who is the one of the pioneer and strong advocate of index investingconsiders it as the most successful investing vehicle, particularly on the basis of Efficient MarketHypothesis. John Bogle gave practical meaning to the earlier ideologies by creating first indexfund, which tracked S&P’s 500 index. He has done extensive research in the field by analyzingvarious cost effects on active versus passive portfolios within a certain time period. In essence,all of the above mentioned scholars agree that in the long run, an index fund will create lessexpensive and optimally diversified portfolios.Burton Malkiel support for Index Funds: The logic behind the index fund is supported by the Efficient Market Hypothesis, whichimplies that it is impossible to out-perform the market due to its continuously changinginformation. Burton Malkiel describes this phenomenon as, “markets can be efficient even ifthey sometimes make egregious errors in valuation, as was certainly true during the 1999-2000Internet bubble. Markets can be efficient even if many market participants are quite irrational.Markets can be efficient even if stock prices exhibit greater volatility than can apparently beexplained by fundamentals such as earnings and dividends (Malkiel, 2003, p. 244).” What thismeans is that investors may be able to beat market on occasional basis, but in the long run it isnot possible as markets are fundamentally efficient. By the time any critical information about asecurity becomes available to investors, it is already too late to jump on the ‘profit bandwagon’as the new price quickly reflects that. Most of the time, fluctuations in prices is only a temporaryphenomenon and once the dust settles, it simply reflects the true underlying value of the security.
  7. 7.   ‐ 4 ‐ Allocation strategies based on market cycles: One of the skills marketed by fund managers is their ability to efficiently move betweencash and equities position based on market cycles. In ideal situation, they would like to havemost of their assets in stocks at the trough of the market cycle, whereas their allocation shouldconsist of more of cash and fixed income assets at the peak just before the downwardmomentum. However, John Bogle’s research in comparing equity mutual fund’s cash to totalassets ratio and S&P 500 shows a contradictory behavior; the peaks in mutual funds’ cashposition coincided with market troughs during 1970, 1974, 1982, end of 1987, and late 1990(Malkiel, 2003, p. 194). Similarly, during the peak periods in the market, they maintained lowcash position. Thus, there is little evidence to support that fund managers can successfullypredict different market cycles and move funds between fixed income and equities positionaccordingly. According to Mr. Malkiel, “over the past fifty-four years the market has risen in thirty-five years, been even in three years, and declined in only fifteen. Thus, the odds of beingsuccessful when you are in cash rather than stocks are almost three to one against you (Malkiel,2003, p. 194).” John Bogle quantified the cost incurred by comparing the dollar-weightedreturns earned by a fund’s shareholders with the time-weighted returns by the fund itself. Hefound that the dollar-weighted returns of the 200 largest equity mutual funds, the returns enjoyedby the shareholders lagged the time-weighted returns by fully 3.3 percentage points per year(Bogle, 2005, p. 8).William Sharpie’s Arithmetic Approach: William Sharpe proposed that a simple arithmetic can be used to justify that a passiveinvestor will always outperform an active investor. His reasoning is based on the fact that over
  8. 8.   ‐ 5 ‐ any specified time period, the market return will be a weighted average of the securities withinthe market, using beginning market value as weights. He presented two assertions to support hisclaim: 1. Before cost, the return on active and passive investment will be equal. 2. After cost, the return on passive fund will be greater than active investment. In order to prove the first point, he reasoned that if the market returns 10% before costs,then a passive investor will also receive the same return. Furthermore, the market return mustequal a weighted average of the returns on active and passive funds, therefore the return onactive investment should be the same as well. The second assertion is justified by the fact that itis more expensive to maintain an active portfolio as it would require research work, payment tosecurity analysts, etc. The cost of managing an index fund is between 0.15% to 0.50% ascompared to active investment where the minimum cost is 1.0% (Sharpe, 2002, p. 3). So, whenwe see fund managers driving luxurious cars and living out loud, it would be fair to assume thatthose are all paid by the courtesy of naïve investors. After accounting for cost, an activeportfolio would result in a lower return than a passive portfolio.Bogle’s Cost Matter Hypothesis: John Bogle explained that even if people disagree with Efficient Market Hypothesis,there are still some strong reasons to believe in index investing. He calls it the Cost MattersHypothesis and explains, “No matter how efficient or inefficient markets may be, the returnsearned by investors as a group must fall short of the market returns by precisely the amount ofthe aggregate costs they incur. It is the central fact of investing.... Intermediation costs in theU.S. equity market may well total as much as $250 billion a year or more. If today’s $13 trillionstock market were to provide, say, a 7% annual return ($910 billion), costs would consume more
  9. 9.   ‐ 6 ‐ than a quarter of it, leaving less than three-quarters of the return for the investors—those who putup 100% of the capital (Bogle, 2004, p. 4).” According to Mr. Bogle, today’s investors undermine the importance of costs because ofthe three reasons. First, costs such as portfolio transaction costs, the un-recognized impact offront-end sales changes, and taxes incurred on realized gains are not clearly defined. Forinstance, when a mutual fund manager presents brochure highlighting their year-to-year market-beating accomplishments, most of the times those graphs do not reflect the effects of cost.Second, during bear market of 1980’s and 1990’s when the stock market returns have been highas compared to average fund, investors tend not to take cost into equation. There have beennumerous studies that prove that the psychological effects of 1-2% become almost negligible inlight of 15-20% return. Third, focus on short-term returns in contrast to long-term opportunities.Most of the average investors get carried away with short-term profits and fail to realize long-term effects of cost in term of real and compounding interest (Bogle, 2007, p. 40).Returns in terms of Real Interest Rate and Compounding Interest: Bogle has found that the nominal long-term returns of about 10 percent on stocks turnedout to be about 6½ percent in real terms. Then, there are effects of compounding costs that cansignificantly widen the difference between index funds versus managed fund returns. “If weassume that mutual fund costs continue at their present level of at least 2½% a year, an averagemutual fund might return 5½%. Extending this tax-deferred compounding out in time on yourinvestment of $3,000 each year over 40 years, and investment in the stock market itself wouldgrow to $840,000, with the market index fund not far behind. Your actively managed mutualfund would produce $430,000—only a little more than one-half as much (Bogle, 2004, p. 20).”Performance analysis of Mutual fund vs Index Fund:
  10. 10.   ‐ 7 ‐  Bogle conducted research on the last 20 years of S&P 500 index versus Average EquityFund. After finding out the gross return, he subtracted several cost factors such as taxes,inflation, and transaction costs to determine net return. Before taxes, Standard & Poor’s 500Index returned 12.8% where as average equity mutual fund returned 10.0%, a difference of 2.8percentage points a year. After taxes, this difference further extended to 4.1 percentage points ayear. By taking inflation into the equation, the real annual return for the index fund drops to8.9% and the equity fund to 4.8% (Bogle, 2005, p. 5). According to a study conducted by John Bogle over a sixteen-year period, investors getto keep only 47% of the cumulative return of the average actively managed mutual fund, but theykeep 87% in a market index fund. This means $10,000 invested in the index fund grew to$90,000 vs. $49,000 in the average actively managed stock mutual fund. That is a 40% gain fromthe reduction of silent partners (Bogle, 2005, p. 6). Kenneth French found that the average difference between the actual standardized cost ofinvesting and the passive cost for the 1980 to 2006 period is 67 basis point. If the expected realreturn on the US stock market is a constant 6.7%, the capitalized cost is 10% of the current valueof the market (French, 2008, p. 21). “Furthermore, the actual cost of investing – the fees andexpenses paid for mutual funds, the investment management costs paid by institutions, the feespaid to hedge funds and the transaction costs paid by all traders – is 0.82% of the value of allNYSE, Amex, and NASDAQ stocks in 1980 and 0.75% is 2006. In the passive scenario,investors pay passive fees, annual turnover is 10%, and there are no hedge funds. As a result, thecost of investing is only 0.18% of the aggregate market cap in 1980 and 0.09% in 2006 (French,2008, p. 23).”Portfolio Turnover:
  11. 11.   ‐ 8 ‐  Turnover refers to the selling and buying of securities by fund managers in order tooutperform the market. Selling securities in some circumstances may result in capital gains taxcharges, which are sometimes passed on to fund investors. A passive investor trade for tworeasons, to accommodate cashflows and to maintain target risk return trade offs. Because indexfunds are passive investments, the turnovers are lower than actively managed funds. Based onthe Kenneth French’s finding, turnover has risen steadily from 20% in 1975 and 59% in 1990 toan impressive 173% in 2006 and 215% in 2007 (French, 2008, p. 16). There are several reasonsfor this extraordinary growth in trading, but some of the most notable are, reduction in cost,negotiated brokerage commission, the development of electronic trading networks, and thedecimalization of stock prices.Tax Implications: Another important advantage of index investing is its tax efficiency, which is the crucialfinancial factor because of its substantial effect on net returns. Index funds do not trade fromsecurity to security thus; they tend to avoid capital gain taxes. Joel Dickson and John Shovenused 62 mutual funds with long-term records; they found that, pre-tax, $1 invested in 1962would have grown to $21.89 in 1992. After paying taxes on income dividends and capital gainsdistributions, however, that same $1 invested in mutual funds by a high-income investor wouldhave grown to only $9.87 (Malkiel, 2003, p. 195). Recently, Exchange–traded index funds(ETF’s) have been designed to lessen the impact of taxes. S&P 500 tends to be more tax-efficient because of their ability to bear in-kind redemption which delivers low-cost sharesagainst redemption request. In order to prove the tax efficiency of index funds, Bogle compared ICA mutual fundwith S&P 500 index fund. He found that during the past 25 years, for example, federal taxes
  12. 12.   ‐ 9 ‐ consumed an estimated 2.5 percentage points of its annual return, reducing it from 13.7% to11.2% for taxable investors. While an S&P 500 index fund is hardly exempt from taxes, itspassive market-matching strategy is highly tax-efficient. During the same period, taxes on anindex fund would have cost an estimated 0.9 percentage points, reducing its 13.8% pre-tax returnto 12.9%, a net after-tax advantage over ICA of 1.7 percentage points per year. Not only dotaxable investors pay high costs in fund advisory fees, operating expenses, and salescommissions when they buy active fund management, they also pay a remarkably high tax cost(Bogle, 2004, p. 13).Reasons for active investment: After looking at all the above reasons, the question that comes in mind is why investorsselect active management over passive. There are number of reasons that can be attributed tothis irrational behavior. According to Kenneth French, “the dominant reason is a generalmisperception about investment opportunities. Many are unaware that the average activeinvestor would increase his return if he switched to a passive strategy. Financial firms certainlycontribute to this confusion. Although a few occasionally promote index funds as a betteralternative, the general message from Wall Street is that active investing is easy and profitable.This message is reinforced by the financial press, which offers a steady flow of stories aboutundervalued stocks and successful fund managers. Overconfidence is probably the other major reason investors are willing to incur the extrafees, expenses, and transaction costs of active strategies. There is evidence that overconfidenceleads to active trading. Investors who are overconfident about their ability to produce superiorreturns are unlikely to be discouraged by the knowledge that the average active trader must lose.
  13. 13.   ‐ 10 ‐  There is another behavioral explanation for active investing. He suggests that, in additionto expected return and risk, investors are concerned with what he calls the expressivecharacteristics of their portfolios. Thus, some investors may accept a lower expected return inexchange for the bragging rights that come with a fund that has performed well. Others maygive up the low cost and diversification of a passive mutual fund for the prestige of their ownseparate account (French, 2008, p. 25).”Conclusion: In conclusion, index investing offers a great way to earn market return without incurringenormous cost that accompanies with active management. By choosing passive funds, investorspay absolute minimal fees, which are at least 50% lower than what is charged by mutual funds.Over the long run, this cost reduction can substantially increase the value of a portfolio becauseof the compounding interest. Furthermore, it has been proven that fund managers can not predictmarket cycles and they have demonstrated poor judgment when moving funds from fixed incometo equities position. Because index funds have lower turn over, investors are protected fromtransaction cost and capital gain taxes. Also, this stability will be in the interest of stock marketas a whole because investors would focus on long term objectives. Fund managers’ quest to beatthe market results in a greater volatility and causes portfolios to drift away from optimalcorrelation. Based on the above facts, it is astounding to comprehend the existence of mutualfunds, especially when the added benefits offered by index funds are unparallel. Recently, therehas been an upsurge in ETF sector as investors have started to switch away from cost intensivesub-par active funds.

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