The Case against Index Tracking

[Brendan Burgess]

Jim Grant makes a sort of a case against Index Tracking and comments on how overvalued the market is in [broken link removed]


Index tracking is stupid because the price of XL, a large insurance company, rose by 5% after it was admitted to the S&P.

Index tracking funds bought Yahoo at 470 times earnings because it was in the S&P. They didn't bother to question whether this was a reasonable valuation or not.

Here are some other quotes:

"We've concluded that indexing is popular because the stock market is high, not the other way around. "

"Infuriatingly, the indexers have not only been winning the intellectual and academic debate over the efficacy of passive investing, they have also been winning the money. In the 10 years through July 31, fewer than 30% of active managers of diversified equity funds succeeded in beating the S&P. "

The article goes on to explain how overvalued the market is at present.

Brendan

 

[Brendan Burgess]

It is just extraordinary that index tracking works so well or to put it another way, how badly active management works.

As an index tracker, I bought Yahoo at 470 times earnings and I artificially pushed up the price of XL by 5%. I blindly dumped stocks which were expelled from the indices irrespective of their real value.

If my investment decisions were so irrational, why on earth did the active managers not outperform me dramatically ?

When I play poker with opponents who play at random, I am a a consistent winner. When I played against people who were much better players than I was, I was a consistent loser.

Why can the well paid, rational, active managers who spend their time reading company reports and the Grant Interest Rate Observer, not consistently outperform the passive managers who spend their times reading novels ?

Brendan

 

[N Leeson]

Trackers

Hi Brendan,

One reason that trackers have performed so well is that for the past number of years equity markets were not acting in a rational manner. A p/e of 200 or 300 or 400 on Yahoo did not deter anyone from pushing the price even higher. Consequently, those active managers that opted for a fundamental approach (and most should have) were not rewarded. Well-run, cash generative businesses were spurned by a market that rewarded people with no experience and businesses with no prospects. Moreover, the telecoms bonanza was another example of extreme irrationality - who dared sell Vodafone even when is traded on a p/e of 60, 70 or 80?

Consequently a rational investor that sold telecoms/internet to buy more reasonably valued sectors was not rewarded.

On top of that many active managers are not very good..

I think that trackers are still an effective and low cost investment alternative to the piss-poor performance of many active managers. However, many active managers are 'closet indexers' so despite their opinions on the valuations of various sectors, they will still maintain a weighting in them because they are scared that they may be wrong.