Index Investing versus Active Investing Average market return
- Slides: 13
Index Investing versus Active Investing • Average market return at minimal cost versus the outperformance of market return, but at cost (transactional, research & management fees). • Are the returns from active investing sufficient to cover the cost thereof to beat the market index? • Are the track record of active managers persistent ? • Over the long run, which strategy is the better?
To think about… • Active investing is a zero-sum game – Net result of “winners” and “losers” yields the market average • Over time markets are efficient – Short-term opportunities exist to outperform the market, but outperformance is not necessarily consistent over time • Diversified risk versus concentrated risk (tracking error) – Active managers deviate invariably from the market index
The Active Manager’s dilemma Sector Market Index Weight Manager’s Portfolio Market Performance Manager’s Performance Resources 20 10 15% 17% Industrials 10 15 7. 5% 9. 5% Consumer Goods 20 25 5% 7% Services 20 20 7. 5% 9. 5% Financial 25 25 7. 5% 9. 5% 5 5 -5% -3% 7. 88% 9. 00% Information Tech Total Return The active manager achieved superior returns compared with the market average and … outperformed the market! In a diversified market environment the active manager would be able to show off his/her skill for superior stock selection and/or timing, but we don’t “live” in perfect equally-weighted markets…
The Active Manager’s dilemma (continued…) The reality is concentrated markets! Sector Market Index Weight Manager’s Portfolio Market Performance Manager’s Performance Resources 40 10 15% 17% Industrials 10 15 7. 5% 9. 5% Consumer Goods 12. 5 25 5% 7% Services 12. 5 20 7. 5% 9. 5% Financial 20 25 7. 5% 9. 5% 5 5 -5% -3% 9. 56% 9. 00% Information Tech Total Return The active manager achieved superior returns compared with the market average, but… underperformed the market!
The Active Manager’s dilemma (continued…) • In concentrated markets (as in South Africa) active managers invariably will take large bets against the market index – some years it will work for them, in other years against them, but it remains risky business…
Results from a recent study* • Over time index and active investing repeatedly replaced one another as the dominant investment strategy. • *MBA research project by DR Wessels, 2004, titled: “Active Investing versus Index Investing: An Evaluation of Investment Strategies”
Results from a recent study (continued…) • Over time index investing would have yielded on average between the 60 th - 70 th percentile of active investing returns, which is in fact an above-average return.
Results from a recent study (continued…) • In search of the magic alpha…
Results from a recent study (continued…) The persistency of active investing performance… Likelihood that a top performer now will be a top performer next quarter
Results from a recent study (continued…) The persistency of active investing performance… Likelihood that a top performer now will be a top performer in three years time
Results from a recent study (continued…) • Optimal results (reward-to-risk) would have been achieved when combining both strategies in your overall investment plan
Results from a recent study (continued…) • An optimal allocation of index and active investing strategies, based on the performance of active managers over time. Expected Performance Percentile Active Allocation Index Allocation 70 th 16% 84% 75 th 22% 78% 80 th 67% 33%
Conclusion • No guarantees can be given where your actual active returns are going to be in the total return spectrum, therefore follow a more prudent, conservative strategy – include an index approach.
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