Sunday, March 1, 2015
Pozen & Hamacher, The Fund Industry, 2d ed.
The roughly 500-page book is divided into five sections: an investor’s guide to mutual funds, mutual fund portfolio management, sales and operations, beyond traditional funds, and the internationalization of mutual funds.
When I reviewed the first edition of The Fund Industry, I called attention to a little understood technical point: how the daily net asset value of funds is calculated. This time I’m going to summarize the authors’ discussion of a hotly debated issue: index vs. actively managed funds. There are a couple of claims and counterclaims that might be new to readers.
Index fund advocates make four arguments. (1) Passive investing minimizes expenses. (2) It is extremely tax-efficient. Index funds rarely buy and sell stocks, so they rarely realize capital gains. (3) Since the market is efficient, it’s impossible to outperform an index for any length of time. (4) Elaborating on the last point, studies show that “performance persistence, if it exists at all, is a short-term phenomenon and is largely confined to the worst-performing funds, not the ones that anyone would want to include in their portfolios.” (p. 129)
Proponents of active management counter with five arguments. (1)There is a small group of managers who outperform over time. (2) There are cycles in the relative returns of active and passive management; index funds don’t outperform in every environment. “Active managers tend to do well when the performance of the stock market is driven by stocks of every capitalization as opposed to a narrow band of the largest cap stocks.” (p. 130) (3) There is a potential tax time bomb that might make index investing unattractive. “[W]hile index funds are very tax efficient right now, that’s partly because the total assets in these funds are growing, so that there are no net redemptions by shareholders that force the funds to sell securities to generate cash. If index funds should ever start shrinking, they could be forced to start generating enormous capital gains for investors.” (4) Index fund investors are free riders on the backs of active managers. “Markets are efficient only because so many analysts are digging for information that will give them an edge. With so many eyes trained on every security, it’s hard for mispricings to last for every long. But if index funds became the predominant form of investing, the securities they held would frequently be under- or overvalued.” (p. 131) In fact, recent increases in market volatility can be attributed to the growth of index funds since these funds buy and sell in response to cash flows into and out of the funds rather than changes in stock prices.” (pp. 131-32) (5) Markets are predictably irrational.
Who is winning the argument? If investor money decides, actively managed funds are the clear winner. They account for 80% of fund assets, excluding money market funds. But over the last twenty years the index fund share of fund assets has been growing steadily, from 1% in 1993 to 15% in 2010 and 20% in 2013. Momentum is on the side of index funds.