Index Investing versus Active Investing

1
Index Investing versus Active Investing

• Average market return at minimal cost versus the
  out-performance 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?

2
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 out-performance is not necessarily
  consistent over time
• Diversified risk versus concentrated risk
  (tracking error)
• Active managers deviate invariably from the
  market index

3
The Active Managers dilemma
Sector Market Index Weight Managers Portfolio Market Performance Managers 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
Information Tech 5 5 -5 -3
Total Return 7.88 9.00
The active manager achieved superior returns
compared with the market average and
out-performed 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 dont live in perfect equally-weighted
markets
4
The Active Managers dilemma (continued)
The reality is concentrated markets!
Sector Market Index Weight Managers Portfolio Market Performance Managers 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
Information Tech 5 5 -5 -3
Total Return 9.56 9.00
The active manager achieved superior returns
compared with the market average, but
under-performed the market!
5
The Active Managers 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

6
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

7
Results from a recent study (continued)

• Over time index investing would have yielded on
  average between the 60th - 70th percentile of
  active investing returns, which is in fact an
  above-average return.

8
Results from a recent study (continued)

• In search of the magic alpha

9
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
10
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
11
Results from a recent study (continued)

• Optimal results (reward-to-risk) would have been
  achieved when combining both strategies in your
  overall investment plan

12
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
70th 16 84
75th 22 78
80th 67 33
13
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.