Reader Mailbag: How is the stock market index of any significance for individuals?

This week, we have a reader question from Jasmin:

How is the stock market index of any significance for individuals?

The significance of a stock market index (or any other index for that matter) is that it is a benchmark. In other words, investors can use indices as a yardstick to measure and/or compare slices of their portfolio to.

For most investors, indices can be used to evaluate the performance of the individual asset classes in their portfolio. Investors can compare the risk and return metrics of an allocation to those of an appropriate index. When utilizing an actively managed strategy, an appropriate index or index fund can be viewed as the opportunity cost of using the active strategy.

If you own US large-cap stocks, you might compare the volatility and performance of those stocks to the S&P 500. If you own international stocks, you might compare them to the MSCI EAFE. You can compare the bond portion of your portfolio to the Barclays Agg or a number of other indices. There are multiple indices for various sectors, regions, countries, and so on. In fact, today there are more indices than stocks!

Although the above is relatively straightforward, many investors misuse indices. Below are two of the more common errors that I see:

  • Comparing a multi-asset class portfolio to a single asset class index. I meet many people who compare their portfolio of global stocks and fixed-income to the S&P 500. The S&P 500 could probably be used to benchmark the US large-cap equity portion of the portfolio, but certainly not the entire portfolio.
  • Viewing an index as a goal. Each individual investor has unique goals and their portfolio should reflect this. Even the largest indices have some fairly substantial risks, which investors should be aware of and may want to avoid. For instance, the “China Region” (China, Hong Kong, and Taiwan) makes up 40+% of most broad-based emerging markets equity indices or the Barclays Agg is overwhelmingly government bonds, which offer much more duration than yield today. These are just two examples of where investor goals may be inconsistent with an index’s composition. Note: Money managers may benchmark to a single index, but this is because they typically run single asset class strategies and are concerned with relative performance, neither of which is typically true of individual investors.

So, the short answer is that individuals can use indices to evaluate single asset class strategies/managers and should not be used for much more than that.

Asset Classes: Active vs Passive

If nearly all investors engage in active management through the development or selection of a portfolio’s asset allocation, then what is the active versus passive management debate all about?

The debate is whether individual asset classes should be accessed via active managers or via passive strategies. Thus, the debate over active versus passive management is at the asset class level, rather than portfolio level (because all investors are active at the portfolio level!).

Below is a brief summary of active and passive management:

Active:
The traditional form of investing, where an investor picks individual securities that he or she expects will result in the best risk or return metrics.

Passive:
At some point (I think in the 1950s) investors began to both deduce and notice that active managers (in the aggregate) could not outperform the average returns in various markets. If managers could not beat the averages, then investors would be better off accepting average returns and minimizing costs. Average returns could be nearly achieved by simply buying the entire market or a representative sampling of them.

Below is an example of where an investor must decide whether to utilize an active or passive strategy:

A hypothetical investor decides to allocate 10% of her portfolio to emerging markets bonds. The investor can do one of two things with the 10%:

  1. Purchase individual emerging markets bonds (or hire a manger that selects the “best” bonds, based on research, analysis, etc).
  2. Invest in a passive strategy that attempts to mirror the risk and return characteristics of the broad emerging market bond market.

If the investor is comfortable with the risk and returns of the broad emerging market bond market, she should consider a passive strategy. If not or she thinks that she can beat this market, active management may be a better choice.

It should be clear that neither active management nor passive management is inherently better. The decision to use one over the other should depend on both investor objectives, as well as the asset classes’ characteristics and market structure. Yet, the debate does carry on, which I believe is driven both by bias from investing product sponsors and by dogma from under-informed investors.

Looking ahead, we will examine various asset classes and how active and passive strategies fare in each.

The American Revolution and Cryptocurrency ICOs

According to All Things Liberty, the American colonists financed their revolution through printing currency (both at the state and colony-wide Congressional level). Although some debt was issued as well, the primary funding came from printing currency. If the war was won, this currency would be needed to pay taxes to the new state and federal governments.

This is similar to the recent spate of cryptocurrency Initial Coin Offerings (ICOs). A group of people issue a currency to raise money for a venture. If the venture succeeds, the currency can be used on the new platform. If the venture fails, the currency will have no use.

There are a lot of problems with the ICO model, but financing a revolution with your own currency seems preferable to taking on external debt. Taking on external debt to finance a war could easily mean trading military occupation for exploitation by creditor(s). It is a good thing that the founding fathers printed money rather than borrowing from other 18th-century powers.

Happy 4th of July!

Asset Allocation: Active or Passive?

Thus far in this series, we’ve looked at market efficiency and management styles in a general sense. Yet, investors must examine these factors and make decisions at multiple points, including when they select an asset allocation.

A completely passive asset allocation would mirror the market portfolio, which may look something like the below. Hypothetically, an investor could construct such a portfolio.

http://www.cfapubs.org/doi/pdf/10.2469/faj.v70.n2.1

However, some investors will want a more aggressive portfolio while others will desire a less volatile portfolio. Consequently, they will adjust their allocation weights to produce different portfolios along the efficient frontier. 

Yet, the efficient frontier is not a constant thing. Does it represent a 3-, 5-, 7-, 10-year, or some other time horizon? The efficient frontier will look different for each horizon, as seen below:

https://www.onefpa.org/journal/Pages/Incorporating%20Time%20into%20the%20Efficient%20Frontier.aspx

Once settled on a time horizon, investors face a new decision: should historical data be used or future assumptions? If historical data is assumed, which timeframe should be used? 100 years of data? Or just the most recent 10 years? Or a decade that most resembled our current situation? Each will provide a different frontier.

http://systematicrelativestrength.com/2016/02/17/22738/

If one chooses to use future assumptions, what assumptions should be used? Rarely do people agree on what the future will look like and nobody can consistently predict it accurately. Below is an example of possible efficient frontiers, based on differing assumptions:

https://www.linkedin.com/pulse/too-much-modern-portfolio-theory-fintech-arena-raffaele-zenti

It’s not just average investors that cannot agree on what the future looks like. There is debate amongst the largest asset managers who have vast resources, huge budgets, and large teams of economists, analysts, and researchers. Below are the 2017 capital markets assumptions from three of the largest asset managers:

Regardless of whether an investor allocates to actively managed funds or passive index funds, selecting an asset allocation is an exercise in active management. In fact, allocation decisions will likely be more determinative to a portfolio’s risk and return than whether active or passive managers are used within each asset class.

Weekend Reads

A late set of weekend links for your reading enjoyment!

Stuff doesn’t make people happier. Control over their time does. So to the extent that the goal of personal finance is to make you happier, I encourage people to view it as a way to gain control over their time, rather than a way to accumulate more possessions. -Morgan Housel

Morgan Housel on What You Need to Know to Be a Successful Investor (Chris Reining)

The Seduction of Pessimism (Collaborative Fund) and What Is Your Belief System (Enterprising Investor)

A Kansas Investment Firm Spurring Change on Wall Street (New York Times)

In the New Bond Market, Bigger Is Better (Wall Street Journal) versus Treasury’s Regulation Unwind Already Having An Effect on Markets (Bloomberg)

Solar Power Will Kill Coal Faster Than You Think (Bloomberg)

American Chipmakers Had a Toxic Problem. Then They Outsourced It (Bloomberg Businessweek)

 

Definitions: Beta & Alpha

Before delving deeper into the topic of market efficiency and active vs passive, it may be helpful to briefly review the definitions of beta and alpha.

Beta

At it’s simplest, beta can be defined as the volatility of an asset relative to a benchmark. The benchmark is often an index of a specific sector or an entire asset class. For example, a US large-cap stock that is 20% more volatile than the S&P 500 index has a beta of 1.2. Or if the volatility is 20% less than the index , it’s beta is .8. Beta is a measure of relative volatility.

Alpha

Within the Capital Asset Pricing Model (CAPM), this same beta is used to forecast returns. Under CAPM, higher beta leads to higher returns and lower beta results in lower returns. In other words, a fund with more volatility should have higher returns and a fund with lower volatility should have lower returns. Reality rarely unfolds as modeled, so an ex-post CAPM equation was created. It adds a variable called alpha to account for the difference between an asset’s actual return and it’s expected return (which CAPM predicts to be the benchmark return, adjusted for volatility). Below are a couple of examples on calculating alpha:

  • An investor invests in large-cap domestic stocks and reports a 10% return, while the Russell 1000 returns 7%. The investor has produced 3% alpha.
  • An investor invests in global equities and reports a 9% return, while the MSCI All Country World Index returns 13%. The investor has (negative) alpha of -4%.
Beta, Colloquially

The term beta is often used to refer to the risk and return characteristics of a benchmark. Some examples: US large-cap beta may refer to the Dow Jones Industrial Average or the S&P 500, investment grade bond beta is often synonymous with the Barclays Agg index, or tech beta may simply refer to a tech-sector ETF. I often refer to index ETFs as cheap, liquid beta. Some may compare large-cap beta to small-cap beta or consumer staple beta to consumer discretionary beta, when discussing risk and returns. Below are some examples of how someone might refer to beta:

  • Utility sector beta is sensitive to interest rates.
  • An index fund may be called beta exposure.
  • An investor holds investment grade bonds and reports a -1% return while the Barclays Agg is down 3%. Some might say that the beta return was -1% (and alpha was positive 2%).
To recap:
  • Beta is an asset’s volatility, relative to a benchmark.
  • Alpha is an asset’s return above it’s benchmark, after controlling for differences in volatility.
  • Technical definitions notwithstanding, the term beta is often shorthand for a benchmark or may refer to the benchmark’s risk and return characteristics.

Weekend Reads

Hanging out in the Rocky Mountains, so just a trio of related articles this weekend:

Stop Pretending You’re Not Rich (New York Times)

Conspicuous Consumption Is Over. It’s All About Intangibles Now (aeon)

The Happiness Spending Threshold And What It Really Means To Live Within Your Means (Nerds Eye View)

Does It Matter Whether Markets Are Efficient or Not?

Does it matter whether markets are efficient or not?

Not really and here’s why:

  • As I mentioned last week, nobody knows how efficient or inefficient markets are (due to the joint hypothesis problem, eloquently summarized here)
  • Asking whether a market is efficient is often a proxy for asking whether one can outperform. However, the questions are different, as we’ll see below.

Last week’s post mentioned Eugene Fama, who won a Nobel prize for developing the Efficient Markets Hypothesis (EMH). However, Jack Bogle (who founded Vanguard) also has a hypothesis called the Costs Matter Hypothesis (CMH), which he introduced here in 2003. Consider the following, which both Fama and Bogle agree on:

  • In any market, aggregate investor performance will equal the overall market performance minus costs. This statement holds whether a market is efficient or inefficient. Regardless of a market’s efficiency, investors as a whole will underperform because they bear costs. To outperform the market, you must beat the market by more than your costs.
  • Since total investor performance is limited to market performance minus costs, any investor’s outperformance comes from another investor’s underperformance. So to beat the market, you must also beat other participants.

Thus, the important question for investors is not whether markets are efficient or not, but whether they can reliably and consistently beat both the market and other investors net-of-fees. If the answer is yes, investors might benefit from using active management. If the answer is no, it is likely better to use a lower-cost vehicle, such as an index fund.

Of course, there is more than one market. There are many asset classes and markets, so the question of whether you can beat the market or not must be asked over and over. Each market is unique and changes throughout different environments, so the question needs to be continually asked: is it possible for me to beat this market net-of-costs?

Weekend Reads

The usual eclectic mix of topics for your weekend reading. Enjoy!

Other Times Unemployment Has Been This Low, It Hasn’t Ended Well (Wall Street Journal)

The Doctor Is In. Co-Pay? $40,000. (New York Times), part of a series The View From Behind The Velvet Rope

Personality Plays a Bigger Part Than IQ in Financial Success (iris)

Alex Honnold First Person to free solo El Capitan (National Geographic)

How The Most Interesting Man In The World (Dos Equis guy) Met The Most Powerful Man In The World (Obama) (Politico)

New Map Reveals Ships Buried Below San Francisco (National Geographic)

An Introduction to Cryptocurrencies and Blockchains, by yours truly 😉 (Morling Financial Advisors)

Earlier This Week: Are Markets Efficient?

Interactive Map: Unemployment Rate by County (GeoFRED)

Mid-Week Reads: Paris Accord Edition

Despite Trump’s recent withdrawal from the Paris Accord, market forces are driving the world away from fossil fuels and towards renewables. Some mid-week Paris Accord reads:

Why Paris Matters Less Than It Seems (Wall Street Journal)

Coal Isn’t Coming Back, Even With Trump Leaving the Paris Accord (Bloomberg)

India Cancels Mega Plans to Build Coal Power Stations Due to Falling Solar Energy Prices (India Times)