Traditional Indexing Delivers Below-Average, Not Average, Returns

Research Affiliates subjects cap-weighted portfolios to same performance evaluation as active managers, and finds them wanting

All investors want above-average returns, yet ironically it is those who settle for the average returns of an index fund who historically have outperformed.

No less a skilled investor than Warren Buffett plans for his heirs to benefit from a Vanguard index fund after his demise (he suggests the traditional cap-weighted S&P 500 fund, VFINX).

But while he remains active and ever alert to investing issues, the Sage of Omaha might want to consider the latest study from Research Affiliates, whose analysts Jason Hsu and Vitali Kalesnik subject index-based portfolios to the same performance evaluation typically used for actively managed funds.

The analysis by the Newport Beach, Calif., firm founded by Rob Arnott is not intended to dwell on the hoary debate between active and passive management; rather, the firm known for its smart beta index products seeks to question a cherished tenet of index investing — namely, that it produces market-based returns.

Hsu and Kalesnik find that traditional index portfolios — capitalization-weighted products like VFINX that hold the bulk of indexing assets — underperform the market average in a statistically significant way, unlike smart beta portfolios, which do deliver market returns.

In an article that is more technical than their usual newsletter articles, the two analysts describe the process for assessing active manager skill. They show this mathematically, but the basic idea is that “the expected return of a portfolio is the sum of the return for an average stock and the return due to the investor’s skill.”

“Covariance” with the stock market is the crucial determinant of skill. A manager whose performance co-varies, or travels together, with higher performing stocks displays skill; covariance with lower performing stocks indicates negative skill, while matching the market has zero covariance.

An effective index therefore should have zero covariance, and that is what the authors’ study found for a smart-beta equal-weighted portfolio. Three other smart-beta indexes with different weighting schemes had slightly negative covariance, but the variance was not statistically significant; in other words, they were indicative of “no skill,” which is what index investors are seeking.

Of five indexing strategies, only the market-dominant cap-weighted index showed a statistically significant covariance reflecting “negative skill.”

“In the U.S. market, over the period 1962 through 2012, the negative return translates into approximately 200 [basis points] of drag per year,” Hsu and Kalesnik report.

This underperformance derives from cap-weighting’s allocating larger weights to overpriced stocks and smaller weights to underpriced stocks, the authors write.

This result implicitly places traditional index funds in the same camp as the average active manager, who is typically a closet indexer. That is because, while investors theoretically select active managers in order to beat the market, these same investors in actuality fire those who underperform the market.

For that reason, a smart beta portfolio with no covariance from the market gives “investors a head start against active managers.”

For those investors who seek skilled active managers, the authors recommend a two-fold approach: insist that their performance show significant variance from the portfolio’s benchmark and lengthen the evaluation period so that managers can make trades with long payoff periods that might underperform in the short term.

“Managers whose tracking error is small aren’t active; they don’t have their own opinions, or don’t hold them strongly,” they write. “Smart beta investing, an alternative to negatively skilled passive management, can also complement unencumbered active managers.”

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