Index Investing's Free Lunch
Recent economic data is showing that the consumer is showing signs of tiring, or just running out of stuff to buy. Auto sales fell 12.7% in November. GM and Ford fared worse as their sales fell 18.5% and 17.7% respectively. Chrysler's sales fell 11.9%. Besides the Big Three, several automakers posted double-digit declines including: Mazda, Mitsubishi, Subaru, Isuzu, Volkswagen, Jaguar, and Porsche. About one-third of the automakers increased sales from last year. Luxury carmakers dominate this list: Honda, Mercedes, BMW, Volvo, Audi, and Land Rover. In a sign that vehicle sales have been pulled forward, Ford announced it would cut production by 2.6%, or roughly 25,000 vehicles.
Retail sales were generally reported as being healthy during the traditional kickoff of holiday shopping. Widespread reports of heavy promotional activity have raised questions on whether the high sales levels will translate into profits. Sales data from the Bank of Tokyo-Mitsubishi revealed that the beginning of November was not nearly as robust as the last weekend. Bank of Tokyo-Mitsubishi said November same store sales fell 0.1% in November. This was the first time that November sales fell in 20 years. Mike Niemira, economist at Bank of Tokyo, reduced his estimate for November-December same-store sales to 2.5% from 3%. This is on top of the anemic 2.2% rise last year, which was the slowest since 1995.
Last year, refinancings were spurred by interest rates falling to 6.5%, this year rates for 30-year mortgages dropped below 6%. Falling rates combined with housing inflation made for a perfect storm for consumer reliquefication. Now, the consumer is facing almost the exact opposite situation. Interest rates are rising, and housing inflation is moderating. Housing prices rose 0.84% during the third quarter, much slower than the 2.39% increase during the second quarter this year and the 1.94% increase during the third quarter last year. In fact, there were 33 metropolitan areas that saw the average home price fall during the third quarter. This is according to the reports from OFHEO, which looks at individual home repeat sales or refinancings. Falling home prices will not bode well for continued household leveraging.
Goldman estimates that half the rise in household spending is due to cash-outs. The Mortgage Bankers Association predicts homeowners will take out $751 billion in refiancing home loans next year, about half the $1.4 trillion expected this year. Along with the record amount of refinancings, consumers have had additional stimulus from a personal income tax cut and lower interest rates. This record amount of stimulus has resulted in sales growing by a nominal amount. At the beginning of the year, economists were hoping consumers would be able to hold out until the second half when businesses would start picking up on capital investment. It turned out that consumers were able to shoulder the burden, helped by record low interest rates, which spurred the refinancing wave.
A survey conducted by Goldman Sachs of 100 chief information officers from among the largest 1,000 firms found that a recovery in IT spending will happen in the second half of next year at the earliest. Additionally, the pick up in spending will be much lower than the glory days of the dot-com bubble. IT budgets will grow by only 6% to 7% instead of the 10% to 13% growth during the late 1990s. Goldman concluded that a second half recovery that has 6%to 7% growth equals 2% to 3% growth for the year, which is below analysts' revenue estimates for the next year.
Hewlett-Packard agrees with Goldman. This week HP told investors that it expects revenue growth to be 2% to 4% next year. JD Edwards also warned this week that it would not meet analysts' revenue and earnings estimates for its next fiscal year, which ends October 31, 2003. Typically technology companies enjoy a good fourth quarter as IT managers "budget flush," but JD Edwards sees no signs of a budget flush this year. Between the surplus of technology throughout corporate America and the newfound focus on profits, IT spending will likely remain stagnant. If the Goldman survey is accurate, there will be several more warnings in the next month.
Index investing has become a major force in the investment community. Not only is the amount in index funds growing quickly, but the number of managers resorting to "closet indexing" is growing as well. Index investing is universally praised as the low cost way to capture market returns and outperform the majority of actively managed funds. It is rare to find someone attacking index investing. Last month Jesse Eisinger, writer for the Wall Street Journal, took index investing to task. In concluding an article discussing the problem regarding Wall Street research, Eisinger wrote, "The Vanguards have pushed indexing, which gave the illusion that absolute performance doesn't matter and that investing is easy, while giving rise to market inefficiencies. Until these idols are smashed, Wall Street research won't be any good."
Jack Bogle, founder of Vanguard and index investing's leading cheerleader, took exception to Eisinger's comment and wrote a response, which launched a point-counter-point discussion that was published in Eisinger's column.
Bogle's initial response centered on the, "staggering costs of financial intermediation." Among these costs are research costs. Bogle claims that, "research, for all it probably contributes to liquidity and market efficiency, creates negative value for the system as a whole." In his counter-argument, Eisinger's best point was:
"Indexing is great if very few people practice it. The more popular it gets, the worse an idea it is. Indexing and its very large cousin, shadow-indexing, drive money into stocks not when they are undervalued, but when companies are included in some index. The practice prevents people from selling stocks that are overvalued, because they are in an index. As more and more money hugs a benchmark, fewer people make decisions about what stocks prices should be. Prices start to diverge from their fundamentals. Indexing and shadow-indexing create inefficiencies because the investors are not trying to make money and prevent themselves from losing money. They are simply interested in relative performance. In the long-run, the more investors index, the more opportunity there is for a good long/short hedge fund doing solid fundamental research to exploit it."
To this Bogle replied:
"Yes, it's at least possible that the more investors who index (or closet index), the more opportunities that are created for "solid, fundamental research to exploit it." But the eternal mathematics of the markets inevitably insure that, in effect, for each hot shot that succeeds in exploiting it by, say, 5 [percentage points], there is a cold shot that must lose by, well, 5 [percentage points] per year -- before costs. After costs, the winner wins by 3 [percentage points] or so. But the loser loses by 7 [percentage points]. That symmetry doesn't appeal to me."
A couple weeks later, John Bogle wrote an editorial for the Wall Street Journal. In his editorial, Bogle further discussed the virtues of index investing. Bogle said, "There is not evidence that research - even the research of the Institutional Investor all-stars - adds value… The stock market is highly efficient, and that stock prices incorporate virtually all information." To be fair, there is a chance that he is only referring to Wall Street research since later he argues:
"If fund managers were willing to put their money where their mouth is and move to incentive-penalty fee schedules, the additional investment in research could be accompanied by far higher profits, for managers and fund owners. Under this scenario, the responsibility for most security analysis and research would gradually shift from the sell side -- with its present conflicted motives and unsatisfactory outcomes -- to the buy side, independent and proprietary."
While, the advantages of this system are obvious, it still does not solve Bogle's main argument of higher costs weighing down returns. First of all, even if a fund loses money by not garnering enough "incentives" and goes out of business, investors would have to continually move their money to the managers that are profitable. This would essentially cause everyone to be a momentum investor, as funds pursuing out of favor strategies or following a contrarian investing style would be forced to close. Plus, with portfolio managers being more risk adverse, there is a good chance that closet indexing would become more prevalent. Bogle returns to his main argument in concluding his editorial:
"for the market as a whole, research is a dead-weight cost that turns a zero-sum game into a loser's game. While the billions spent by Wall Street and institutional managers on research doubtless elicits useful information, stimulates trading activity, and fosters liquidity, its costs, along with all of the other -- and even higher -- costs of financial intermediation, guarantee that for investors as a whole, beating the market will remain a loser's game."
I must commend Jesse Eisinger for tackling this issue; few seem able to find any fault with index investing. Eisinger got real close to the central issue against index investing when he argued that as more investors participate in indexing, prices start to diverge from their fundamentals. But, he missed the heart of the argument by focusing on the trees and not the forest.
Bogle said, "research is a dead-weight cost that turns a zero-sum game into a loser's game." It is true that active managers on average will earn less than the market return due to costs. This is Bogle's main argument for indexing since an index fund does not incur research cost and can generally save money on transactions because turnover is minimal. In a world where index funds exist side-by-side with active managers, index funds will always outperform the average actively managed fund. But, research costs provide a valuable service. It is research that maintains the system and while it might cause managers to under-perform an index, research allows the game to exist. I submit that these costs are necessary to foster a financial system that efficiently and effectively allocates capital.
In his editorial, Bogle quipped, "Never think you know more than the market. Nobody does." Bogle obviously believes in the efficient market theory, which can be debated. But lets look at what Eugene Fama wrote in his Ph.D. dissertation when he coined the term efficient market in the 1960s:
"An 'efficient' market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value."
With a large number of market participants following index investing, there is a lack of "profit-maximizers actively competing, trying to predict future market values of individual securities." Without these market participates, the central premise of efficient markets is thrown out the window.
Bogle also seems to dismiss "the role of the security analyst as a financial statesman," as Benjamin Graham wrote in "Security Analysis," Granted, analysts have not acted as statesman during the past several years, but shouldn't we attempt to rectify that problem instead of compounding it by adding an additional problem? Financial analysts and money managers have an obligation to the financial system to allocate capital where it will be most beneficial. This clearly cannot happen when money managers invest in an index.
In an article earlier this year in the Investors Business Daily, Gus Sauter, managing director of Vanguard's Quantitative Equity Group, which runs $205 billion in 32 index funds, said, "Diversification is the big lesson on the Enron situation. If you have concentrated positions in stocks, you're subjecting yourself to the risks of just a few holdings." This shows just how far the mentality of indexers is removed from actual investment decision making. How about realizing research is the biggest lesson, or footnotes should actually be read? Perhaps the lesson from index managers is, make sure your bad investments are no worse than anyone else's.
Perhaps an even greater evil is "closet indexing." Even Bogle admits that closet indexing is "pernicious." Unfortunately, it is also widespread. Closet indexing has grown as portfolio managers learned that they will not be fired for providing returns similar to their benchmark. There is no easier way for an investment firm to lose assets than to significantly underperform its benchmark, especially now with all the consultants and other purveyors of performance monitoring. Last week, Bloomberg news reported that the University of California is firing nine internal managers and will outsource almost $14 billion after the in-house team gained 10.3% over the ten-year period ending June 2002. This compared to the 11.6% gain in its benchmark. Hopefully there is more to the story than active managers underperforming a benchmark by roughly the cost of doing business. This week, JPMorgan Fleming Asset Management was fired by the Massachusetts' state pension fund for losing 2.2% more than its benchmark this year.
Bogle claims that, "indexers accounted for 4/10 of one percent of stock market volume last year, so it's hard to imagine that tiny tail wagging the giant stock market dog." The trading volume of pure index firms might be that low, but the amount of assets controlled by indexers and closet indexers is enormous. A Financial Times story from early this year said, "Large index-tracking investors, who account for 10 to 12 percent of the world markets." In the article it estimates the S&P 500 is followed by almost $11 trillion. This is not the amount indexed, but the amount that is benchmarked to the S&P 500.
The growth in indexing can be explained by portfolio managers seeking safety. A survey sponsored by AIMR found that while individual investment performance was the most popular factor (71%) in determining the amount of discretionary bonuses, the organizations business performance (not investment performance, but the firm's bottom line) was second at 57% for portfolio managers. Obviously, the more profitable the firm, the more available to hand out to employees.
The ratings that Wall Street uses should be a big indication of how widespread "closet indexing" is. Several firms use the ratings: over-weight, equal-weight, and under-weight. If the firm thinks the stock is fully valued or overvalued why recommend any position in it. It can only be to cater to those trying to closely mimic an index or utilizing an enhanced indexing strategy. Enhanced indexing involves sticking to index weighting for the majority of the portfolio and tweaking slightly to fit personal investment merits. Enhanced indexing is usually done by maintaining the industry weightings of an index and taking a few bets on specific companies, either by over-weighting them or by including companies that are not part of the index.
What would happen if all investing were indexed? Bureaucratic committees instead of investors would determine which companies would have access to precious capital. Somebody needs to bear the costs of research for the financial system to operate effectively. This cost must be borne by investors since they are ultimately the users of the financial system. Indexers are getting a free lunch by utilizing the public good derived from the research conducted by other firms and using this to reduce their own cost and thus their returns. Perhaps, one way to solve this would be to levy a 1% fee on funds that have a correlation to one of the major indexes higher than 0.9. This fee could help fund Spitzer's independent research board. One percent of $1 trillion (a lowball estimate of the amount of money being run by indexing) should be able to fund some solid, fundamental research.