Thank you,

I’m going to explain some basic concepts, why index investing often implies an above-average outcome, some evidence why the results of active investing do not always yield the expected returns and some ideas how both strategies can be employed.

Let’s play a game of golf – closest to the pin – where we all can win some money. Some basic features of the game: we don’t know how many players there will be, but there will be pros, low-handicaps and less skilful players. The prize money will be proportionally distributed among the players; meaning that the winners won’t win all the money, but the most. Even the below-average group of players will win something. Furthermore, there is no entry fee.

Let’s look at the expected outcome when everybody is playing. The outer circle will represent the average distance from the pin for all players while the inner circle would be the average for the skilful players. In fact, it is an easy game for the skilful players and they would easily win the most of the prize money.

But now we introduce a new option whereby players can select the average distance from the pin. The logical choice for the less skilful players should be to pick the average option rather than playing themselves because they should win more money this way. Hereby the game will become more difficult for the remaining players asthe average distance from the pin is reduced by the absence of the less skilful players.

At the end only the real skilful players should play, but what does it mean for the players who selected the average option? Basically, the “indexers” would have outperformed about 50% of the skilful players!

The relevance of the game for investing: Like the game, investing over time is a positive gain for everyone. Also, if we had to repeat the game again next year, the percentages would remain the same, but we won’t beat necessarily the same group of players again.

Yet, unlike the game, with investing we don’t know where the target is – we disagree about prices and their direction.

Also, with investing it is much more difficult to differentiate between luck and skill. In ourgolf game we would need a player only to play a few strokes to determine whether he has skill or not whereas with investing we could easily need more than thirty years of data to prove statistically beyond reasonable doubt that a managers’ outperformance was due to skill and not luck.

Then, investing will always cost you money that reduces the managers’ net returns.

Thus, more than 50% of managers will perform below the benchmark over time…

The point is that index investing is not necessarily the same as the average of professionally-managed investing. In the fact, the evidence from the market leads us to believe it is in fact much better than the average!

For example, consider the percentage of actively-managed funds outperforming the index over different time intervals – over ten-year period about 40%, but note that funds that failed in the past and thus ceased to exist are not included in this comparison. Thus, survivorship bias makes the past actually better than it really was!

However, this relationship between index performance and the average fund performance is by no means a constant and we experienced wide swings in the fortunes of active fund management over time.

Obviously, in a South African context it is a function of the performance of the resources sector – the dominant sector (40-50%) of the market portfolio. Typically fund managers underweight this so-called “volatile” sector in their portfolios. Furthermore, managers have more equally-weighted portfolios than the index portfolio.

Most of us favour active investing, not only because we like or believe the good stories told and sold to us, perhaps we also don’t know enough about the alternative, namely index or enhanced index investing. However, we should be aware there are some fundamental issues that will erode our returns from active investing…

First, we don’t necessarily have the ability to predict the next set of winners, simply because the outperformance records of managers are not persistent over time. For example, consider a three-year review strategy where we selected the top three funds over the preceding three years and review that selection three years later. Here we find that this strategy did considerably worse than the performance of the actual top three funds (June 1998 to June 2010).

Second, our actual cash flow- or money-weighted return from investing might differ considerably from the published or reported returns that are measured from period-to-period, irrespective of the actual monies invested and cash flows.

We often invest in funds after-the-fact and we don’t have special skills to time our entry and exit points. For example, we will find that investors on average performed much worse than the performances of the high-flying value funds would indicate.

Third, we underestimate the real effects of investment costs over the long term. Simply, we underestimate the time we will spend in the market or we don’t know what effect costs will have on our potential returns.

For example, an investment with a one percent fee will reduce the potential final value by a factor of 25%over a thirty-year time span. Thus, outperformance relative to a low-cost option is a necessity for any investor, but unfortunately that cannot be guaranteed.

I believe a more sensible approach would be to use both active and passive investing in an investment strategy, otherwise known as core-satellite investing. We could derive at the “blending formula” by making use of “quants” and applying some common sense logic.

For example, if we want to manage/control the tracking error of our investment: Simply, if we want to outperform the market index, we need a high tracking error – an investment that is very different from the market portfolio – but that also means the risk of underperforming the market is real.

In this example, depending on our acceptable tracking error we will use different combinations of index and active portfolios.

Let’s look at some evidence from the past: In this example based on average fund performances (June 1997 to June 2010)the inclusion of an index investment at 30% of the total investment portfolio would have yielded the highest return per unit volatility.

Different time frames will reveal different optimal combinations (20-80% index investing), but I think 20-40% is a good conservative benchmark, especially given the host of effective and low-cost index and enhanced index ETFs available these days.

Finally, going to the gym is not really an exciting prospect for me, but the benefits to my healthare real over the long term. Likewise, with index investing the real benefits to my wealth will reveal itselfover time.

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