aswath_damodaran-investment_philosophies_2012

to investing style/strategy, the second is the tendency to indulge in herd behavior, and the third is the practice of making portfolios look better after the fact (window dressing).

1.Lack of consistency. As we noted in an earlier section, funds all too often invest in assets that do not match their stated objectives and philosophy. In fact, explicitly or implicitly, managers switch from one investment style to another. Studies seem to indicate that there is substantial switching of styles from period to period, usually in reaction to market performance in the preceding period. Brown and Van Harlow examined several thousand mutual funds from 1991 to 2000 and categorized them based on style consistency. They noted that funds that switch styles had much higher expense ratios and much lower returns than funds that maintain more consistent styles.38

38K. C. Brown and K. V. Harlow, “Staying the Course: The Impact of Investment Style Consistency on Mutual Fund Performance” (SSRN Working Paper 306999, 2002). The style consistency is measured using the R-squared of a fund with an index that reflects its stated objective. A fund that has a lower R-squared is deviating more from its stated style.

2.Herd behavior. One of the striking aspects of institutional investing is the degree to which institutions tend to buy or sell the same investments at the same time. Thus, you find the institutional holdings in a company drop off dramatically after a poor year and increase in sectors that outperform the market. With emerging markets, you often notice the phenomenon of institutional flight from an emerging market after a severe market decline. Borensztein and Gelos examine emerging market funds in Asia, Latin America, Europe, and the Middle East/Africa and report that there is significant herding behavior in each of these regions.39 There are two negative consequences to funds from herding. The first is that collective selling can make a retreat into a rout, and a small price drop on an investment into a big one; similarly, collective buying can push stock prices up for all buyers. The second is that herd behavior wreaks havoc on investment strategies. A portfolio manager who sells a low price-earnings ratio stock after a price drop may be undercutting her own long-term potential for returns.

3.Window dressing. It is a well-documented fact that portfolio managers try to rearrange their portfolios just prior to reporting dates, selling their losers and buying winners (after the fact). This process is called window dressing and it is based on the premise that investors will look at what is in the portfolio on the reporting date and ignore the actual return earned by the portfolio. Whatever the rationale for window dressing, it creates additional transaction costs for portfolios. O’Neal presents evidence that window dressing is most prevalent in December and that it does impose a significant cost on mutual funds.40

F I N D I N G T H E R I G H T F U N D

What are the lessons that individual investors can draw from past studies on mutual funds? These are a few:

Pick a fund that best fits your philosophy and needs. Before you pick a fund, develop a view on markets. In other words, choose

(continued)

39E. R. Borensztein and R. G. Gelos, “A Panic-Prone Pack? The Behavior of Emerging Market Mutual Funds” (IMF Working Paper No. 00/198, 2001).

40E. S. O’Neal, “Window Dressing and Equity Mutual Funds” (SSRN Working Paper 275031, 2001). He estimates that window dressing costs mutual funds about $1 billion each year in transaction costs and price impact.

Of the 28 basis point shortfall, the researchers estimate that 18.45 basis points comes from the management fee and the balance is caused by the noninvestment of dividends. In contrast, the Vanguard 500 institutional index fund underperformed the index by only 10 basis points a year, and the individual index fund underperformed the index by 17 basis points.42

There may be tax advantages associated with investing in an exchangetraded fund. When exchange-traded funds are redeemed, the trustee has the option of distributing the securities that comprise the index rather than cash. If the securities distributed on redemption are those with substantial capital gains, exchange-traded funds may be able to reduce investors’ ultimate tax bills, relative to index funds.

In summary, investors get the advantage of immediate liquidity with exchange-traded funds, but they do pay a price for the immediacy both in terms of transaction cost (from buying and selling SPDRs) and slightly lower returns. These costs may decrease over time as management fees come down, but for the moment, index funds still have a cost advantage and may be more efficient investments for investors with no need for liquidity and with long time horizons. A comparison of the trading costs of ETFs and index funds led Guedj and Huang to conclude that investors who value liquidity more are more likely to invest in hedge funds and that ETFs are better suited for narrower and less liquid indexes.43

I n d e x F u t u r e s a n d O p t i o n s

There are both futures and options traded on the S&P and other equity indexes, and they can be used to replicate the index. For instance, a passive investor with $10 million to invest can generate the equivalent of an index fund by buying a futures contract on the index and investing the cash in Treasury bills. If futures contracts are priced at their arbitrage value

42The Vanguard index fund, which is open to individuals, has slightly higher costs and underperforms the index by about 17 basis points a year.

43I. Guedj and J. Huang, “Are ETFs Replacing Index Mutual Funds?” (SSRN Working Paper, 2009).

(as defined in Chapter 11), the return on such a strategy should be equal to the return on the S&P 500 less the transaction cost of buying a futures contract. For a large institutional investor, this cost should be very low and the strategy may yield slightly higher returns than investing in an index fund. Derivatives-based strategies do not make sense for individual investors, since they tend to have much higher transaction costs. For these investors, index funds will continue to dominate and generate higher returns than alternative strategies.

E n h a n c e d I n d e x F u n d s

Enhanced index funds claim to have all of the advantages of index funds, while delivering the excess returns associated with actively managed funds. There are no free lunches in investing, though, and enhanced index funds are no exception. In fact, enhanced indexing is, in our view, an oxymoron. You are either an index fund or an actively managed fund but you cannot be both. Enhanced indexing is really active money management with selfimposed constraints on activity.

M e c h a n i c s The idea behind enhanced indexing is simple. Staying as close as you can to the index, you try to find pockets of mispricing that allow you to deliver slightly higher returns than the index. Broadly speaking, there are four classes of enhanced indexing strategies.

1.In synthetic enhancement strategies, you build on the derivatives strategies that we described in the preceding section. Using the whole range of derivatives—futures, options, and swaps—that may be available at any time on an index, you look for mispricing that you can use to replicate the index and generate additional returns. With a futures-based strategy, Elton, Gruber, Comer, and Li note that since the implicit spot price (estimated from the arbitrage relationship) in S&P futures contracts is generally slightly lower than the actual spot price, a strategy of investing in futures may generate returns that exceed the returns on the index.

2.In stock-based enhancement strategies, you adopt a more conventional active strategy using either stock selection or allocation to generate the excess returns. To see how the first would work, consider a strategy of holding all but the 20 most overvalued stocks in the S&P 500. If you could correctly identify these 20 stocks, you would have a portfolio that closely mimicked the index while delivering higher returns. In the second approach, you would hold all the stocks in the index but you would overweight those stocks or sectors that you believed to be undervalued and underweight those that you believed to be overvalued.

How would you identify these? You could use any of the strategies described in earlier chapters, ranging from screening to intrinsic valuation, to come up with the valuations.

3.In quantitative enhancement strategies, you use the mean-variance framework that is the foundation of modern portfolio theory to determine the optimal portfolio in terms of the trade-off between risk and return. Thus, if you have the expected return and standard deviation of each stock in the S&P 500 index and the correlations between every pair of stocks, you can find the portfolio that generates the best trade-off between return and risk.44

4.In fundamental enhancement strategies, you tilt the index fund more heavily or only toward stocks that have been shown to generate excess returns in the past: value stocks with price momentum, for instance. Arnott, Hsu, and West argue that “fundamental indexing” yields the best of both worlds: the low transaction costs of index funds and the excess returns of value-based strategies.45

Especially with the second and fourth strategies, notice that the only real difference between an enhanced indexing strategy and any other active investment strategy is the constraint that the portfolio you create stay close to the index. In fact, it is misleading to even label these funds as “index” funds, since they are active investing strategies in a different guise. You could argue that investors in these funds would be better served if these funds stripped the index component from their labels and looked for more efficient ways to exploit the inefficiencies that they claim to benefit from.

T r a c k i n g E r r o r , I n f o r m a t i o n R a t i o , a n d C l o s e t I n d e x i n g Since enhanced index funds claim that they are index funds that deliver extra returns, their risk is measured by looking at how much the returns on these funds deviate, period by period, from the returns on the index. As we noted in Chapter 6, the measure used for this is tracking error and is computed by taking the squared deviations of the returns on the fund from the returns on the index. A fund that perfectly tracks the index will have zero tracking error. An enhanced indexed fund will always have a tracking error that exceeds zero, but if it delivers on its promise, it will also have a return greater than the

44This is not a new idea. Harry Markowitz laid the foundations by capital market theory by explaining portfolio optimization in the 1950s.

45R. Arnott, J. Hsu, and J. M. West, The Fundamental Index: A Better Way to Invest

(Hoboken, NJ: John Wiley & Sons, 2008).

F I G U R E 1 3 . 2 0 Fidelity Magellan: Active and Passive Portions

Source: M. Cremers and A. Petajisto, “How Active Is Your Fund Manager? A New Measure That Predicts Performance” (SSRN Working Paper, 2009).

prevalent globally and that closet indexers underpeform the market by roughly 1 percent.47

P e r f o r m a n c e While the promise of enhanced index funds is index fund risk with enhanced returns, it remains an open question as to whether this combination is delivered. Riepe and Zils examined 10 enhanced index funds, two of which used synthetic enhancement strategies and eight of which used stock-based or quantitative strategies, from 1991 to 1997.48 They compared the annual returns on each fund to the returns on the S&P 500 index, and their findings are summarized in Figure 13.21.

While the names of the funds were not revealed, the period for which each fund had been in existence was provided and is reported next to the fund. Note that three of the 10 funds delivered returns lower than the S&P 500, which clearly puts the “enhancement” part of the strategy into question. When the standard deviations in returns on the funds were compared

47M. Cremers, M. A. Ferreira, P. P. Matos, and L. T. Starks, “The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees and Performance” (SSRN Working Paper 891719, 2011).

48M. W. Riepe and J. Zils, “Are Enhanced Index Mutual Funds Worthy of Their Name?” (working paper, Ibbotson Associates, 1997).

25.00%

20.00%

15.00%

10.00%

5.00%

Source: M. W. Riepe and J. Zils, “Are Enhanced Index Mutual Funds Worthy of Their Name?” (working paper, Ibbotson Associates, 1997).

to the S&P 500 (in Figure 13.22), seven of the 10 funds reported standard deviations that exceeded that of the index, raising doubts about the “indexing” part of the strategy.

A study of the behavior and holdings of enhanced index funds finds interesting patterns in their deviations from the index. In particular, enhanced index funds are overweighted in stocks with higher liquidity, larger capitalization, and higher past performance (price momentum). They are less