Par for the Course? Using Stock Indices as a worthy competitor
Imagine heading out for a round of golf with a friend. You arrive at the clubhouse and get a copy of the course-card. Your friend says, “I’ll pass thanks, I don’t play my rounds to their artificially imposed Indexes”. So as you take a 5 iron to the par 3, Index 1, 190m hole, he goes with a driver. To most people it would seem odd to ignore and play a round blindly ignoring the parameters suggested, but then at the end still being measured against them with a score that is over or under par.
There is currently a fashion within active Funds Management for “Index Unaware” managers who take high conviction stock calls. The odd thing, from our perspective, is that despite this their success or failures are measured against an index – indeed the most index unaware investor still measures himself against an index (1) – as ultimately there has to be a way to gauge someone’s success The rationale offered is that “index hugging” where managers buy stocks only because they are in the index is sub optimal for client outcomes.
To us at Morphic it seems somewhat odd to be so disparaging to Indices, when according to most studies show that ¾ of active US managers failed to beat the benchmark after fees and less than 1% exhibited true skill that was distinguishable from luck. We have the utmost respect for the market and the Index against which we are measured (MSCI All Country World – the broadest measure of listed stocks in the world). Indeed we see it as the most formidable of competitors: It has no fees; it does not suffer from behavioural biases that humans do as stocks fall out when they shrink; most indices which are market cap based (i.e. the larger the value of the business the larger it’s weighting), whilst having other problems, do have the advantage of being adaptive to changes in the world in that as say the rise of Technology sector in the real world, is mirrored in the index; and it never ever gets scared predicting a false recession, unlike most economists and carrying too much cash.
With such an array of data, why should one even bother? Indeed, our advice would be that the same as Cliff Asness and Warren Buffett: if you chose not to use Morphic for whatever reason (and one hopes we can convince you we can!), an index Fund is the best alternative option. There are undoubtedly skilled managers out there, but it is a hard game and reversion to the mean is a powerful force.
So how do we suggest beating the market (in a risk adjusted way – putting all your money in 2 stocks that finish higher one year isn’t)?
The Morphic solution draws on some of the very tools that were created to try and solve the above problem: Futures and Indices Exchange traded Funds (ETF’s). These are designed to give you market exposure and these are low cost and liquid by their nature. Doing this then enables the rest of the fund to be invested in a smaller range of stocks that we believe will beat the market.
So why not put all the money into the smaller range of stocks? A very low number of stocks can lead to excessive volatility and reduces the likelihood of skill showing through over luck. On the other side (so compared to largely diversified funds with 100+ stocks) of the equation, this approach takes away a lot of what is called basis risk whereby an investor succeeds (or fails) by simply choosing a stock in one sector; and diversification for the sake of it – the opposite problem to small number of stock issue.
Lastly, the use of liquid futures for market exposure has the added advantage of allowing us to reduce the overall exposure to the equity market swiftly and without ‘friction costs’. One of the issues with increasing the level of cash in a fund to protect against loss of capital in falling markets, is that the selling of your stock holdings has an effect on the level of the stock price. The more you try to sell, the more of an effect there will be. The S&P 500 index on the other hand is so large and liquid the market impact is minimal. This enables the fund to be run more efficiently.
This approach, we believe, gives us a fighting chance against this most formidable of competitors.
About the Author:
Joint CIO, Morphic Asset Management
(1) In reality no-one can achieve an Index return as it is pre-taxes and pre-transaction costs, so the aim of tracker funds is to just get as close as reasonably possible.