INDEX INVESTING IN PRACTICE

FNCE 455Class Session #4Lloyd KurtzSanta Clara University

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Topics

•The Separation Property in Practice

•Three Indexing Strategies• Bogle’s Strategy• Swensen’s Strategy• Gibson’s Strategy

The Separation Property in Practice

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4Asset Allocation Analysis Zephyr AllocationADVISOR: Nelson Capital Management

Efficient FrontierCase: Allocation Case Return vs. Risk (Standard Deviation)

0 2 4 6 8 10 12 14 165

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Risk (Standard Deviation)

Ret

urn

Vanguard 500 IndexVanguard Total BondVanguard Short-Term

Asset Allocations

Vanguard 500 Index

Vanguard Total Bond

Vanguard Short-Term

A capital allocation line (CAL) can be drawn from the risk-free rate to the most northwest point on the efficient frontier (highest Sharpe ratio). Points on this line are superior investment opportunities to all other points along the efficient frontier. (See BK&M p. 159)

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Markowitz-efficient portfolio with bond-equivalent risk.

Optimal risky portfolio.

Practical problems w/ cash as an asset

• Clients want action• “Why should I pay a fee for my advisor to hold cash?”

• Cash pays poor commissions• “If you want to hold cash, put it in the bank.”

• Cash holds you back when markets are rising• “Cash is trash.”

• Cash invites consumption• “It’s just sitting there.”

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Three Indexing Strategies

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John Bogle

Key Insight: A simple

indexing approach

outperforms most active

management strategies.

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Keep it simple

“As the Oracle has said, it is simple but it is not easy. Simple arithmetic suggests, and history confirms, that the winning strategy is to own all of the nation’s publicly-held businesses at very low cost...

“The best way to implement this strategy is indeed simple: Buying a fund that holds this market portfolio, and holding it forever.”

- John Bogle

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The virtues of indexing• Diversification• Low cost • Avoid pitfalls of active management• Guaranteed market-like performance• Ease of implementation

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0

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20

30

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60

1 2 4 6 8 10 20 30 40 50 100 200 300 400 500 1000

Number of Stocks in Portfolio

Ave

rag

e P

ort

foli

o S

td D

evia

tio

n %

Based on data in M. Statman, "How Many Stocks Make a Diversif ied Portfolio?" Journal of Finance and Quantitative Analysis 22 , September 1987.

Typical actively managed fund.

Typical broad-market index fund.

Index funds are better-diversified

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5,000

10,000

15,000

20,000

25,000

Valu

e o

f 1,0

00 I

nve

ste

d

8% Return Fund 6.7% Return Fund

Low costs better performance

Index funds have no research costs and lower trading costs. The typical index fund has a 1.3% annual performance advantage over the average actively-managed fund (20 bps expenses vs. 150 bps). Since the performance of the average fund is likely to be, well, average...the index investor keeps the costs savings as additional return.

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Avoid pitfalls of active management

• It’s harder to pick winners than you think.

• In 1970 there were 355 equity mutual funds• 223 closed (mostly due to weak performance)• 60 more underperformed by 1% or more per year• 48 matched the market (+/- 1% per year)• 24 beat the market by 1% or more

• Of those 24, 21 saw their performance peaks over a decade ago.

• “Only three out of the 355 equity funds that started the race in 1970 – 8/10 of 1 percent – have survived and mounted a record of sustained excellence.”

John Bogle, The Little Book of Common Sense Investing, 2007.

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The (lucky?) winners

• Davis New York Venture• Fidelity Contrafund• Franklin Mutual Shares

• Honorable Mention:• Legg Mason Value Trust (started in 1982)

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An unlikely champion

“I see no reason why investors should be content with results inferior to those of an indexed fund.”

- Benjamin Graham

From John Bogle’s The Little Book of Common Sense Investing

The value of self-knowledge

Not Confident

(Indexer)

Confident

(Active Investor)

Skillful

Underachiever

Incurs opportunity cost of not getting better returns, but is still

average.

Successful Active Investor

Earns superior investment returns.

Unskillful

Index Investor

Earns best possible (average) returns.

Unsuccessful Active Investor

Earns inferior investment returns.

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Are you a skillful investor?

• How have your investments generally worked out?

• Do you have a clear plan?

• Do you have the resources to execute that plan?• Data• Time• Energy

• Do you have some unique insight that could let you do better than a broad-based index fund?

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David Swensen

Key Insight: Investors

should consider a wide

range of asset classes in

constructing their portfolios.

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Who is this guy?

• Manages $19 bn Yale Endowment

• Innovator in the field of multi-asset class investing

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Is Swensen a skilled investor?

• How have your investments generally worked out?• Yale endowment had best performance of any educational endowment

over the 10 years ended 2011.• Disappointing performance in 2009-2010, however.

• Do you have a clear plan?• Yes

• Do you have the resources to execute that plan?• Yes

• Do you have some unique insight that could let you do better than a broad-based domestic index fund?• Yes

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His recommended asset classes

Source: David Swensen, Unconventional Succes

Domestic Equity “Equity investments remain a central part of a thoughtfully-assembled, long-term-oriented investment portfolio.”

Foreign Developed Equity

“Sensible investors invest in foreign equity markets through thick and thin, regardless of past performance.”

Emerging Markets Equity

“High expected returns with commensurately high levels of risk.”

Real Estate/REITS

“Powerful diversification…”

Treasury Bonds “No other asset type comes close to matching the diversifying power created by [T-bonds].”

TIPS “A compelling addition to the tool set.”

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Recommended asset class weights*

Asset Class Target Wgt. (%)

Domestic Equity 30

Foreign Developed Equity 15

Emerging Market Equity 5

Real Estate/REITS 20

U.S. Treasuries 15

TIPS 15

* “Fully 70% of assets promise equity-like returns.”

Source: David Swensen, Unconventional Success

Equity-Like Investments

Fixed-Income Investments

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Asset Class Target Wgt. (%)

Domestic Equity

[Russell 3000 Index Fund, IWF]30

Foreign Developed Equity

[MSCI EAFE Index Fund, EFA]15

Emerging Market Equity

[MCSI Emerging Markets Index Fund, EEM]5

Real Estate/REITS

[Dow Jones U.S. Real Estate Fund, IYR]20

U.S. Treasuries

[Lehman Aggregate Bond Fund, AGG]15

TIPS

[Lehman TIPS Bond Fund, TIP]15

Source: David Swensen, Yale Endowment, iShares website

Recommended asset class weightsUsing ETFs

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Roger Gibson

Key Insight: Adding

commodities and REITs

to equity portfolios can

greatly reduce portfolio

volatility.

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Multiple asset class portfolios outperform

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Why doesn’t everyone do this?

The Power of Diversification is Not Understood

“Investors lack an awareness of the power of diversification. The typical investor

understands that diversification may reduce volatility but suspects it simultaneously

impairs returns.”

They Want to Believe

“Investors naturally want to believe that there must be some way to predict which asset

class will come in first place.”

Domestic Market Focus

“Investors tend to use the domestic market as a frame of reference. When it outperforms

other asset classes, the investor perceives that diversification has impaired returns.”

Source: Roger C. Gibson, "Asset Allocation: Balancing Financial Risk," 2000.

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What was your worst year?

A B C D ABCD

S&P 500   EAFE   NAREIT   GSCI   Equal Allocation

Year Return Year Return Year Return Year Return Year Return

                         

1974 -26.47 1990 -23.19 1974 -21.40 1998 -35.75 2001 -13.12

2002 -22.09 2001 -22.61 1998 -17.50 2001 -31.93 1974 -7.63

1973 -14.66 1974 -22.15 1973 -15.52 1981 -23.01 1981 -5.74

2001 -11.88 2002 -17.52 1990 -15.35 1975 -17.22 1990 -3.16

2000 -9.10 2000 -15.21 1999 -4.62 1997 -14.07 1998 -1.08

Adapted and updated from Roger C. Gibson, "Asset Allocation: Balancing Financial Risk," 2000. Indices are provided for comparison purposes only and are not available for investment.

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The new worst year

A B C D ABCD

S&P 500   EAFE   NAREIT   GSCI   Equal Allocation

Year Return Year Return Year Return Year Return Year Return

                         

2008* -37.0 2008 -44.1 2008 -37.1 2008 -54.6 2008 -43.2

1974 -26.47 1990 -23.19 1974 -21.40 1998 -35.75 2001 -13.12

2002 -22.09 2001 -22.61 1998 -17.50 2001 -31.93 1974 -7.63

1973 -14.66 1974 -22.15 1973 -15.52 1981 -23.01 1981 -5.74

2001 -11.88 2002 -17.52 1990 -15.35 1975 -17.22 1990 -3.16

2000 -9.10 2000 -15.21 1999 -4.62 1997 -14.07 1998 -1.08

Adapted and updated from Roger C. Gibson, "Asset Allocation: Balancing Financial Risk," 2000. Indices are provided for comparison purposes only and are not available for investment.

*2008 returns from Vanguard Index 500 mutual fund, Vanguard Total International Stock Index fund, Vanguard REIT Index, Oppenheimer Commodity Strategy Fund.

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How the strategies did in 2008