Thoughts on Indexing and Performance


From Bill Miller's Quarterly Market Commentary - January 22, 1999
Mr. Miller is President of Legg Mason Fund Adviser, Inc. and portfolio manager of the Legg Mason Value Trust and Special Investment Trust. He was named Domestic Equity Fund Manager of the Year for 1998 by Morningstar.

Most money managers again failed to keep pace with the benchmark S&P 500 in 1998, which outperformed over 80% of active managers for the year and over 95% of active managers over the past five years. Last year was a particularly hard year to beat the market, since only 28% of the stocks in the S&P outperformed the index, and those were concentrated mostly in the largest names. As evidenced by the very poor returns of the Russell, to the extent active managers focused their efforts on smaller companies, by charge or by choice, they had very little chance to deliver index-beating returns.

The S&P 500 is the benchmark for most active managers; it is the competition1. It is also the cost of capital for active management. Just as companies that invest above their cost of capital—which is the weighted average cost of their debt and equity—add value for owners and those that do not destroy shareholder value, so too with money managers. To the extent money managers outperform the index, they are adding value for their shareholders; to the extent that they underperform, they are destroying value relative to returns that could be obtained by investing in an index fund. The rapid growth of indexing over the past decade or so is a direct result of the inability of most active managers to add value relative to what is misleadingly referred to as passive investing.

Money managers are often quick to criticize companies that do not perform well, and to offer management advice on how to do better. Companies that are consistently beaten by the competition are rightly admonished and urged to adopt strategies with a greater probability of success. Those companies that are consistently superior are closely studied and their methods are often copied in order to improve results.

Surprisingly scant attention appears to be directed at the methods and strategies of the S&P 500 despite its long-term record of superiority relative to most active money managers. Data compiled by Tweedy Browne & Co. indicates that since the beginning of l982, the S&P 500 has outperformed over 90% of all surviving mutual funds. The proportion would of course be even higher if funds that subsequently failed or were merged were included. A recent book, Indexing for Maximum Investment Results2, contains the results of numerous studies of active managers vs. index performance. The results are consistent across a wide variety of time frames: index funds routinely beat the overwhelming majority of active managers. Index funds do particularly well relative to active managers in large capitalization stocks such as those found in the S&P 500. Even with very broad market indices, such as the Wilshire 5000, the superiority of indexing holds. From 1973 through l995 there were only 8 years that active managers beat that index, and 6 of them occurred prior to l983.

Two questions suggest themselves: why does indexing work, and can active managers improve their results by careful study of the competition?

The answer to the first question is easy: indexing works because the market is efficient. Academics refer to the notion of market efficiency as a hypothesis, but they are just being overly fastidious. We can dispense with trying to distinguish, as they do, between various forms of efficiency, and with an unnecessary discussion of the various studies of possible market anomalies and inefficiencies. For the purposes of real world investing, let’s call a market "pragmatically efficient" if it beats most active managers most of the time. It is clear that the market for large capitalization US stocks is pragmatically efficient.

An efficient market is one where stock prices reflect all available information. Notice that this description does not say prices are correct, just that in the aggregate they incorporate what is believed about the present value of the future. The information available to the market is reflected in prices through the collective behavior of the agents operating in it. These agents encompass an ecology of objectives, time horizons, risk tolerances, and utility functions. This leaves plenty of room for recurrent, exploitable anomalies such as those that may arise due to systemic errors in probability assessment. But any such opportunities are unlikely to be available to the average investor. Average hitters can’t win many batting titles.

The most important implication of a market that is efficient is that there is no algorithmic or systematic way to outperform it. More simply, there is no formula which can specify a portfolio that is likely, over time, to outperform the market. Any such formula or mechanism would be copied and its advantage arbitraged away as it quickly spread among investors. There may be formulations or principles used by those who have outperformed, but such statements will not specify a portfolio. We use just such formulations: we buy companies that trade at large discounts to intrinsic value. Unfortunately, that simple description doesn’t specify any particular portfolio. (When asked the secret to hitting, Stan Musial—I think—said, ‘wait for a good pitch, and then smash it’.)

This means that all of the popular methods of stock selection: value, growth, momentum, sector rotation, thematic investing, etc. are either too vague to be useful, or if specific, as many purely quantitative methods are, are likely to have a short half-life.

Is active management just a loser’s game, and passive indexing the only viable investment strategy? Not at all. Just as poorly performing companies can often improve their results by studying winning competitors, active managers can improve theirs by deconstructing the sources of competitive advantage of the index, in this case the S&P 500.

The first and most important feature of the S&P 500 is that it does not employ a passive selection strategy. Managers of index funds employ such a strategy, since they engage in no active stock selection. But the S&P 500 is an actively selected index. Its stocks are chosen from the nearly 9000 publicly traded securities on the New York, American and NASDAQ markets by a committee using specific investment criteria.

The returns of the S&P 500 are the best evidence of the long-term advantage of active portfolio management. It has consistently beaten broader, passively constructed indices such as the Wilshire 5000, the Russell 2000, and the NYSE Composite. That it has also beaten other active money managers is not an argument against active management, it is an argument against the methods employed by most active managers.

The S&P 500 is a long-term oriented, low turnover index employing a buy and hold strategy, which is by nature tax efficient. It lets its winners run, and selectively eliminates its losers. It never reduces a successful investment no matter how far up the stock has run, and it does not arbitrarily impose size or position limits on holdings, either by company or industry. Size is fixed at 500 names, and new names usually come into the portfolio because of the merger or acquisition of existing companies. Periodically, new names are added and others eliminated in an attempt to replace companies that are marginal with those whose position in the economy or in an industry are deemed more important.

The overall index is positioned to represent the broad sweep of the US economy. The stock selection committee at S&P consists of 9 analysts, and new names are meant to be seasoned companies with a history of profitability, financially sound, leaders in their industry or market, with a probability of being in business over the next 10 to 20 years. Portfolio turnover averaged 25 to 30 names in the l980’s but has picked up to 40 or so in the past few years.

The contrast with the typical active manager is stark. The average mutual fund is short-term oriented, has high turnover, is tax inefficient, and employs a trading oriented investment style. Most funds systematically cut back winners or rotate out of stocks that have done well into those expected to do better. Position limits and industry weightings are usually rigidly maintained in the name of either investing discipline or risk control. The number of holdings is usually well over 100, but may vary significantly, both among funds and within the same fund over time. The overall portfolio is constructed in accordance with some style the manager erroneously believes is likely to outperform the long term, low turnover approach of the S&P 500.

Since the selection criteria for inclusion in the S&P 500 are not terribly arcane, it is not superior stock selection that has led to its methods beating most other active management styles. There are services out there that are pretty good at identifying likely candidates for the index. America Online was widely expected to be added, as happened at December 31, and Warren Buffett’s Berkshire Hathaway is another favorite for eventual inclusion.

What is the source of the S&P’s superiority over active management styles? I think it comes back to market efficiency. The market is pretty well aware of the information that may affect the prospects of its constituent companies for the next year or so. New information arrives unpredictably. Beyond the next year, the complexities, uncertainties, and vagaries are such that no one is vouchsafed any special insight into the future. Most of the activity that makes active portfolio management active is wasted; it adds no value since it is engendered by the mistaken belief that the manager possesses information the market is unaware of, or that the market has mispriced. It does impose costs: trading costs, market impact costs, and taxes. It is also often triggered by ineffective psychological responses such as over-weighting recent data, anchoring on irrelevant criteria, and a whole host of other less than optimal decision procedures currently being investigated by cognitive psychologists.

Money managers often wrongly decry the growth of indexing and complain that it is a mindless strategy. While they may be right that pure factor based indexing strategies, e.g. buy all companies with characteristics xyz, are unlikely to add value over time (the evidence is not clear on this), they are surely wrong to bemoan either the desire of investors for S&P 500 index funds or their own inability to compete with the results of such funds. Investors are rationally selecting an active money management style that is sensible, tax efficient, has a long history, and works.

Bill Miller, CFA
Legg Mason Fund Adviser, Inc.
January 22, 1999

1It is not possible to invest directly in the S&P 500.
2Neubert Alberts, Editor


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