Fundamental Index Funds: Passive or Semi-passive Management Using Criteria

The first step towards active management is not particularly active. In reality, it is semi-passive – as we shall see.

The passive funds or ETF indexes discussed in the previous section are based on underlying indexes – S&P 500, IBEX 35, MSCI World Index, etc. – whose component parts are determined according to their size. In other words, large companies have a proportionately greater weight than smaller companies, in accordance with their relative size. This creates a perverse effect – when a business flounders, its price falls and it is ultimately expelled from the index – and in a passive index we accompany it throughout this downward journey to expulsion. Normally, this business is then substituted for one that has grown a lot and therefore has increased its capitalisation, something we have not taken part in. Put simply, we end up buying stocks that have already risen and selling them once they have fallen. Completely the wrong way round.

Therefore, if passive management doesn't convince us and we want to do something more in the belief that the market may not always be efficient and that we can do better, then the next option is a variation on index or exchange-traded funds: passive funds which have a predefined strategy able to beat the index. This is also known as factor investing or investing with fundamental index funds (FIFs). This could include funds that invest in companies with a low P/E ratio or a high dividend yield.

These FIFs make sense if they are able to obtain a better return than the market or the passive capitalisation indexes. And this can arise because of mean reversion, which is one of the least understand phenomena in human behavioural analysis. We will discuss this in more detail in Chapter 9.

Various authors have demonstrated that share prices experience mean reversion: after a bad spell, they improve and outperform the market and vice-versa, bubbles deflate. Stocks which trade with low multiples perform better than average, while high-multiple stocks perform worse, both trending towards the mean.⁶

James P. O'Shaughnessy has extensively and clearly analysed a multitude of investment strategies over the last 50 years, enabling us to verify which have been the most successful in dealing with mean reversion.

As can be seen from the table on the next page, lots of strategies beat the market on a regular basis. Over the period from 1964 to 2009, a strategy including all American stock obtained an 11.2% annual return. A pretty attractive return, but various alternative approaches could have fared better through building portfolios focused on a series of criteria:

• Low P/E ratio.
• Low EV/EBITDA (EBITDA is essentially an estimate of operating profit and EV is the enterprise value, the sum of debt plus stock market capitalisation).
• Low price/sales ratio.
• High dividend yield.
• Etc.

For example, a strategy which includes the group of shares with the lowest EV/EBITDA ratio would have obtained an annual return of 16.58% (by contrast, stocks with the highest ratio would have posted a measly 5.33% return).

He also considers various combinations of strategies, which deliver even better results. For example, he includes the following criteria in what he calls the ‘Value Factor Three’ strategy:

1. Price/book value.
2. P/E ratio.
3. Price/sales.
4. EBITDA/EV.
5. Price/cash flow.
6. Share buyback.

The Value Factor Three strategy, which employs the best combination of these factors – low P/E ratio, low price/sales, etc. – would have obtained an annual return of 17.39%.

Thus it would appear that it is in fact possible to improve on the results of capitalisation indexes using indexes of different criteria.

And surprisingly, if we add the concept of ‘price momentum’ to these ‘value’-based strategies, the results are even better: among all value stocks, the best performers over the last six months post a higher return during the following year. Some of the strategies calculated on this basis would have obtained a 23% annual return.

The fund managers at the hedge fund AQR have reached the same conclusion: value plus price momentum is the way to go.⁷

The logic behind ‘price momentum’ is that if you buy a stock which is already starting to rise then the opportunity cost is lower, reducing the time spent waiting for the rest of the market to wake up to the opportunity. This waiting time is the biggest problem for value investors, because we have a natural impulse to buy too soon and sell too early. In any case, for somebody accustomed to buying shares when they are on the way down, it feels counterintuitive to buy what is rising, making it a challenge to apply this ‘price momentum’ strategy.

O'Shaughnessy⁸ provides a detailed ranking of strategies, alongside the associated risks. It could be argued that such studies – which analyse the past – are a case of ‘data mining’, but in reality there is a logic to these results, underpinned by the concept of mean reversion.

The bigger challenge is choosing among the endless options. Even so, choosing one of these approaches makes a lot of sense, given that they can significantly outperform the indexes by between 5% and 10% a year. In reality, all active managers – especially us value investors – are constantly shuffling between the most attractive strategies. We are all on the lookout for cheap companies, using a variety of criteria to analyse them. When we post good results, they come from repeatedly applying these strategies, albeit sometimes intuitively or unwittingly.

Semi-passive or fundamental strategies, like passive approaches, save on management costs, but also help guard against character flaws that can prevent us from taking the right decisions. The more automatic the decision, the easier it will be. The downside is that when markets are performing poorly and the strategy itself is not working – and this can happen for lengthy periods of time – there is no shoulder to cry on. We are out in the wilderness on our own with no one to reassure us. This can be tough.

Obviously, there are not enough funds to cater for every possible form of semi-passive management, but the main alternatives are covered. In this regard, it's worth highlighting Dimensional Funds, which work directly with academics – especially Fama and French – to offer strategies that could obtain above-market returns. Not only have they developed some of the value strategies discussed here, but they also offer other types. AQR invest along these lines. Wisdom Tree is another asset manager specialised in this type of management, although the heavyweights, Blackrock and the like, also now offer semi-passive options.

Active Managers

The next step is to consider whether an active manager can do any better than these high-performing strategies. The answer is far from obvious, as can be seen in O'Shaughnessy:

Over the years, only 30% of American asset managers have managed to beat the indexes. Furthermore, according to the S&P Dow Jones Indices, in the last 10 years, 80% of European funds (France, Spain, Denmark, Switzerland, and Holland) failed to outperform the indexes. The success rate is even worse in Spain.⁹ (There are several studies on this topic, with different results, but always with a minority of managers beating the indexes.)

But the problem runs deeper still. Although some active managers have obtained good results, there is scant chance that they will continue to do so in the future. Research by two Morningstar analysts, Alex Bryan and James Li,¹⁰ shows that we have the same probability of outperforming the market in the future by investing with the worst-performing investors as we do with those who have the best track record (although for a horizon of less than a year, a certain persistence remains due to the ‘price momentum’ of certain stocks). Indeed, the CNMV – Spain's securities market regulator – requires all funds to provide a mandatory warning that past performance is no guarantee of future results.

Furthermore, if there are semi-passive strategies with proven track records of beating the indexes, why would we need an active manager?

Truth be told, there isn't much need. If we don't know anyone whose approach or results inspire us with confidence, it's clearly better to stay within the confines of passive or semi-passive management.

That said, I could certainly recommend some managers whose approach I find convincing and who have the results to substantiate it. I could also refer to a 1970s study by Buffett on his investment friends, who posted exceptional results by taking the right approach.¹¹

The Superinvestors of Graham-and-Doddsville

Source: Buffett (1984).

But nothing guarantees that future returns will replicate former glories, as the regulators rightly require us to point out to clients.

However, we can sustain an argument that most investors who have obtained excellent results did so by applying the previously mentioned value criteria. Furthermore, despite the cost of fees and the lack of certainty on results, there are still some reasons for investing with active managers:

1. Some managers capitalise on market inefficiency and may continue doing so in the future. It's undeniable. Look no further than Buffett.
2. We may not know how to choose or even find the right semi-passive or fundamental fund for us.¹² With a good asset manager we delegate the choice of strategy to them to apply: low P/E ratio, high dividend yield, low price/book value, etc. The best active managers are constantly shuffling between multiple strategies to find attractive stocks (whether consciously or otherwise), and this is exactly why they obtain good results. We could go so far as to say that some active managers are closet selectors of semi-passive strategies.

   It's true that it comes at a price, as they charge high fees, but sometimes it is worthwhile paying (bear in mind that unless we do the work ourselves, the person helping us find the right semi-passive fund will also charge).

3. The right strategy can vary from year to year, meaning that the portfolio needs ongoing adjustment. This is part of the job of being an active manager, but it's not easy for a private investor to do.
4. We are talking about our life savings and being in close contact with a fund manager that we trust can be a tremendous reassurance. Especially a manager who has a clear and consistent strategy, delivers good results, and to whom we can ‘put a face’. It is not easy to mentally prepare oneself for a passive and anonymous strategy, even if that may be the best approach for our future well-being. While a degree of automatism helps protect us from our own character flaws, it is also true that good advice from our asset manager can help during times of doubt or market difficulties, which are very frequent occurrences.

   The ‘emotional side of finance’ suggests that we need help to overcome anxiety brought on by investment. Meir Statman also points to other factors, such as status-seeking or the desire to have the ear of a recognised authority, which can drive us to seek out ‘prestigious’ investors.¹³

5. Another psychological benefit is the illusion of control or of having been responsible for success. If we choose an asset manager who is sufficiently responsive, we can have the sense of controlling decisions, as if we were the ones calling the shots. It's the closest thing possible to taking the decision to invest in a particular stock.

Berkshire Performance vs. S&P 500

Source: Berkshire Hathaway Annual Report, 2015.

None of these motives are conclusive; we haven't resolved the problem and some readers will doubtless remain unconvinced. But there are reasons for considering investing through an active manager, so long as we trust them. If we come across somebody or a particular team whose track record is reassuring to us, then it may make sense to invest. If not, we can stick to passive strategies and we won't be putting our foot in it.

But it is worth emphasising that the search cannot be superficial. It is vital to have an in-depth understanding of the manager or team: their approach to business, investment, and, of course, their outlook on life. I find it a real struggle to recommend other managers, as I don't have the time to carry out a rigorous appraisal, but when I do so it is after getting to know them in as much detail as possible. If we are able to meet the asset manager in person, so much the better.

And having a good track record is not enough; it's crucial to know how it was constructed. All of us are subject to the whims of luck, and it's important to determine the role played by underlying logic in the results.

It's no easy task, but there are good active managers out there in the financial markets. At times the market becomes entranced by undeniable irrationality, and investors who are able to make the most of it will obtain very positive results.

Direct Investment in Shares

The last option is investing directly in stocks, analysing and buying the most attractive options. And why not? I know some superb private investors who have a long-term approach, enjoying the total freedom from only being accountable to themselves. Nowadays we have the tools to be able to perform our own analysis and execute our investments in stocks. The only thing that's needed is time and desire.

The best way for these potential investors to obtain good results is by focusing on stocks identified from the previously mentioned strategies; doing so consistently, without wavering. It's difficult, but not impossible. One starting point is to search for and analyse the stocks selected by investors with a respectable track record, who have spent a lot of time thinking about them. Part of the work in selecting stocks has already been done for us. From then on it's a question of developing one's own criteria and sticking to them consistently.

The next chapters are aimed at such audacious investors, but they may also be useful to anyone seeking an active management fund. We will get into the detail of how to overcome the problem. It can be done!

A final word before we go wild and start buying. Taxes are the main problem with direct investing. The tax burden on individual investors from buying shares directly is greater than when investing in a fund. This is at least the case in Europe, where investors in regulated funds generally pay next to no taxes – for capital gains or dividends associated with shares – so long as they maintain their savings in these funds. This helps to significantly delay any possible tax bill. Furthermore, in Spain, transfers between funds are tax-exempt, meaning that if we keep our savings within the funds loop we may end up never paying those taxes.

That is why I personally refrain from investing directly in equities. Obviously it's a big help managing my own mutual funds, since I can invest my savings in the funds we manage.