Indexation does more than plug in numbers and connect the dots

Sampling method offers the performance of an index while holding only the most liquid stocks

Ahighly qualified investment professional was recently quoted as saying index managers should work for free, as they actually do nothing and add no value.

This underlines the extent to which ignorance remains an inherent part of the investment industry today. More concerning is the extent to which such opinion may feed the already misunderstood and underappreciated perspectives on indexation.

Indexation is an elegant and sophisticated investment approach that is created organically. One does not walk into a supermarket and ask for one index, please. Nor does one plug in a machine that grinds away while the portfolio manager plays Candy Crush, and then at 5pm voila! The index!

It is important to note that the purpose of an index tracker is to track the performance of the index, not to simply replicate the index itself. There is no tangible index, but the reason an investor invests is to achieve the performance of the selected index.

PROPORTION

There are a number of ways this can be done, the most obvious of which is to replicate the holdings of the index being tracked; to hold all the stocks in the index in the proportion they are held in the index.

However, this can have serious implications from a liquidity perspective should the fund need to repurchase smaller stocks that may not be easily tradable. There may not be buyers for specific stocks and/or the price may be impacted should there be an anxious seller.

There is a more efficient and cost-effective way that ensures liquidity for the investor.

This is a method we at Gryphon call sampling. This methodology offers the performance of the index while holding only the most liquid stocks, thus ensuring maximum liquidity for the investor.

The point was further made by the investment professional mentioned above that passive is not passive anymore, that it’s now all about factor investing.

To quote Berkshire Hathaway CEO Warren Buffett: “Investors should be sceptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive.

“Too often, though, investors forget to examine the assumptions behind the symbols.

“Our advice: beware of geeks bearing formulas.”

Further, while some of the larger fund providers offer funds at an annual management fee of zero, any vaguely savvy investor knows there’s no such thing as a free lunch. Expenses are always recouped, either as part of the underlying trading cost ultimately reflected in the total investment cost, or through more scurrilous means that can place investors’ money at risk.

Investors in an indexationbased strategy will tell you one of the primary benefits is lower fees. This is because active funds generally charge substantially higher fees than index trackers and this is the main reason for their underperformance.

However, there is another aspect that needs to be considered. What is the point of paying a lower fee for an index tracker that fails to track the index?

In an ideal world you would want a tracker fund to exactly match the performance of the index it endeavours to mimic, but in reality some funds post a much larger differential than can be explained by the total investment charges related to managing the fund.

PERFORMANCE

In the accompanying graph we have taken all the indexationbased unit trusts (general equity sector) and compared their performance with the indices they track, over various periods.

A position on the grey line would indicate that the fund’s performance exactly matches the index, while a position above or below the grey line is an indication that the fund is not effectively delivering the index. Gryphon’s sampling approach can result in deviations over the short term; these smooth out over the longer term.

In conclusion, an extract from Buffett’s comment in the Berkshire Hathaway annual financial statement of 2013: “My money, I should add, is where my mouth is: what I advise here is essentially identical to certain instructions I’ve laid out in my will.

“One bequest provides that cash will be delivered to a trustee for my wife’s benefit. My advice to the trustee could not be more simple: put 10% of the cash in short-term government bonds and 90% in a very lowcost S&P 500 index fund.

“I believe the trust’s longterm results from this policy will be superior to those attained by most investors whether pension funds, institutions or individual who employ highfee managers.”