The Wrong Way To Use An Index Tracker

Courtesy of Tim of The Psy-Fi Blog

Sedate and Inept

Index tracking is supposed to be a sedate affair, a quiet contemplation of the tempestuous dynamics of market forces from an appropriate distance.  A passive approach to investing, if you will.
 
Instead it seems that people who use index trackers either don’t understand that they’re simple commodities or simply trade them like any other instrument available to private investors: frequently, ineptly and in a manner calculated to abrogate their inbuilt advantages.  Nothing new there, then.
 
Dumb Money
 
As we saw in Intelligence Can Seriously Damage Your Wealth, many bright people seem unable to understand that index trackers are essentially commodities, where the main consideration ought to be the total expense ratios of the various funds.  After all, one S&P500 tracker ought to be much like another, but all too often smart people end up paying higher fees than necessary, seemingly because they're confused by the opaqueness of the charging structures.
 
This is what Michael Boldin and Gjergji Cici call The Index Fund Rationality Paradox.  On investigating this puzzle they come up with a couple of interesting findings.  Firstly they suggest that this isn’t the widespread problem it has previously appeared to be, because the anomaly seems to be explained:

“As being largely driven by an identifiable group of unsophisticated investors that buy funds through brokers. This finding is noteworthy because it contrasts with industry claims that the structural features of funds that charge loads and/or 12b-1 fees are beneficial to investors.”

Essentially investors who use brokers tend to end up with expensive index trackers which, the industry claims, add value through extra services.  However, the researchers suggest, these extra fees are often actually used to incentivize intermediaries to push naive investors into these funds.
 
Secondly, though, and on a more positive note they also find that the paradox is decreasing in general as most investors are learning to select their funds based on total expense ratio – a finding that indicates that they’re behaving more rationally over time. This is, at least, vaguely encouraging, because it suggests some of the messaging about the advantages of passive investing are getting through. However, we should never underestimate our innate ability to screw up even the most foolproof of plans.
 
Cold and Tasty Turkey
 
Of course index tracking is supposedly about passivity – a fixed and formulaic approach to stock selection which removes all of the nasty behavioral problems we’re inclined to suffer from.  It’s the active investor’s equivalent of going cold turkey.  Unfortunately the way that many active investors actually use index trackers is the equivalent of discovering the cold turkey is addictive and developing a whole new method of substance abuse. 
 
Fundamentally the logical beauty of an index tracker is that it largely removes the psychological problems associated with choosing and timing the buying and selling of shares.  Typically we lose 6% a year through overtrading, often because we keep changing our mind about whether we should be in a particular stock or not (see: Your 6% Self-Inflicted Trading Tax).  So deliberately setting out to avoid this problem should remove a whole class of behavioral issues.
 
It turns out, though, that instead of attempting to finesse trades in individual stocks the users of index trackers are trying to finesse trades in the style of stocks.  The research suggests investors are flipping between momentum stocks, value stocks and small and large market capitalisation stocks.
 
Young, Dumb and Indexing
 
Of course it’s unlikely that they’re actually switching between the specific factors identified, but it’s quite possible that their sensitivity to risk is changing based on the macroeconomic environment and that they’re switching style of investment depending on whether they’re feeling confident or not about the future progress of markets.  And, as is usual in these situations, they manage to trade away their profits.
 

“Investors who use these index-linked securities are younger than the investors who do not use these index-linked securities. They also differ in their level of active investing and portfolio performance. They trade more often. They do more stock picking, as measured by the level of idiosyncratic risk they bear. Their portfolio performance is better. We conclude from the above evidence that the users are better traders than the non-users of index-linked securities.”

To unpick this, the evidence seems to be that it’s younger investors who are tending to use index trackers and they seem to be better at trading using them.  So, you’d imagine, they get better results.  And, of course, you’d imagine wrongly because, as usual, people manage to pluck defeat from the jaws of certain victory: our active users of passive investment vehicles don’t perform any better than anyone else – which is to say; they don’t do very well.
 
Chase the Trend
 
Although these investors are not able to embrace the time-honored tradition of poor stock selection they are able to demonstrate an all-too-typical ability to chase market trends. The researchers looked at three common market factors or trends – the momentum, the high minus low (HML) and the small minus large (SML) factors.  (Momentum is presumably self-explanatory, the HML measures book to market and SML measures the size effect).
 
When the portfolio returns of the passive investors were adjusted for these effects they did at least as well, if not better, than their actively trading counterparts.  So the researchers hypothesised:

“This implies that the deterioration in portfolio performance for users compared to non-users could be attributed to bad factor timing on the part of users after use. This is surprising. The reason has to be that the users are employing these easy-to-trade index-linked securities to time factors, and they are timing them wrong.”

Basically they’re trend following.  Rather than using passive investment funds for the purpose for which they were intended – passive investing – our young index tracker trading friends are chasing the latest hot factor.  As usual these tend to mean revert as soon as they become popular, just as active funds do, so all of the benefits of a passive approach are getting traded away.  The ability of investors to introduce psychological malfeasance into the most unlikely of areas never ceases to amaze.
 
Education Limits
 
Of course, aggressively trading vanilla index trackers to chase particular market trends was never the intention, but it really isn’t surprising that many people do so.  The fact that it tends to be younger investors who act in this way is possibly indicative of some measure of education about the pitfalls of active stockpicking creeping into the group consciousness (see: The Tyranny of Numeracy).  Just as investors are learning to select funds based on total expense ratios, so they’re being slowly educated to avoid individual stocks.
 
Unfortunately this baseline education can only take you so far.  Behavioral bias is implicit in the human condition, so unless investors take on the simple point that market prediction at all levels is extremely difficult, and is something that should be left to people who get paid for doing so, then they’ll still find ways of losing money. The tendency to throw away any advantages that this might bring is certainly indicative that while you can lead an investor to the Promised Land you can’t actually prevent them razing it to the ground when they get there in order to build a better future.  Or so they think.
 
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