Comments on: Indexes Have the Advantage in Bear and Bull Markets http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/ Not just another (Canadian) financial blog Wed, 03 Dec 2008 07:30:46 +0000 http://wordpress.org/?v=abc By: Weekly Dividend Investing Roundup - December 7, 2007 Edition » The Dividend Guy Blog http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7590 Weekly Dividend Investing Roundup - December 7, 2007 Edition » The Dividend Guy Blog Fri, 07 Dec 2007 15:27:52 +0000 http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7590 [...] the use of mutual funds. Canadian Capitalist reminded me about this debate. It is pretty clear from Investing Intelligently’s rebuttal that our little blog world hear disagrees with [...] [...] the use of mutual funds. Canadian Capitalist reminded me about this debate. It is pretty clear from Investing Intelligently’s rebuttal that our little blog world hear disagrees with [...]

]]> By: Two Strikes against Active Management http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7582 Two Strikes against Active Management Thu, 06 Dec 2007 03:20:47 +0000 http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7582 [...] Investing Intelligently recently wrote a nice rebuttal of Rob Carrick’s article on how actively managed funds handily beat the index during the last bear market. You may not be able to count on mutual funds outperforming the index in the next bear market though. David Breman notes in today’s Financial Post that Canadian equity funds fell 6.1% in the month of November barely beating the TSX Composite Index, which slid 6.2%: Fans of actively managed funds will often defend the hefty management fees associated with mutual funds by saying that active management shines when markets turn volatile. That is when money-management expertise can steer dollars away from obviously overvalued, over-hyped sectors and into areas that should perform well. [...] [...] Investing Intelligently recently wrote a nice rebuttal of Rob Carrick’s article on how actively managed funds handily beat the index during the last bear market. You may not be able to count on mutual funds outperforming the index in the next bear market though. David Breman notes in today’s Financial Post that Canadian equity funds fell 6.1% in the month of November barely beating the TSX Composite Index, which slid 6.2%: Fans of actively managed funds will often defend the hefty management fees associated with mutual funds by saying that active management shines when markets turn volatile. That is when money-management expertise can steer dollars away from obviously overvalued, over-hyped sectors and into areas that should perform well. [...]

]]> By: Dave http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7539 Dave Sat, 24 Nov 2007 05:58:29 +0000 http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7539 FourPillars: According to the graph the average is about 5% and they shift around by about /- 1% from year to year. So that's why I used 1%. You can't compare a mutual fund with 5% /- 1% cash to an ETF, it wouldn't make sense, in that same way that comparing pure cash to an equity ETF doesn't make sense. You'd have to a mutual fund to an ETF 5% cash. Or imagine a mutual fund that's fully invested but moves into cash /- 1% from time to time (like say, before a bear market). This is hypothetical (but instructive) example I gave in my comment above. FourPillars: According to the graph the average is about 5% and they shift around by about /- 1% from year to year. So that’s why I used 1%. You can’t compare a mutual fund with 5% /- 1% cash to an ETF, it wouldn’t make sense, in that same way that comparing pure cash to an equity ETF doesn’t make sense. You’d have to a mutual fund to an ETF 5% cash. Or imagine a mutual fund that’s fully invested but moves into cash /- 1% from time to time (like say, before a bear market). This is hypothetical (but instructive) example I gave in my comment above.

]]> By: FourPillars http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7538 FourPillars Sat, 24 Nov 2007 02:48:25 +0000 http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7538 Good point Dave, a 1% cash position won't make much of a difference. I'm not sure what the average cash position of mutual funds is but it's probably a bit higher than 1% - but not much higher so your logic stands up. Good point Dave, a 1% cash position won’t make much of a difference.

I’m not sure what the average cash position of mutual funds is but it’s probably a bit higher than 1% - but not much higher so your logic stands up.

]]> By: Dave http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7533 Dave Fri, 23 Nov 2007 05:05:26 +0000 http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7533 TheDividendGuy: I think one of Carrick's problem is that he has to write every day or so. Unlike us bloggers who can just take a break whenever we want if there is nothing to write about. You make a great point about short-term vs. long-term focus and I'm glad you also think his advice is crazy. You can see the ridiculousness of Carrick's article if you replace every occurrence of "bear market" with "a down day on Bay/Wall street." Imagine if people considered a "down day" a bear market and an "up day" a bull market and reacted in some way to that by trading. This is no different from reacting on a monthly or yearly basis and neither makes any more sense. The only time anything that happens on a yearly or monthly time frame should matter to you is if your investing time frame is similar. If your investing time frame is much longer (20 years), a year or month is like a day. So don't be a day-trader I say! TheDividendGuy: I think one of Carrick’s problem is that he has to write every day or so. Unlike us bloggers who can just take a break whenever we want if there is nothing to write about.

You make a great point about short-term vs. long-term focus and I’m glad you also think his advice is crazy. You can see the ridiculousness of Carrick’s article if you replace every occurrence of “bear market” with “a down day on Bay/Wall street.” Imagine if people considered a “down day” a bear market and an “up day” a bull market and reacted in some way to that by trading. This is no different from reacting on a monthly or yearly basis and neither makes any more sense. The only time anything that happens on a yearly or monthly time frame should matter to you is if your investing time frame is similar. If your investing time frame is much longer (20 years), a year or month is like a day. So don’t be a day-trader I say!

]]> By: Dave http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7532 Dave Fri, 23 Nov 2007 04:47:54 +0000 http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7532 Mike, you're right this small cash amount will be a drag in a bull market and a buffer in a bear. If this cash percentage is constant, it will overall be a drag since overall the market is always going up. From that graph we see ~1% shifts here and there in the short term since ~1997, around a nominal 5%. For a fair comparison we would have to compare that to an ETF 5% cash, or instead we could compare a fully invested mutual fund that shifts 1% of assets into cash during a bear market. Let's say a mutual fund is fully invested and shifts 1% of its portfolio to cash in a bear market. The bear market takes off 20% of the value of the equities. The ETF will experience a loss of 20%. The mutual fund's 99% equity portion will experience a loss of 20% but the cash will stay the same. This amounts to an effective loss of 19.8%. So it's reduced the loss by 0.2%, or 1% of the equities' loss. 0.2% still doesn't even make for the difference in MERs between ETFs and mutual funds. Most Canadian equity funds have MERs of around 1.5-2%. The iShares TSX Composite Index has an MER of 0.25%. Let's assume the gap is 1.25%. During a -20% bear market loss in the market, a fully invested mutual fund would have to have a loss of -18.75% just to compete with an ETF. So it would have to transfer 5.75% of it's assets to cash at the start of the bear market to reduce its losses to exactly the difference between it's MER and that of a typical ETF. But according to that graph, American mutual funds transferred no where near that amount of additional assets into cash at the start of the 2001-2002 bear market. Mike, you’re right this small cash amount will be a drag in a bull market and a buffer in a bear. If this cash percentage is constant, it will overall be a drag since overall the market is always going up.

From that graph we see ~1% shifts here and there in the short term since ~1997, around a nominal 5%. For a fair comparison we would have to compare that to an ETF 5% cash, or instead we could compare a fully invested mutual fund that shifts 1% of assets into cash during a bear market.

Let’s say a mutual fund is fully invested and shifts 1% of its portfolio to cash in a bear market. The bear market takes off 20% of the value of the equities. The ETF will experience a loss of 20%. The mutual fund’s 99% equity portion will experience a loss of 20% but the cash will stay the same. This amounts to an effective loss of 19.8%. So it’s reduced the loss by 0.2%, or 1% of the equities’ loss. 0.2% still doesn’t even make for the difference in MERs between ETFs and mutual funds.

Most Canadian equity funds have MERs of around 1.5-2%. The iShares TSX Composite Index has an MER of 0.25%. Let’s assume the gap is 1.25%. During a -20% bear market loss in the market, a fully invested mutual fund would have to have a loss of -18.75% just to compete with an ETF. So it would have to transfer 5.75% of it’s assets to cash at the start of the bear market to reduce its losses to exactly the difference between it’s MER and that of a typical ETF. But according to that graph, American mutual funds transferred no where near that amount of additional assets into cash at the start of the 2001-2002 bear market.

]]> By: The Dividend Guy http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7531 The Dividend Guy Fri, 23 Nov 2007 04:10:20 +0000 http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7531 This is a great post- usually Carrick is pretty good but it sounds like he is being influenced by the funds now! I wish people were not so short-term focused on the market. Staying away from index funds because the market has done well for the past five years is crazy. The Dividend Guy This is a great post- usually Carrick is pretty good but it sounds like he is being influenced by the funds now!

I wish people were not so short-term focused on the market. Staying away from index funds because the market has done well for the past five years is crazy.

The Dividend Guy

]]> By: FourPillars http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7530 FourPillars Fri, 23 Nov 2007 02:57:17 +0000 http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7530 Mutual funds almost always have some cash because they need it for redemptions or if they are purchases, it may take a while to invest it. In my opinion, even if this amount is small (ie 2-3%), it will act as a small drag in a bull market and a small buffer in a bear. Mike Mutual funds almost always have some cash because they need it for redemptions or if they are purchases, it may take a while to invest it.

In my opinion, even if this amount is small (ie 2-3%), it will act as a small drag in a bull market and a small buffer in a bear.

Mike

]]> By: Dave http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7529 Dave Fri, 23 Nov 2007 02:12:34 +0000 http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7529 FourPillars: I think Carrick mentioned something about this: <blockquote> Fund managers can also hold cash to buffer the effect of a declining stock market, and they can allocate money to defensive sectors like consumer staples and health care. This flexibility is what makes funds, ideally, a better choice than index funds for putting money into a market that appears to be at a high point. </blockquote> But I brushed over it...there was already enough in the article that I objected to. :-) First of all, I remember reading somewhere about how this never really happens. Mutual fund managers really want to beat the index and they are already handicapped by their higher MERs, then cannot afford to have much cash. So do mutual fund managers switch part of their holdings to cash right before a bear market? Again, they have no idea when it will happen. If they guess wrong and the market continues upwards, they lose out to the index because their cash will not grow much and they've increased costs. They're damned if they do and damned if the don't because no matter what, the fund managers are fighting against the average but they have higher fees. Check out this graph: <a href="http://www.gold-eagle.com/gold_digest_02/images/consensus092802a.gif" rel="nofollow">Mutual fund % cash from 1962 to 2002</a>. I don't see anything from 1998-2002 that really convinces me that mutual fund managers successfully "switched to cash" to cushion the blow. And once again, during the bull market this cash will only hurt them. FourPillars: I think Carrick mentioned something about this:

Fund managers can also hold cash to buffer the effect of a declining stock market, and they can allocate money to defensive sectors like consumer staples and health care. This flexibility is what makes funds, ideally, a better choice than index funds for putting money into a market that appears to be at a high point.

But I brushed over it…there was already enough in the article that I objected to. :-)

First of all, I remember reading somewhere about how this never really happens. Mutual fund managers really want to beat the index and they are already handicapped by their higher MERs, then cannot afford to have much cash. So do mutual fund managers switch part of their holdings to cash right before a bear market? Again, they have no idea when it will happen. If they guess wrong and the market continues upwards, they lose out to the index because their cash will not grow much and they’ve increased costs. They’re damned if they do and damned if the don’t because no matter what, the fund managers are fighting against the average but they have higher fees.

Check out this graph: Mutual fund % cash from 1962 to 2002. I don’t see anything from 1998-2002 that really convinces me that mutual fund managers successfully “switched to cash” to cushion the blow. And once again, during the bull market this cash will only hurt them.

]]> By: FourPillars http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7528 FourPillars Fri, 23 Nov 2007 01:05:31 +0000 http://www.investingintelligently.com/2007/11/22/indexes-have-the-advantage-in-bear-and-bull-markets/#comment-7528 Excellent post Dave. I agree with you that ETFs will beat most mutual funds over any significant length of time. In theory, in a relatively quick bear market the opposite probably will be true because of the fact that most funds have a cash portion (intentional or not) which will soften the fall. On average the ETF will probably not do as well in that case. If the bear market lasts for a few years then the ETF should catch up again because of the lower fees. Regardless, as you so accurately point out - what difference does that make if you can't predict the timing of the bull/bear market?? ETFs all the way! Mike Excellent post Dave.

I agree with you that ETFs will beat most mutual funds over any significant length of time.

In theory, in a relatively quick bear market the opposite probably will be true because of the fact that most funds have a cash portion (intentional or not) which will soften the fall. On average the ETF will probably not do as well in that case. If the bear market lasts for a few years then the ETF should catch up again because of the lower fees.

Regardless, as you so accurately point out - what difference does that make if you can’t predict the timing of the bull/bear market??

ETFs all the way!

Mike

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