What’s wrong with tracker funds? In theory, these should be the core of investors’ portfolios. This is for a simple reason. The average investor - by definition - must hold the market portfolio. Most of us are around average so most of us should hold a tracker fund. If we’re more willing to take risk than the average, we should hold more of the tracker and fewer safe assets and if we're less tolerant of risk we should hold more safe assets and fewer trackers. But either way, our equity investments should be in trackers. Strictly speaking, this should be a fund that tracks the global equity market, but given high correlations between national stock markets, an All-Share tracker is a reasonable second-best.
This poses the question: why don’t more people simply hold trackers?
One answer won't do - that many investors know more than average and so can spot stocks that beat the market. The facts show that, in practice, this is not the case. Brad Barber and Terrance Odean, two Californian economists, have shown that most retail investors around the world underperform the market and researchers at Vanguard have shown that most funds do too. The idea that you know better than the average might well owe more to overconfidence than to genuine knowledge.
In this context, there’s a common but mistaken leap of logic. It’s easy to dismiss the efficient markets hypothesis - the idea that share prices embody all available information - as absurd or even contradictory. But it is far too hasty to infer from this that you can beat the market by knowing better. There’s a big element of randomness which determines which companies thrive and which don’t, which means that even if we are well-informed about companies we might not be able to identify successful ones in advance.
Instead, there are three other reasons not to invest solely in trackers.
One trivial one is simply that some of us get intrinsic satisfaction from investing for ourselves, just as others do from fishing or playing the theremin. Whether one can make money from an enjoyable hobby is, though, another matter; it’s a very lucky person who can get paid for having fun.
A second reason is that trackers do badly sometimes. If big stocks underperform the market - as they did between 2010 and earlier this year - then capitalisation-weighted indices such as the All-Share index will out-perform more equal-weighted portfolios of the sort that active investors own.
Whether this happens over the long-run is, however, an open question. Andrew Clare at Cass Business School in London has shown that it has been true in the US, where equal-weighted indices have beaten capitalisation-weighted ones, but Issac Tabner at Stirling University has shown that it hasn't been the case in the UK.
This isn’t as contradictory as it seems. In a highly competitive economy - or one in which bosses of big firms are prone to hubris and reckless decision-making - big firms will see their advantages competed away, so capitalisation-weighted indices will underperform equal-weighted ones. But in a sclerotic economy which allows monopoly power to persist, there might be a Matthew effect allowing big companies and hence capitalisation-weighted indices to thrive. The merits of tracker funds against active portfolios will therefore vary from time to time and place to place.
There is, though, a third and more robust reason not to hold trackers - or at least not exclusively trackers. Some of us are not average investors simply by virtue of our risk exposures. And this deviation from average justifies holding a non-average equity portfolio, which means not holding merely a tracker.
For example, if you’re retired you no longer have to worry about the risk of recession as you no longer have a job or business to lose. In fact, you might even benefit from a recession if you're on a fixed-rate annuity and the recession reduces inflation. This means you are in a better than average position to hold cyclical stocks which are vulnerable to recession risk, such as housebuilders. Such stocks offer you a risk premium in exchange for taking a risk that bothers you less than the average investor. You might therefore want to hold more cyclicals that a tracker fund would.
In some respects, all retail investors are in this position. One source of risk premia is benchmark risk. Fund managers avoid some stocks because they run the danger of underperforming a rising market - an event which could get them sacked. Such stocks must offer good returns in average times to compensate for this risk. This is one reason why defensives and momentum stocks tend to do well. However, retail investors don’t have to worry about benchmark risk and so should be able to reap these benchmark risk premia. They might therefore want to hold more defensives and momentum shares than a tracker fund would.
However, such strategies come with two costs. The obvious one is the dealing costs involved in buying cyclicals, defensives or momentum.
The less obvious cost, though, might be greater. It's the temptation cost. Once we have set up an account with a broker and traded a few times, we’ll be tempted to trade more and upon bad ideas rather than our limited number of good ones. Worse still, we might be tempted to give up on even profitable strategies when they suffer the inevitable periods of short-run underperformance. Remember - the key to Warren Buffett’s success isn’t the ability to pick stocks, but the discipline to stick with good strategies even in bad times.
In this context, tracker funds have an overlooked virtue. They are a commitment device - a way to stop us succumbing to the temptation to trade too much whilst still giving us a decent equity portfolio.
On balance, I suspect that tracker funds are not a wholly optimal investment. But they are a cheap and reasonable one. For those of us content to satisfice rather than optimise, this is good enough.
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Chris blogs at http://stumblingandmumbling.typepad.com