How to Pick Managed Investments

1. How to Pick Managed Investments Travis Morien Compass Financial Planners Pty Ltd travis@travismorien.com http://www.travismorien.com

2. Types of Managed Funds There are two types of fund: • Index funds seek to capture the performance of an asset class as cheaply as possible • Actively managed funds seek to add extra value on top of asset class performance through selection and timing, using a variety of research strategies

3. Index Funds • Adopt a passive approach. • Main focus is on achieving maximum diversification at a minimum expense by holding a fixed percentage of every security in the market, or a representative basket. • Performance is determined by the asset class, index funds make little attempt to do better. If the asset class does poorly, index funds do poorly. If the asset class does well, index funds do well. • These funds are quite boring because they offer no potential to beat the market, most investors aren’t even aware they exist. Many “sophisticated” investors (and those that aspire to be) flatly refuse to even consider indexing because it is just too mediocre and too dull.

4. Active funds • When you buy an active fund, you are making a bet on a team of professional investors, and their ability to generate high returns. • May perform quite differently to the asset class as the manager adjusts the portfolio based on their research. • You pay extra for this research, usually about an extra 1%pa. • It seems defeatist to settle for asset class returns. Why would anyone settle for average performance when you can be above average?

5. What people think of active fund managers • Active fund managers enjoy a strong marketing edge over passive managers. Many attain celebrity status and their opinions on what the market is doing are highly sought after by the media. • Great faith is often placed in their abilities, and what they do is often portrayed as glamorous. • Some fund managers are paid seven figure salaries and bonuses and are often aggressively headhunted by rival firms. • Above all, active fund managers are usually perceived to be “interesting”. Picture by Vanguard Investments.

6. What people think of passive fund managers • In contrast to their more colourful active counterparts, passive fund managers are seen as the “nerds” of the investment business. • Their performance objective is only to match an index. Is this deliberate mediocrity bordering on negligence? • You probably wouldn’t want to be stuck next to a passive fund manager on a long flight, because all they ever talk about is tax efficiency, cost minimisation, diversification, asset allocation and buy and hold investing. Where is the fun in that? • Passive fund managers claim to have no special insights into what the market is going to do, and have no clever strategy that they intend to employ to “beat the market” by a large margin, often recommending investors “stay the course” and hold a diversified portfolio through thick and thin. • Above all, passive fund managers are usually perceived to be “boring”. Picture by Vanguard Investments.

7. Source: Mercer/Morningstar IDPS Survey

8. Source: Mercer/Morningstar IDPS survey

9. A portrait of failure: the performance of every US large cap fund with a 15 year history vs the S&P500 and CRSP 1-10 indexes. 15 Years ending 31 December 2001 (285 Funds) Picture credit: Dimensional Fund Advisors

10. It gets a whole lot worse! DALBAR Inc wanted to work out how much of a return retail investors were actually getting from their US mutual fund investments. The return they get isn’t necessarily the same as the average return of mutual funds because hardly anyone buys and holds, they usually chase the performance of funds that appear to be doing well, selling their funds that lag. They also have a tendency to sell (or cease contributing) during weak markets, but buy enthusiastically during strong markets, especially when those strong markets have run for several years. Figures show that the average time retail investors hold US Mutual funds is only 29.5 months, this has been trending downward for many years. DALBAR, Inc. have been tracking monthly inflows and outflows by retail investors since 1984, in the 1997 update of their Quantitative Analysis of Investor Behaviour Study, they concluded that: “Mutual fund investors earn far less than reported [fund] returns due to their investing behaviour. In their attempt to cash in on the impressive stock market gains, investors jump on the bandwagon too late, and switch in and out of funds trying to time the market. By not remaining fully invested for the entire period, they do not benefit from the majority of equity market appreciation.”

11. Annual returns of “buy and hold” index vs actual annual returns enjoyed by US mutual fund investors from 1984 to 2002 Source: DALBAR, Inc. Media release of 2003 update of study.

12. Frightening thought…. • The average American mutual fund investor only managed to earn 2.57%pa during one of the strongest bull markets US equities have ever seen, underperforming the S&P500 index by a truly staggering 10%pa. Inflation was about 3.14%pa over this period! • The most inept investor in the world could have made about 12.22%pa by buying and holding an S&P500 index fund. • Dalbar Inc place the blame squarely on the shoulders of market timing. The pattern is always the same: investors are notorious for buying in during the dying moments of a bull market and tend to get in near the top. Then the market falls and investors react by selling. They then stay out of the market for a long time until another long bull market has convinced them it is once again “safe” to invest, just in time to catch the next big fall! • If these levels of market timing skill and fund selection prowess continue, what kind of return will these investors earn if the market isn’t as strong? The 1990s were a truly fantastic time to be invested in equities. Despite the strong markets, investors still managed to snatch defeat from the jaws of victory. • Incredibly, these figures don’t take into account taxes, advisor fees, wrap account fees or transaction fees. OUCH!

13. Inflow and outflow data has been suggested to be useful as a “contrarian” timing signal. Unusually high mutual fund inflows are often a sign of an impending market top, serious outflows often auger a market bottom. Although exactly how much money one could make by doing the opposite is questionable, there is little doubt that performance chasing is historically a bad strategy.

14. "Investors continue to sour on stocks. So far this year, investors have made net withdrawals of $11.3 billion from their stock mutual funds according—including a hefty $3.7 billion just last week—according to AMG Data Services.” Source: Gregory Zuckerman, "Investors Rush to Buy Bonds, Fleeing Stocks," Wall Street Journal, March 11, 2003

15. Is index tracking more risky? You’d think that with diligent professionals at the wheel, even if they can’t outperform indexes after costs at least they can manage risk properly by prudently avoiding risky companies. Are active funds less volatile? Actually, active funds on average are more volatile than index funds because they are less diversified. Source: TAM Asset Management, Inc “Investment Policy Guidelines & Strategies Within the Context of The Prudent Investor Rule, “average active fund” = average of 7125 US domestic equity mutual funds in the Morningstar Principia Pro Database July 1991 - July 2001.

16. The average active fund does not outperform the index, and the average managed fund unit holder does even worse because they trade too much. • Active funds are less diversified and therefore more volatile than index funds and there is no evidence that they outperform in down markets, quite the contrary in fact. • Especially in the conservative asset classes like bonds and cash, and even property securities, there are almost no outperforming active funds and based on the statistical evidence it is very hard to justify active investing in these sectors. The stock market has its Warren Buffetts, Peter Lynchs and John Templetons, but not other asset classes.

17. Research houses in general refuse to even go near index funds, they won’t rate them, insisting that their job as researchers is to identify funds that will beat the index. • While corporate pension funds are taking up indexing enthusiastically, indexing is still anathema to financial advisers and private DIY investors share no more enthusiasm for index funds than the professionals. • Index funds are unpopular with every type of investor because almost 100% of investors think they are above average and possess superior investment skills. Is this faith warranted based on the evidence from Dalbar Inc and others? Mathematically, is it possible for most people to be above average or are investors deluding themselves?

18. The arithmetic of active management • The average performance of all investors will be the same as the market. It is impossible for everyone to be above average, mathematically it just can’t happen!! Half will fail because somebody always gets stuck holding the bad stocks! • The aggregate return of all investors in the market will be the market return, (obviously), because all the investors own all the stocks. The market return is the weighted average of passive returns plus active returns. • If the index funds have the same pre-fee return as the market (which is what they set out to do), then the other type of investor (active) will also have the same pre-fee return. If index funds bought, say, 30% of every stock issued, the remaining 70% left to the active investors would still have market index weightings. • This is a zero sum game, the average return of all active investors before costs is necessarily going to equal the average return of the market. • Active investment is usually more expensive than passive investment so active funds, as a group, will do worse than index funds after fees. • No amount of trading or research will change that. Some will outperform, but as a group they will underperform. Like a poker game, money is redistributed but not created or destroyed by active management. • Costs drag down the average performance of all investors. The average performance of all investors will be the market average return, minus the average expenses. To ensure that your net performance is above average, diversify extensively and keep expenses well below average.

19. Whether the market is up or down, low cost diversified investors will still outperform the majority of investors after costs, even if some investors still manage to outperform. Source: “The Inefficient Market Argument For Passive Investing”, Professor Steven Thorley, the Marriot School at BYU. Used with permission.

20. Source: TD Waterhouse, data by ASSIRT

21. Survivorship bias • Over longer time frames, “survivorship bias” affects the data. If you close down or merge the underperforming funds (and delete them from your database), replacing them with new funds with better track records, you’ll bias the sample average upwards, making active funds look better as a group. • In a previous slide “the arithmetic of active management” I mentioned that somebody always gets stuck holding the bad stocks. Survivorship bias is the mechanism for ensuring that these people are ignored. The database will exclude a number of below average performers, making the average look a lot better. • US researcher Burton Malkiel (author of A Random Walk Down Wall Street) estimates that survivorship bias adds 1.4%pa to the return of the median fund manager. For small company funds and sector funds, estimates exceed 2%pa.

22. Survivorship bias: amount median prices are overstated per year Source: Russel Investment Group, periods ending 30 June 2004, “Insights” IN107.

23. Another bias called “creation bias” is introduced when fund managers create new funds. They give seed capital to a lot of money managers, but the ones that underperform during their trial period are never opened to the public. In this way, all new stock funds (that the public hears about) come with a suitably high past performance, further tainting the data. It is of course nearly impossible to get accurate figures to quantify the size of creation bias.

24. Survivorship bias of course affects other asset classes as well. • This means that active funds do even worse in international markets than they do in the biased sample. (Scary thought!) • Estimates made in the US show that barely 15% of active stock funds outperform the S&P500 index over the long term once survivorship bias has been corrected. • Most funds will underperform, but how do we identify the exceptional ones?

25. Source: Frank Russell Australia, data by Morningstar

26. Source: Frank Russell Australia, data by Morningstar

27. If you are going to select active funds, you are best not going on recent past performance (if anything, do the opposite, but I don’t recommend blind contrarianism as a strategy). According to Morningstar, about 75% of investors invest in last year’s top quartile funds, which explains DALBAR Inc.’s figures. • While long term performance data seems to have some value, it is mainly effective as a negative filter. Long term losing funds tend to be discontinued by the fund manager, they rarely get better by themselves. Winners don’t reliably repeat. • I don’t take fund research house ratings very seriously. For example $1,000 invested in funds given a 5 star rating by Morningstar Australia between June 1998 and June 2000 would have produced $1,460 at the end of the two year period. But $1,000 invested in a four star fund would have produced $1,588, despite the funds’ lower rating.* • Hulbert Financial Digest, an American investment newsletter, tracked the performance of Morningstar US’ 5 star picks from 1991 to 1997 and found they lagged the S&P500 on average by nearly 3%pa. • Ok, so what does work then? *Source: Frank Russell Australia, though Morningstar retorted with a similar finding on Frank Russell’s recommendations, which have done little better.

28. Fama and French’s “Three factor” model Your returns mostly come down to asset allocation: • The mix of stocks vs bonds • The average company size • The value characteristics of the stocks - how “cheap” stocks are compared to book value. Picture credit: Dimensional Fund Advisors

29. Source: Dimensional Fund Advisors

30. Value premium • Academics who used to favour the random walk hypothesis and dart throwing no longer debate whether there is a performance premium for “value” stocks, they now debate why there is a performance premium. • Is the value premium because value stocks are underpriced (inefficient market) or because they are more risky (efficient market)? This is still hotly debated in academic circles and there is evidence to support both arguments, so in reality it is probably a bit of both. • A value premium has been demonstrated in virtually every market examined, including USA, Europe, Asia, Australia, UK and various smaller markets. • Dimensional Fund Advisors run two passive value funds that buy the cheapest 30% of stocks on the market, the DFA Australian Value Trust, and the DFA Global Value Trust.

31. Small company premium • The small company premium is almost certainly due to the higher risk of smaller companies, to that extent it seems to be consistent with the efficient market hypothesis. • The small company premium is certainly less reliable than the value premium, outperformance seems to be restricted to rapid bursts, they are quite volatile. • Small cap performance seems to be correlated with rising inflation rates, some researchers think this is because small companies can adjust their prices more readily than large companies, but this is just one explanation, there are many others. • Probably best for conservative investors to avoid small caps and buy value indexes if they want to beat the market with moderate risk. • The small company premium has not been observed in every market, including Australia. Small caps have underperformed the ASX100. • Dimensional also has Australian and global small cap index funds, the DFA Australian Small Companies Trust and the DFA Global Small Companies Trust.

32. Value vs growth The academic definitions of value and growth are polar opposites, they usually define value stocks as being the stocks with the lowest price to earnings ratios (PER) or price to book ratios (PBR). Growth is defined as the stocks with the highest ratios. Value and growth are practically irrelevant in large cap funds, there are few deep value or extreme growth stocks in the top 100. Thanks to their preoccupation with “tracking error”, many large cap “value” and “growth” managers hold virtually identical portfolios. This has lead to a myth that value and growth are just “investment styles” that perform about the same in the long term. In fact, “deep value”, really extreme value stocks as identified by PER or PBR performs markedly better than high priced “growth” stocks. Small cap value companies perform extremely well, but small cap growth are a disaster in both risk and return - speculators beware!

33. What are the best indicators of future returns? • The most reliable indicator of future performance is the fund fee: more expensive funds underperform the most. This accounts for the majority of variation between fund managers over the long term. • The next indicator is asset allocation, which dominates short term returns (quarterly data), but in the long term accounts for a significant but not dominant difference. Obviously funds with a higher weighting to stocks instead of bonds do better in the long term and deep value small company stocks are particularly rewarding. • Stock picking obviously has an impact on performance, but identifying skilled stock pickers in advance is hard. By the time the manager’s skills are recognised the fund may have become so large that keeping up this high performance becomes extremely difficult. Headhunting is also rife, so you may find that the manager you respect may well not be working there much longer. • Tax efficiency has a major effect on post-tax returns. This goes beyond just franking levels, you also need to look at capital gains distribution rates, the amount of short term distributions (as opposed to “long term” discountable capital gain distributions), and also unrealised capital gains on unsold stock. If you must use a tax-inefficient fund, consider buying it in super, stick with tax efficient funds for personal investments. Source: Common Sense on Mutual Funds by John Bogle

34. Why buy an index fund? • Chances of relatively high performance compared to active funds are very good. • Most index funds are extremely tax efficient (stocks anyway, not bonds of course!), so their performance after tax compares even more favourably. • Index funds don’t change much. You can buy one and safely forget about it, no need to change funds every year. Apart from anything else this saves you the time and costs of having to closely monitor your investments, or pay an advisor to do it. • Index funds are usually less volatile than actively managed funds. Active funds usually hold more concentrated portfolios, but index funds only hold a couple of percent in their biggest investments. Exposure to individual stocks is minimal. • Indexing means never having to say you’re sorry.

35. Why buy an actively managed fund? • There are a few reasons to use active funds instead of, or as well as index funds: • despite the odds, perhaps you think a particular fund can outperform • there may not be an index fund available for an asset class you wish to invest in, so you don’t have much choice • if the active fund is different enough to the index, maybe it will diversify the portfolio and potentially reduce overall portfolio volatility (long/short managers are particularly good for this).

36. Other things to look for in an actively managed fund: The fund should be very different to an index fund. Active funds that try to minimise “tracking error” inevitably fail to add value in the long term. To outperform the index takes more than conservative tilts to 20% of your portfolio. Top investors like Warren Buffett get beaten by the index 40% of the time. You may remember the heady days of the tech boom of the late 1990s, pundits called Buffett an obsolete dinosaur who had lost his touch, though in the end Buffett was proven right, as usual. If you want to outperform in the long term you’ll have to be prepared for periods of underperformance, and learn to ignore the pundits. Index funds are cheap. You can buy the SSGA Streettracks ASX200 index fund for an annual fee of only 0.286%pa, so how do you value active management? An active fund that is 80% index + 20% active will not add value. If the index hugging “active” fund is charging 1.5%pa, then they are charging a small fortune for their little tilts:80% x 0.286%pa + 20% x 6.356%pa = 1.5%pa It would be more cost effective to combine a cheap index fund with a fire breathing active stock picking fund if you want performance, rather than buy an index hugging active fund. Don’t pay active MERs to index your money.

37. The marketing business vs the investment business The priority of a fund manager keen to reduce tracking error is first and foremost to avoid upsetting people. They want to minimise the risk of relative underperformance, not maximise the probability of outperformance. If a fund manager doesn’t like an index stock, he probably shouldn’t buy it. It seems rather silly to load up on something just because it is a big company. Many fund managers bought Newscorp at $30 not because they thought it was a good stock (in fact the majority of fund managers hated NCP at that price), but because they feared that the stock might go up further and they would temporarily lag behind. They bought NCP just in case it didn’t fall! Nobody was fired for losing money on Newscorp becauseall the rival funds lost the same amount. Investors are less likely to pull their money out if the fund has been average than below average. Thus, managers focus on relative quarterly performance compared to peers, not long term absolute returns. For business reasons unconnected with prudent investment strategy, fund managers keen to avoid redemptions would rather buy major index stocks they don’t like than take the risk of watching them go up while not holding them. Tracking error is a good thing, it helps diversify your shares portfolio!

38. Portfolio turnover and market costs • Buying and selling stocks is expensive. Brokerage is a comparatively small expense compared to market impact costs. According to a US researcher, the Plexus Group, managed funds incur costs of around 0.8% on each side of a transaction. It costs about 1.6% in total to buy and sell a stock. • Funds that turn over 100% of the portfolio give away 1.6% to market costs every year. If we assume that stock markets are going to average 10%pa in the long term, there goes 16% of the total annual returns, straight into the pockets of brokers and market makers. • There is little or no evidence to show that fund managers are able to consistently time the market with any reliability (and at any rate, they are only trading with one another), so turnover drags down the performance of managed funds as a group.

39. Turnover and gross returns • In a review of 3,560 American stock funds, Morningstar discovered that funds with low turnover ratios generate superior long term returns to funds with a high turnover. Over a ten year period, funds with an annual turnover below 20% outperformed funds with an annual turnover above 100% by a margin of 1.58%pa.* • Other studies by Morningstar have shown that high turnover is associated with poor performance in both rising and falling markets, debunking a myth that being “more active” helps preserve capital during bear markets. • This is completely consistent with the Plexus figures estimating how much 100% turnover costs and proves that trading adds no value at all! *Source: Carole Gould "The Price of Turnover”, New York Times, November 21, 1997

40. Turnover and tax efficiency • Turnover also wrecks tax efficiency because it increases the rate of capital distributions and often leads to substantial short term (non discountable) capital gains distributions, these are taxed at your full marginal tax rate. • Looking around for low turnover managed funds places major restrictions on your choices. There are less than a dozen fund managers in Australia who adhere to a lowish turnover strategy, only half a dozen adhere to a very low turnover strategy. • Very low turnover Australian fund managers include Maple-Brown Abbott, Investors Mutual, Deutsche Alpha Fund and virtually all index funds. These managers typically keep fund turnover below 30%pa.

41. Turnover and tax efficiency cont’d • I won’t name names, but most of the biggest funds have turnover between 50%pa and 200%pa. There are funds with turnover even higher, 400 or 500% turnover is not unknown. So much for long term investment! • On the other hand, turnover generated by tax-loss selling can actually improve tax efficiency. Not every fund manager does this because tax efficiency is usually ignored by investors, who rarely bother to calculate after tax performance compared to an index fund. Fund managers will continue to ignore tax efficiency for as long as their customers are willing to overlook it as well. • I was shocked but not surprised recently when I asked a researcher from one of Australia’s leading fund research groups how much consideration tax efficiency was given in the selection of managers for their fund of funds products and manager ratings, his reply, “you know Travis, that’s never come up before!” Tax efficiency, so it turns out, wasn’t included in the rating system at all. • Value funds tend to have lower portfolio turnover than growth funds because of their longer time horizons and less reliance on “momentum” approaches.

42. Fund size It is a well established fact that the bigger a fund becomes, the more difficult it is to add value. (Though of course index funds don’t find size a handicap and in fact some fund managers have used size to their advantage using methods like block trading.) Billion dollar funds simply can’t invest in small and/or illiquid companies because they impact prices too much and would take too long to buy or sell their holdings. There is a direct conflict of interest between a fund manager’s marketing people that would like the fund to become infinitely large, and the investment people that want to keep it manageable. There is no point researching small companies because the manager couldn’t possibly invest a meaningful amount in them, so big funds are forced to deal in the more “efficient” large cap sector of the market, where outperformance is largely a matter of luck! Buying a very large fund with high fees & high turnover is an almost guaranteed way to underperform over the long term. Corollary: don’t buy funds that advertise on TV! In the last few years, boutique fund managers have really come into their own, managers like Investors Mutual, Hunter Hall, MMC, Platinum and PM Capital have amazed investors with spectacular performance. There is little or no evidence that these managers are any more risky than more familiar large funds.

43. Staff and stability Nothing is more annoying than buying a managed fund because you are impressed with the chief investment officer, only to have that manager poached by a rival fund manager. Managed funds have very high staff turnover, poaching is rife! Although generally funds have succession plans in place and documented investment strategies, stock picking skill is innate to individuals and can not be branded. Staff turnover is one of the major reasons why past performance is no guarantee of future results. Classic examples include ING’s Smaller Companies Fund, a great performer until BT poached the managers offering them seven figure salaries, also BT used to be great until the managers now known as the “BT Babies” left, and even Colonial First State have had several bad years, which just happened to coincide with Greg Perry and a few others leaving. This “musical chairs” goes on all the time in the funds industry.

44. Case study: the “BT Babies” • Following the careers of the “BT Babies” is interesting. This is the nickname given to three of BT’s top former fund managers who left the firm to open their own boutique fund management firms. • Kerr Neilson left BT to start Platinum in 1994, Paul Moore left to start PM Capital in 1998 and Mike Crivelli started Perennial Investment Partners in 1999. • Each of these individuals were extremely successful managers for BT for many years and the BT funds they ran all beat their benchmarks by a handy margin. When they left to start their own firms they did even better. • With the loss of their top managers BT never really recovered, they’re now little more than a shadow of their former self. There are lessons here for other leading fund managers, you can create a brand but no institution can make a team outperform. (BT has since reinvented itself and has an entirely new team of investors.) • My own investigations show that past performance is more reliable when you track the performance of an individual investor rather than a firm. The short duration of many investors’ terms with a particular fund is, in my opinion, one of the reasons why past performance is such an unreliable measure of future potential when you base your analysis on funds. I follow the person, not the institution.

45. Nobody works harder than an owner • A very encouraging signal that a manager is not going to be seduced by a better offer is that the manager owns significant equity in the business. • Platinum, Investors Mutual, Hunter Hall, PM Capital, Maple-Brown Abbott are all fund managers where the man managing the money owns significant equity in the firm and/or is paid according to performance. • The manager will retire one day, and there is no guarantee the successor will perform well, but at least poaching is probably out of the question. It is hard to poach the founder of a firm, much easier to target an employee.

46. Eating their own cooking • Another good sign is when managers have a significant amount of their own money invested in their own funds, including their superannuation and their family’s personal investments. • One has to worry when a fund manager has their personal money invested very differently to the construction of their managed fund, but this is not uncommon among very large funds where committees run the show and risk managers tell the fund to load up on major index stocks purely to reduce “tracking error”. • You rarely see money managers for the really large institutional funds given equity in their product or even investing their own money in the funds they run. What you more often see is the manager running their own in-house funds, quite different to the products they sell the public, usually for their own money they ignore tracking error and omit, rather than underweight, index stocks they don’t like.

47. Questions to ask your fund manager • Break down your performance figures into “income” and “growth”? Growth is more tax efficient for most investors. • Break up the income component into realised capital gains and dividends / interest / rent? If the income figure is more than, say, 4 or 5%, much of it is probably trading profits and indicates that the manager is probably churning the portfolio. • Break up the realised capital gains into discountable (long term) CG vs non-discountable short term CG? Personal investors and super funds pay a much lower rate of tax on long term capital gains. • What is your normal expected portfolio turnover, and what has it been in each of the last three years? Anything more than 30 or 40% is high churn. • What is your franking level?

48. Efficient market hypothesis You’ll note that so far in this presentation I have not made the claim that the market is completely efficient and that exceptional investors are the product of pure luck, as many academics do. I didn’t make that claim because I don’t believe it. Warren Buffett was not “lucky” to have earned nearly 30%pa from 1956 to the present day, and I don’t doubt that Colonial First State’s Greg Perry was a first rate stock picker and “his” Imputation Fund was a real winner – up until the point when he quit! The trouble lies in identifying such individuals in advance, before their funds get too large and before the manager retires or gets poached. This isn’t much easier than outperforming the market yourself because it usually takes a superior investor to recognise a superior investment approach. Track records are fickle things in this business, by the time you have established a good one the factors that enabled you to outperform (including small portfolio size and the attendant flexibility this brings) may be gone. Index approaches work because of low costs and tax efficiency, not because outperformance is impossible. Index funds would beat active funds regardless of how efficient the market is, in small caps, emerging markets, overseas or anywhere else. You can believe in inefficient markets and still embrace indexing. (I do!)

49. If everyone indexed, would the market cease to be efficient? Would there be a bubble in index stocks? The critics of indexing have made this claim since indexing first started gaining momentum in the 70s, but it lacks credibility. Studies have found that index funds account for only a small percentage of monthly transactions in stocks, typically under 5%.To claim that 5% of trades by passive investors doing no analysis set the prices for the other 95% of trades by active investors defies common sense. If sheer weight of “dumb” indexed money was what drove index stock prices then it is hard to understand how individual stocks move so differently. There are always stocks moving against the trend, indicating that those 5% of trades are not as influential in price setting as critics claim they are. Studies have failed to find any evidence of “index bubbles”.

50. If you are going to invest in actively managed funds… • Remember that the odds are against you, you should only invest in an active managed fund if you have a very high level of confidence in the manager. If you aren’t willing to do a significant amount of homework you should stick to index funds. Few active funds have come anywhere near the long term performance of value indexes, which have in turn beaten large company indexes like the All Ordinaries and MSCI World index and you have to remember that the value index funds are highly tax efficient as well, magnifying their relative outperformance. • It should not be a surprise that the characteristics of an ideal fund manager resemble those that any good investor should strive for: long term discipline, a willingness to ignore the crowd and take unpopular positions, an ability to isolate facts from opinions and a willingness to take a long term view. • Read up on Warren Buffett and the great masters. There are common threads that may help you recognise a good investor when you see one. • Such fund managers are actually very rare. The majority of funds are really just “product” produced by financial institutions. Their concerns are the same as any product manufacturer: maximising profit margins, increasing volume and market share, building a brand and getting their logo printed on everything! These concerns are usually directly opposing the interests of investors.