Long-term returns and a competitive track record help silence skeptics when the market turns turbulent

Toronto -- The market volatility of the past few weeks has some commentators questioning the effectiveness of index investing. Indexing is simply investing in a market index such as the TSE 300 or the S&P 500, rather than in an actively managed fund where the manager picks the stocks that are expected to outperform the market. There are two principal ways to index: index mutual funds, and exchange-traded index participation units such as i60s and SPDRs.

When the stock market surprises us, as it has recently, the skeptics of index investing come out in full force. They have three major objections: First, look at how badly index funds have done since the market has fallen. Second, how can anyone think the market is unbeatable when it is so obviously inefficient and irrational? And finally, the Canadian index is so heavily influenced by Nortel that it's imprudent to invest in it, since you end up overweighted in one stock. Not only do these objections not undermine the power of one of the most historically successful investment strategies, but they unknowingly help cement the case for indexing!

On the first objection, index products are naturally going to follow the market down when it declines. Even so, they've managed to beat the average U.S. equity fund in the worst possible market conditions. While not quite beating the average Canadian equity fund, index products have gone down only a few percentage points more. The S&P 500 has outperformed the average U.S. equity fund by more than four percentage points in three of the four worst periods.

The TSE 300 has indeed lagged the average Canadian equity fund, but only by between roughly two to three points. And don't forget these periods reflect the worst-performing months possible; they exclude the subsequent market recoveries and long-term outperformance of the indexes. The TSE 300 beat 68 per cent of active Canadian equity funds over the 10-year period ended December, 1999, and 83 per cent over five years. The S&P 500 beat 93 per cent of U.S. equity funds over the same 10-year period, and 91 per cent over five years.

The numbers, not the objections, speak for themselves.

However, to judge any investment, let alone an index product, over a two-week or two-month period is as absurd as deciding the outcome of a marathon only five minutes after the starting pistol is fired. If an investor's time horizon is five years or longer (as it should be, if stocks are invested in), then short-term volatility is relevant in one and only one way: as an extraordinary buying opportunity.

What about the second and more legitimate objection, related to market efficiency? The argument here is that the obvious lack of rational valuations in the market, up 10 per cent one week and down 10 per cent the next, give the active manager an advantage over the indexer. The active manager can take advantage of these blips to beat the market.

No one can deny that there is a certain amount of irrationality in the stock market, which detracts from its efficiency. And why shouldn't there be? Stock market prices are nothing more than a reflection of the thinking and behaviour of you and I -- imperfect individuals -- buying and selling. And we are as vulnerable to emotion between the market hours of 9:30 a.m. and 4:00 p.m. each weekday, as we are after the market closes when we overreact to being cut off in the passing lane on the way home, or freak out the next morning because we misplaced our car keys. The irrational elements that drive the markets in the short term are as unpredictable as anyone's reaction on a given day to losing their keys. Sometimes it doesn't matter much, other days it seems catastrophic.

But here's the leap in logic: You can't jump from the reasonable assumption that markets are inefficient because they move irrationally in the short term, to the unwarranted conclusion that market indexes can easily be beat. The fact that market moves are often irrational is precisely why it's so hard to beat the indexes. Short-term fluctuations can be random, unpredictable and impossible to consistently anticipate. That's why the index has such a competitive track record against active management.

As for the last objection of certain stocks, notably Nortel, having a heavy weight in the TSE 300, who's to say what a more appropriate weight is, if not market capitalization? Who's active call on what underweighting Nortel should have is the most compelling? It's hard to argue persuasively for a predetermined weighting that makes more sense than what the market as a whole believes, as reflected in the stocks market capitalization. Regarding prudence, in a properly diversified portfolio with international equities having a greater weighting than Canadian stocks, as they should, Nortel will hardly impose excessive risk on an investor.

There are solid and persistent reasons why indexing is so powerful, including low fees, low trading costs, deferred tax and market unpredictability. That's why over the long term, index products are likely to continue to outperform most active managers, in most markets, in most years.

That's not to say there isn't a place for active management in an investor's portfolio. If you start with an index fund or index participation unit, and complement that passive core holding with some active stock picking when (and only when) you have confidence in an active manager's ability to pick stocks, then you get the best of both worlds. As a core base to a portfolio, indexing plays a crucial role as performance protection. There is too much talk and concern currently about protecting principal, and far too little attention paid to protecting your returns from underperforming the markets themselves, which is a much more significant risk for investors over the long run.

Among the many compelling reasons to index is the calm acknowledgment that the market can move unpredictably in the short term. In turbulent markets, you won't meet more relaxed investors than indexers -- they've already committed themselves to the ultimate buy-and-hold strategy, which rewards them with the more consistent long-term returns of the markets themselves.

Ted Cadsby, MBA, CFA, is the head of CIBC Mutual Funds and author of The Power of Index Funds: Canada's Best-Kept Investment Secret, published by Stoddart.