Keeping it simple is not stupid

Each year S&P Dow Jones Indices measures how actively managed investment funds in different asset classes compare against the passive indices of those classes. The results for Australia are published in a SPIVA Scorecard. According to S&P Dow Jones Indices “SPIVA Scorecards go beyond providing simple performance data for each fund category to offer detailed apples-to-apples comparisons corrected for survivorship bias, as well as asset and equal-weighted peer averages... The SPIVA Scorecards serve as clean, unbiased reports on the ongoing active versus passive debate.”

The main conclusion of the latest SPIVA Scorecard to 30^th June 2013 is that:

“The only consistent data point we have observed over a five-year horizon is that a majority of active equity managers in most categories lag comparable benchmark indices. In the domestic equities category (the one we market time), over a five-year horizon, the S&P/ASX 200 Accumulation Index has outperformed over 60% of active Australian equity general funds.”

The SPIVA Scorecard also found that the S&P/ASX 200 Accumulation Index also beat 68% of active funds managers over a three-year period and over 60% over a one-year period. Note that the SPDR S&P/ASX 200 Fund ETF (ASX code STW), which is the most liquid (i.e. easily tradeable) for market timing purposes uses the same basket of stocks as the S&P/ASX 200 Accumulation Index.

Small caps the exception

SPIVA Scorecard also found that with the exception of active Australian Equity Small-Cap funds, a majority of funds across all categories (domestic and international shares, property and bonds) have failed to beat their respective indices over three and five-year periods studied in the report.

The reason that active managers do comparatively better than the share index in the equity small cap space is that such shares are less researched and traded so are more prone to market mispricing. By contrast the largest 200 listed companies (which comprise the S&P/ASX 200 Accumulation Index) are both intensively studied by analysts and heavily traded with the result that their prices reflect all known information about them. 

Another interesting finding of the SPIVA Scorecard is that over a five-year period almost 20% of actively managed funds across all asset classes ceased operating. There are various reasons for this including the tendency of active funds managers to launch a range of funds and then keep only those that perform well over time. Survivorship bias overstates the performance of the actively managed funds sector in investment performance league tables, though the SPIVA Scorecard corrects for this.

The bottom line for investors is that keeping it simple by using a low-cost ETF for a particular asset class (general equity, international equity, property and bonds) rather than buying a basket of individual securities or investing in a high-fee actively managed fund makes sense except for small cap stocks where an active funds manager can add value.

Warren Buffet certainly thinks so. Buffett, the world’s most successful investor, has just made public his last will and testament (See “Passive aggressive… Buffett’s new principle”). His $59 billion fortune will be left in a trust account for his wife’s benefit to be invested 10% in short dated government bonds and 90% in a low cost S&P 500 indexed fund. His reason for doing so is that he doesn’t trust active fund managers to do better than indexed funds such as ETFs. To me that says it all!

I favour ETFs for timing the share and gold markets and backing the strongest asset classes in an ETF Rotation Strategy. I do so because they are diversified, low cost, liquid and transparent. They also enjoy a high survivorship track record.

Applying slow trend following strategies to ETFs provides two advantages over holding actively managed funds:

1. As the annual SPIVA Scorecards show, passive asset class indices as used by ETFs do better than actively managed funds; and
2. As empirical studies show, slow trend trading an ETF (using its medium to long-term moving average) outperforms its passive index on a risk-adjusted basis over the course of a market cycle. 

Slow trend trading

Slow trend trading an indexed equity-ETF to avoid stock market crashes offers the attraction of high share market returns, but the lower volatility of bonds. No other share market investing system to my knowledge has achieved that record.

Even the strongest advocate of buy and hold, Professor Jeremy Siegel in Stocks for the Long Run, concedes that since 1886 a simple 200-day moving average trading system achieved slightly higher and much smoother annual returns than holding a portfolio of shares that reflected the share index.

An example I often cite to illustrate slow trend-trading is applying a 50 and 250 day (moving average) trend-line crossover strategy to the SPDR S&P/ASX 200 indexed fund (ASX code STW) to identify when to buy the ETF and when to sell it.  In the following chart the red lines show when the ETF should have been sold and the blue ones when you it should have been bought.

Click to enlarge

Using such a trend-following strategy would have kept you out of the share market crash of 2008 and its correction of 2011, yet got you back into the market when it rallied in 2009 and took off in 2012.

Notice also that you would have done only six buy or sell trades over this seven-year period. That’s what I mean by slow trading designed to manage share market risk. It stands in sharp contrast to aggressive trading based on share price patterns (e.g. heads and shoulders, flags and pennants), which few investors master and which most who try it lose money on.

The main criticism of slow trading from my clients is that it’s very boring to which my answer is that if you want thrills visit a casino and chance your luck. But it’s not what you should be doing with your hard-earned savings. Also investors holding balanced funds (typically with 60% equity exposure) are taking a huge risk if they don’t trend-trade their share portfolio to avoid a crash. Using an indexed equity ETF is the easiest and cheapest way to do that. 

There are presently 94 ETFs listed on the ASX with an estimated $10 billion of assets under management. Notice the rapid growth in ETF assets under management in just the last five years.

Canada (which has a slightly smaller superannuation pool than Australia), just topped $60 billion in ETFs, suggesting that Australian investors and SMSF trustees are only just waking up to the advantages of low cost ETFs over traditional managed funds. That’s not surprising because ETFs, unlike actively managed funds, have not paid upfront inducements and trailing fees to financial planners. According to the Vanguard and Investment Trends last year only 8% of SMSFs owned ETFs, though just over a third more said they were considering them.

Global ETF assets are now $2,000 billion. Australia’s share of this is only 0.5%, suggesting local ETF assets could quadruple to $40 billion in the next five years. As Australian ETFs grow in size their trading turnover and hence liquidity will also increase which will further narrow their trade slippage (price bid/ask spreads) and their tracking error (price discounts or premiums to their underlying net asset value or NAV).  

Percy Allan is a director of MarketTiming.com.au For a free three week trial of its newsletter and trend-trading strategies for listed ETF funds, see www.markettiming.com.au.