Inspired by the book, Born To Run, I started doing more trail running a few years ago using a natural barefoot- inspired gate. Barefoot 10-mile runs on the beach on flat “hard” sand at low tide and 8- to 14-mile runs in shoes through the backcountry hills are inspiring and do my body good. I’ve subscribed to the “middle path” theory in my life while still attempting to attain excellence in the things I focus on. Translation: Work hard but don’t overdo it.
There are many folks around the world who run marathons and ultra marathons that range from about 26 to 100 miles for a single event. I’ve always had a feeling that running these distances might not be ideal for the body. It turns out I was right.
A study published online in the Mayo Clinic Proceedings suggests that excessive endurance exercise might actually put people at risk for permanent heart damage and lethal cardiovascular events. Measurements of many endurance runners who were in the midst of or had just completed endurance events found elevated naturally produced substances in their system that can lead to scarring of the heart and enlarged ventricles that can lead to irregular heartbeats and even sudden cardiac death.
Switching gears here to my professional area of focus, index funds are a good thing, but as it turns out, too much of a good thing can impair your financial health, much like distance running can impair your physical health. Any investor who has done some research probably understands that active investing has many drawbacks compared to indexed (passive) investing. An active manager’s goal is to beat an index by pulling out his crystal ball to predict the future. An index fund’s goal is to closely track an index. Since you can’t invest directly in the index itself, investment companies have created hundreds of index funds that allow you to invest in something that closely mimics a particular index. If the index funds are doing a good job of mimicking the index, they are said to have a low tracking error, which is their goal.
And herein lies the crux of the problem. There are too many index funds tracking indices and they all essentially have to buy and sell the same stocks about the same time. Why? Since their goal is to track the index as closely as possible, when an index board says “these stocks are now out of the index and these stocks are now in,” all these index funds have to blindly follow suit, buying and selling these same securities in an attempt to mimic the index as closely as possible.
This phenomenon, of course, has a detrimental effect on your return versus the index itself. I’ll offer a car analogy as an explanation. Let’s say everyone in the country wanted to, no, must, buy a red Ford F150 tomorrow because they had to. The price of that particular truck would go up significantly. Everyone then buys one at an inflated price. Then, once bought by everyone, the price of course goes down again. Everyone pays more for that truck than they should, and once owned, the truck’s value goes down more than it should.
How could you have avoided this? If you just had the flexibility to wait a while, you’d get a much better price on that vehicle than everyone else.
How can you help avoid this situation when investing? Use enhanced index strategies that rely on patient trading. Like our car analogy, just wait a while.
The effect of this phenomenon with index funds can be significant. A recent study by Dimensional Fund Advisors (DFA) showed that for three sets of Russell indices, there was a performance benefit of “approximately 0.45% to 2.21% per year” over the indices themselves just by delaying trades relative to what the indices are actually doing. [Index Reconstitution: The Price of Tracking, June 2016, DFA]
The moral of the story is this. When comparing costs between traditional index funds and enhanced index funds that use patient trading, you don’t get the full story by just looking at the expense ratios. As it turns out, walking down to the nearest index shop and looking only at expense ratios may not be the lowest cost route to go.
A better goal than blindly tracking the index is beating it, and one way to get started is by using enhanced index funds that incorporate patient trading.
Please contact me if you would like to see the full study or learn more at morgan.smith@wpwm.
2016 Q2 Index Performance Review
(Table disclosures and http://worthpointeinvest.com/disclaimer/) performance for periods greater than one year are annualized. Selection of funds, indices and time periods presented are chosen by the client’s advisor. Indices are not available for direct investment and performance does not reflect expenses of an actual portfolio. Past performance is not a guarantee of future results. Russell data copyright © Russell Investment Group 1995-2013, all rights reserved. The S&P data are provided by Standard & Poor’s Index Services Group. MSCI data copyright © MSCI 2013, all rights reserved. Barclays Capital data provided by Barclays Bank PLC.)
The second quarter was led by US REITs among the indicated indices. It’s been on a tear for the last year with a 23.71% return. Smaller stocks (Russell 2000) outpaced larger stocks (S&P 500) for the quarter, with international stocks (EAFE) doing relatively poorly not only for the quarter but for the past year.
When you look at the global markets, you realize the U.S. has been a haven of stability in a very messy world. Focusing on the five-year column in the chart, you can definitely see this when comparing emerging and international indices to the U.S. indices. Yes, your international investments are down right now, but eventually you can expect them to come to the rescue when the American bull market finally turns.
Meanwhile, interest rates have stayed low, once again confounding prognosticators who have been expecting significant rate rises for more than half a decade now. Although there is not always a direct correlation between interest rates and bond prices, bonds have provided a healthy return not only for the quarter but for recent years as well.
Looking at short-term numbers can satisfy our curiosities and is helpful in understanding some aspects of portfolio management, but they really don’t tell us much about potential portfolio risk or returns. There is always alarmist speculation and short-term thinking about a long-term phenomenon that will require years to play out; Brexit is a perfect example. It takes analysis of decades of market risk and returns to get to a point where you can effectively build all-weather long-term portfolios and that’s the starting point for our investment strategies.
There will be plenty of other opportunities for panic in a future. A good advisor and a long-term plan and strategy will have a calming effect on headline stress and increase the likelihood of a successful outcome.
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