Index Funds 1, Active Managers 0

I was catching up on podcasts this morning and my mp3 player served up this gem from NPR's Business Story of the Day podcast:

Despite Losses, Star Investor Trusts In Stocks

David Swensen, manager of Yale University's endowment, says that individuals should be investing in index funds:

... because most so-called actively managed mutual funds — the ones that pay managers to pick stocks — charge such high fees that the fees more than eat up the added returns they're able to achieve, he says. So, in effect, you're losing money by paying for this active management, Swensen says.

Swensen has done some research on this point. He and others have found the odds are 100 to 1 that you're better off in an index fund.

Swensen's track record isn't bad. Yale's endowment is down 25% in a market that's down 50% or more. But, he has a staff to help him with investment research. For individuals with less time to devote, an index fund is the way to go.

Managing Credit

One of the topics in my personal finance course (FINM1401) is Managing Credit. Yesterday I finally got around to listening to the recent EconTalk podcast about credit and bankruptcy. Russ Roberts interviews law professor Todd Zywicki about the history of credit and bankruptcy law in the US. The first half of the interview, about credit, is very relevant; the parts about US bankruptcy law, while quite interesting, are not so relevant here in Australia.

Of particular interest were the following points:

• Before the rise of the credit card in the 1960s, credit was extended by sellers of durable goods (white goods, cars, etc.) through installment loans which allow payments to be extended over a fixed period of time. Credit was also extended by pawn shops and payday lenders. Therefore, it is difficult to compare the level of household debt today with levels 50+ years ago.
  
• The separation of credit provision from sales of durable goods made credit cheaper and allowed manufacturers to compete more transparently on price and features. Price is often obscured when credit is extended by the seller, as interest may not be explicitly stated.
• With the current credit crisis we're seeing a resurgence of some of these older methods of finance -- pawn shops, payday lenders, buying goods on installment loans. These often cost much more than credit card debt. Lay-away (Lay-by), where customers pay over time before receiving the product, is also becoming more common.
  

The cost of financial advice

Currently there's a big debate on whether financial advisors should be compensated using a fee-for-service model or a commission model. The Sydney Morning Herald chimes in with an article by Simon Hoyle. The conclusion, based on recent research:

...consumers pay 13 times more for commission-based advice than for fee-based advice.

Alan Kohler has argued that commission-based advice gives the planner the wrong incentives. That is, planners will recommend investments based on their commission structure rather than the return they will provide for their clients. (See his article "Too Little, Too Late" on the Business Spectator site). The new research cited by the SMH adds more ammunition to the fee-for-service side of the debate.

Portfolio Construction

The Australian Stock Exchange provides a podcast for investors. The latest item to show up in the feed (though not listed on the ASX podcast page) is a talk on Portfolio Construction by Dale Gillham, Chief Analyst at Wealth Within.

I listened to the podcast the other day while commuting and found it quite interesting. Mr Gillham makes some good points about diversification, but also seems to confuse some of the basic theory taught in finance courses. The basic Capital Asset Pricing Model (CAPM) assumes that market prices are efficient -- that is, that you can't consistently beat the market by choosing individual securities. If this is true, then your best course of action is to replicate the market portfolio. And the cheapest way for individual investors to replicate the market portfolio is to buy index funds or ETFs.

Any investment strategy designed to beat the market is implicitly assuming that the market is NOT efficient (probably not a bad assumption in smaller markets like Australia's). These strategies will beat the market to the extent that they are able to consistently identify undervalued investments. Such a strategy requires assuming a reasonable amount of company-specific risk -- the more you diversify, the closer your portfolio is to the overall market and the closer your return is to the market return.

So, when constructing your portfolio you need to be clear about your assumptions. Do you believe the market is efficient? Then go with index funds. Do you believe the market is inefficient? Then you need to decide whether you can consistently select undervalued companies. If you can't (or if you don't have the time), then index funds are still your best bet.

Welcome to a new academic year

Don't know if anyone is still checking this feed -- it's been months since I last posted.

Down here, January means school holidays and summer vacation. Most of my non-academic friends assume that means I'm on holidays too, but this is not the case. I did take the first two weeks of January off to pursue my creative hobbies, but now it's back to work. I have two research papers to revise and resubmit, and I need to get ready for semester 1, which starts on 25 February.

This semester I'm teaching half of three courses (I've divided my teaching load with a colleague so we can pick and choose topics that we are interested in). FINM1401 is an introduction to personal financial planning for non-business students. No finance background is assumed. FINM2401 is the introductory finance course for business undergrads. Many of the students will not take another finance course, but others will major in finance. It's a huge course with 600 students each semester. We break that into two lecture streams (and countless tutorial streams). FINM7065 is introductory finance for MBAs. The content is similar to FINM2401 with a more applied/managerial slant.

I've set up some shared tags in Google Reader so I can tag new items relevant to these courses. For FINM1401 you'll find the shared items here. For FINM2401/7065 they are here.