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Sreenivasan Srikanth

PASSIVE equity investment portfolios, especially those that replicate the popular S&P 500 index of US stocks, have been one-way ticket to hell in the last three years. Investments in that strategy lost close to a staggering 37 per cent in value from January 1, 2000, causing a phenomenal destruction of wealth in a short period.

Stocks in the S&P 500 index currently have a market capitalisation of around $7.6 trillion, approximately 80 per cent of the total stock market's. Nearly 97 per cent of all active managers of the US stock portfolios use this index as the performance benchmark. Additionally, over $1 trillion is invested in passive strategies tied to the index.

Havoc of the magnitude we have witnessed to these indexed portfolios was not supposed to happen. Indexing is believed to be the most sensible way to invest based on the assumption that in efficient markets, where quality information is available equally to all investors, all stocks are correctly priced most of the time. Advocates of indexing strategies, therefore, strongly believe that an active manager will be unable to consistently outperform the market index. Indeed, indexed portfolios routinely beat 60-70 per cent of all active managers in almost all market conditions.

Why, then, did a strategy with such a creditable record flop in this bear market?

The essential weakness of indexing is the incorrect assumption that all stocks are rationally valued in efficient markets. While good information for security analysis is available to all who require it, investors do not act rationally in processing it, especially in the case of initial public offerings. How else can one explain the extraordinary gullibility of those who bought stocks of dotcom companies based on nothing more than appealing stories? Indexes can get terribly overvalued during times of irrational exuberance. Indexed strategies will be unable to protect investors from severe losses when bubbles collapse.

The simple truth is that at any time, in most stock markets, some stocks are overpriced and others underpriced. A competent active manager can profit from the pricing anomalies and deliver superior risk-adjusted returns, which is not to be confused with beating the index. While such managers are relatively rare, most other active managers perform below their true potential because they take unnecessary risks in an effort to beat the index.

For some years now, I have been questioning the appropriateness of using the S&P 500 index as a benchmark, or of investing in passive portfolios tied to it. There is too much trading activity now, especially in stocks that are in the spotlight. The index has, therefore, become far too volatile and too risky for most investors. The dull and neglected stocks within the index and some value stocks not included in it offer better opportunities for the patient investor.

Since the main goal of investing is to earn a steady rate of return higher than inflation and bond yields, it is more beneficial to set a required (absolute) return rate as the performance benchmark, instead of relative performance against the unknown return of an index. The fund manager or individual investor can then select stocks that have the potential to meet realistic expectations, with the least volatility. A few active managers in the US follow this approach and have very impressive investment records.

The importance of setting specific return goals is especially important in India. Historically, it has been difficult to make a strong case for equities in India — a common situation in most over-regulated economies — since fixed income alternative have given high yields, without too much risk.

The removal of most meddlesome controls on economic activity has now created genuine investment opportunities and transformed equities into an interesting asset class. Market forces now increasingly determine performance in the corporate sector, providing interesting opportunities to the intelligent equity investor to set and meet specific investment goals with the least level of risk.

(The author, based in Clinton, New Jersey, is a financial planner and investment adviser for private clients.)

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