1. INDEX INVESTING IN PRACTICE FNCE 455 Class Session #4 Lloyd Kurtz Santa Clara University 1

2. 2 Topics The Separation Property in Practice Three Indexing Strategies Bogle’s Strategy Swensen’s Strategy Gibson’s Strategy

3. The Separation Property in Practice 3

4. 4 A capital allocation line (CAL) can be drawn from the risk-free rate to the most northwest point on the efficient frontier (highest Sharpe ratio). Points on this line are superior investment opportunities to all other points along the efficient frontier. (See BK&M p. 159) + Markowitz-efficient portfolio with bond- equivalent risk. Optimal risky portfolio.

5. Practical problems w/ cash as an asset Clients want action “Why should I pay a fee for my advisor to hold cash?” Cash pays poor commissions “If you want to hold cash, put it in the bank.” Cash holds you back when markets are rising “Cash is trash.” Cash invites consumption “It’s just sitting there.” 5

6. Three Indexing Strategies 6

7. 7 John Bogle Key Insight: A simple indexing approach outperforms most active management strategies.

8. 8 Keep it simple “As the Oracle has said, it is simple but it is not easy. Simple arithmetic suggests, and history confirms, that the winning strategy is to own all of the nation’s publicly-held businesses at very low cost... “The best way to implement this strategy is indeed simple: Buying a fund that holds this market portfolio, and holding it forever.” - John Bogle

9. 9 The virtues of indexing Diversification Low cost Avoid pitfalls of active management Guaranteed market-like performance Ease of implementation

10. 10 Typical actively managed fund. Typical broad- market index fund. Index funds are better-diversified

11. 11 Low costs  better performance Index funds have no research costs and lower trading costs. The typical index fund has a 1.3% annual performance advantage over the average actively-managed fund (20 bps expenses vs. 150 bps). Since the performance of the average fund is likely to be, well, average...the index investor keeps the costs savings as additional return.

12. 12 Avoid pitfalls of active management It’s harder to pick winners than you think. In 1970 there were 355 equity mutual funds 223 closed (mostly due to weak performance) 60 more underperformed by 1% or more per year 48 matched the market (+/- 1% per year) 24 beat the market by 1% or more Of those 24, 21 saw their performance peaks over a decade ago. “Only three out of the 355 equity funds that started the race in 1970 – 8/10 of 1 percent – have survived and mounted a record of sustained excellence.” John Bogle, The Little Book of Common Sense Investing, 2007.

13. 13 The (lucky?) winners Davis New York Venture Fidelity Contrafund Franklin Mutual Shares Honorable Mention: Legg Mason Value Trust (started in 1982)

14. 14 An unlikely champion “I see no reason why investors should be content with results inferior to those of an indexed fund.” - Benjamin Graham From John Bogle’s The Little Book of Common Sense Investing

15. The value of self-knowledge Not Confident (Indexer) Confident (Active Investor) Skillful Underachiever Incurs opportunity cost of not getting better returns, but is still average. Successful Active Investor Earns superior investment returns. Unskillful Index Investor Earns best possible (average) returns. Unsuccessful Active Investor Earns inferior investment returns. 15

16. 16 Are you a skillful investor? How have your investments generally worked out? Do you have a clear plan? Do you have the resources to execute that plan? Data Time Energy Do you have some unique insight that could let you do better than a broad-based index fund?

17. 17 David Swensen Key Insight: Investors should consider a wide range of asset classes in constructing their portfolios.

18. 18 Who is this guy? Manages $19 bn Yale Endowment Innovator in the field of multi-asset class investing

19. 19 Is Swensen a skilled investor? How have your investments generally worked out? Yale endowment had best performance of any educational endowment over the 10 years ended 2011. Disappointing performance in 2009-2010, however. Do you have a clear plan? Yes Do you have the resources to execute that plan? Yes Do you have some unique insight that could let you do better than a broad-based domestic index fund? Yes

20. 20 His recommended asset classes Source: David Swensen, Unconventional Succes Domestic Equity “Equity investments remain a central part of a thoughtfully- assembled, long-term-oriented investment portfolio.” Foreign Developed Equity “Sensible investors invest in foreign equity markets through thick and thin, regardless of past performance.” Emerging Markets Equity “High expected returns with commensurately high levels of risk.” Real Estate/REITS “Powerful diversification…” Treasury Bonds “No other asset type comes close to matching the diversifying power created by [T-bonds].” TIPS “A compelling addition to the tool set.”

21. 21 Recommended asset class weights* Asset ClassTarget Wgt. (%) Domestic Equity30 Foreign Developed Equity15 Emerging Market Equity5 Real Estate/REITS20 U.S. Treasuries15 TIPS15 * “ Fully 70% of assets promise equity-like returns. ” Source: David Swensen, Unconventional Success Equity-Like Investments Fixed-Income Investments

22. 22 Asset ClassTarget Wgt. (%) Domestic Equity [Russell 3000 Index Fund, IWF] 30 Foreign Developed Equity [MSCI EAFE Index Fund, EFA] 15 Emerging Market Equity [MCSI Emerging Markets Index Fund, EEM] 5 Real Estate/REITS [Dow Jones U.S. Real Estate Fund, IYR] 20 U.S. Treasuries [Lehman Aggregate Bond Fund, AGG] 15 TIPS [Lehman TIPS Bond Fund, TIP] 15 Source: David Swensen, Yale Endowment, iShares website Recommended asset class weights Using ETFs

23. 23 Roger Gibson Key Insight: Adding commodities and REITs to equity portfolios can greatly reduce portfolio volatility.

24. 24 Multiple asset class portfolios outperform

25. 25 Why doesn’t everyone do this? The Power of Diversification is Not Understood “Investors lack an awareness of the power of diversification. The typical investor understands that diversification may reduce volatility but suspects it simultaneously impairs returns.” They Want to Believe “Investors naturally want to believe that there must be some way to predict which asset class will come in first place.” Domestic Market Focus “Investors tend to use the domestic market as a frame of reference. When it outperforms other asset classes, the investor perceives that diversification has impaired returns.” Source: Roger C. Gibson, "Asset Allocation: Balancing Financial Risk," 2000.

26. 26 What was your worst year? ABCDABCD S&P 500 EAFE NAREIT GSCI Equal Allocation YearReturnYearReturnYearReturnYearReturnYearReturn 1974-26.471990-23.191974-21.401998-35.752001-13.12 2002-22.092001-22.611998-17.502001-31.931974-7.63 1973-14.661974-22.151973-15.521981-23.011981-5.74 2001-11.882002-17.521990-15.351975-17.221990-3.16 2000-9.102000-15.211999-4.621997-14.071998-1.08 Adapted and updated from Roger C. Gibson, "Asset Allocation: Balancing Financial Risk," 2000. Indices are provided for comparison purposes only and are not available for investment.

27. 27 The new worst year ABCDABCD S&P 500 EAFE NAREIT GSCI Equal Allocation YearReturnYearReturnYearReturnYearReturnYearReturn 2008*-37.02008-44.12008-37.12008-54.62008-43.2 1974-26.471990-23.191974-21.401998-35.752001-13.12 2002-22.092001-22.611998-17.502001-31.931974-7.63 1973-14.661974-22.151973-15.521981-23.011981-5.74 2001-11.882002-17.521990-15.351975-17.221990-3.16 2000-9.102000-15.211999-4.621997-14.071998-1.08 Adapted and updated from Roger C. Gibson, "Asset Allocation: Balancing Financial Risk," 2000. Indices are provided for comparison purposes only and are not available for investment. *2008 returns from Vanguard Index 500 mutual fund, Vanguard Total International Stock Index fund, Vanguard REIT Index, Oppenheimer Commodity Strategy Fund.

28. 28 How the strategies did in 2008