Foreign Funds-Index versus Active

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InvestingMom
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Foreign Funds-Index versus Active

Post by InvestingMom »

Are there many bogleheads investing in active funds for their foreign funds? How about US small cap?

Like most bogleheads, I believe in investing mostly in index funds. In fact I exclusively invest in index funds for my US large cap holdings. However, I also have believed that one can choose some good active funds for small cap and especially foreign. Therefore I have invested 50/50 in index/active for both small cap and foreign.

So far (only since the beginning of this year), in total, my index funds have prevailed. I know this is not a long enough period to judge so I am willing to keep holding. However, since they have not done well and these funds are in taxable accounts, it might be a good opportunity to switch now. So I am curious are there many of you who subscribe to the belief that you can beat the market....over time....in foreign active funds or US small cap funds? I mean over say 20 years because I feel very strongly that I don't want to give this up to the IRS.

PS Unfortunately most of my investments are in taxable accounts and the 401K I have does not offer good active funds (and I don't have enough room in my 401K anyway for my foreign/small cap allocation).
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Post by stratton »

Like most bogleheads, I believe in investing mostly in index funds. In fact I exclusively invest in index funds for my US large cap holdings. However, I also have believed that one can choose some good active funds for small cap and especially foreign.
If you want true, tiny microcaps then actively managed funds are your only choice. The problem is the price is stratospheric. I can imagine small foreign could be the same way. There is also the underserved "frontier" (think beyond EM) markets. Actively managed funds which can keep an eye on political developments might actually do better than an index fund. The question is will the increased ER outway the gains. You just have to realize you're taking managerial risk if the fund manager likes to concentrate investments.

Paul
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Re: Foreign Funds-Index versus Active

Post by ddb »

InvestingMom wrote:However, I also have believed that one can choose some good active funds for small cap and especially foreign.
Why?

I wish I knew who started the myth that certain asset classes are less efficient and therefore more appropriate for actively-managed funds.

- DDB
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Re: Foreign Funds-Index versus Active

Post by Doc »

InvestingMom wrote: So I am curious are there many of you who subscribe to the belief that you can beat the market....over time....in foreign active funds or US small cap funds?
Why does everybody think that the only purpose of active funds is to "beat the market"?

Vanguard has dozens of bond funds yet only a few are index funds. Is the purpose of all the other funds to "beat the market"? No of course not. They are there because they fill a place in one's portfolio that isn't adequately filled with an index fund.

The same thing apples to equity funds as well. Sometimes index funds just don't fit the bill.

As far as foreign is concerned, most well informed investors invest in foreign not to "beat the market" but to diversify their domestic equities. The main criteria for choosing a foreign fund is therefore not beat the market (active?) or lowest cost (index?) but rather what is the correlation with say the S&P 500? Sometimes active funds better meet this objective than index funds.

Re small caps: Ditto (but its not as clear.)
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Re: Foreign Funds-Index versus Active

Post by InvestingMom »

ddb wrote:
InvestingMom wrote:However, I also have believed that one can choose some good active funds for small cap and especially foreign.
Why?

I wish I knew who started the myth that certain asset classes are less efficient and therefore more appropriate for actively-managed funds.

- DDB
One person who advocated this, at least for a while, was Charles Schwab. I know, I know. He has a vested interest in this.

Anyway, it made sense to me, especially with regard to foreign funds. With US large cap all of the managers are chasing the same companies and there is very little that they can come up with that is not known by everyone. On the other hand with foreign and small cap, if a manager is doing his/her work, then they may be able to discover good companies. The other theory is that Foreign companies are not as highly regulated as US and so their is risk that the indexes are not representative of quality companies. Does any of this hold water? I would love to hear your opinions.
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Re: Foreign Funds-Index versus Active

Post by Doc »

ddb wrote: I wish I knew who started the myth that certain asset classes are less efficient and therefore more appropriate for actively-managed funds.
I think it was because most of the actively managed small value funds "beat" the Russell 2000 Value Index for many years. (Maybe it was all of the small cap funds and the Russell 2000.)

On the other hand, I think it is not hard for active bond managers to fairly consistently beat the appropriate index by using derivatives and other trading techniques.

Whether or not it is a myth would depend on how well you can develop an index that adequately reflects the particular asset class. I'm thinking of South Korea and how some indexes are including it in developed and others are not. There can be a lot of inefficient buying and selling by index funds that can be avoided or taken advantage of by active managers.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.
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Re: Foreign Funds-Index versus Active

Post by InvestingMom »

Doc wrote:
InvestingMom wrote: So I am curious are there many of you who subscribe to the belief that you can beat the market....over time....in foreign active funds or US small cap funds?
As far as foreign is concerned, most well informed investors invest in foreign not to "beat the market" but to diversify their domestic equities. The main criteria for choosing a foreign fund is therefore not beat the market (active?) or lowest cost (index?) but rather what is the correlation with say the S&P 500? Sometimes active funds better meet this objective than index funds.

Re small caps: Ditto (but its not as clear.)
Good points. So if I understand you correctly you are saying that if there is an index fund that adequately diversifies your investments, then there is no need for a managed account?
So then I am curious as to whether you think any one or two of the Vanguard index funds would diversify one enough? The total intl index? It is a bit confusing because almost by definition, the index is the market. So which index best diversifies a portfolio against the US market?
It still seems logical to me that part of the goal is to "beat the index" expecially if one does not feel comfortable with the index, such as with a foreign index which is composed of companies which are not as regulated?
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SPIVA

Post by gatorking »

I recommend looking through the SPIVA report (S&P's Index vs. Active) available here:
http://www2.standardandpoors.com/spf/pd ... 007_q1.pdf

From pg. 17: Over the last 5 years, small cap international index outperformed 72% of the corresponding active funds.

From pg. 4: For U.S.: Small cap value index outperformed 60% of active small cap value funds over five years. This number goes up to 80% from small cap blend.

Regards.
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Post by alec »

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Gatorking and Alec-Thanks!

Post by InvestingMom »

Nothing speaks better than numbers (when they are calculated the correct way!)
Wow do I feel like a dope! I am going to study the information you passed on a bit more, but I think I am moving over to a lazier and more profitable portfolio.
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Index vs managed funds

Post by Taylor Larimore »

Hello Investing Mom:
I am curious are there many of you who subscribe to the belief that you can beat the market....over time....in foreign active funds or US small cap funds?
Each quarter Standard and Poor's publishes a "Scorecard" showing the percentage of index funds outperforming managed funds. You will see (report 1, page 5) that Small Cap Index funds outperformed Small Cap managed funds in all three domestic Small-Cap categories during the past five years ending 12-31-06.

International index funds (Report 14, page 18 also outperformed 78% of international managed funds for the 5-years ending 12-31-06:

http://www2.standardandpoors.com/spf/pd ... _Q4-sc.pdf

It is mathematically certain that the average index fund will have higher returns than the average managed fund in ANY asset class using the same stocks or bonds.

Best wishes.
Taylor
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InvestingMom
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Taylor -thanks

Post by InvestingMom »

Taylor,
Thanks to you as well. I saw you logged in and was hoping that you would comment.
I continue to be amazed at the great advice I get on this forum. I hope that newbies like myself do not keep you too busy repeating the same information over and over. If it helps, I ordered the paperback version of your book...just waiting for it to arrive. :D
Sincerely, InvestingMom
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Post by livesoft »

Here is a paper by Millicent Holmes who studied and published the results of an index vs active. http://www.fpanet.org/journal/articles/ ... 7-art6.cfm
Surprisingly, indexing outperformed active management in the active Small-Cap Value and Growth asset classes, precisely the asset classes in which one would expect active management to outperform index management.
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Post by biasion »

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Post by Doc »

Taylor wrote:
It is mathematically certain that the average index fund will have higher returns than the average managed fund in ANY asset class using the same stocks or bonds.
Taylor is absolutely correct: "higher returns than the average managed fund in ANY asset class using the same stocks or bonds."

But there are two problems with this statement.

1) My initial point was: "Why does everybody think that the only purpose of active funds is to "beat the market?" Taylor's comment addresses only returns not risk. Especially risk in certain down markets like bubble bursting.

2)"... the same stocks and bonds." This assume that the index reasonably represents the asset class in question. I direct everybody's attention to the recent question of South Korea's inclusion as a "developed" market. Some indexes say its developed" some its emerging. For example: http://news.morningstar.com/news/ViewNe ... 0_univ.xml Also i think people who are long time members of this (and the M* parent) will recall all the deficiencies of the Russell 2000 as a basis for index funds.
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Re: Gatorking and Alec-Thanks!

Post by grok87 »

InvestingMom wrote:Nothing speaks better than numbers (when they are calculated the correct way!)
Wow do I feel like a dope! I am going to study the information you passed on a bit more, but I think I am moving over to a lazier and more profitable portfolio.
InvestingMom,
It get's even better than this. In a taxable count, active funds should be avoided because they are tax-inefficient. They generally do lots of trading (look at the turnover ratio on morningstar to see this, 100% turnover ratio means they turnover 100% of the portfolio every year). All that trading invariably leads to capital gains distributions which are bad.

So even those who believe in active funds (I am not one of them) generally agree that you should hold them in a non-taxable account.

cheers
grok
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Post by dave.d »

I think part of the explanation for why active funds do no better in the small cap and international areas that they do elsewhere is that trading costs (bid/ask spread and market impact) are higher. Thus even if it's true in some sense that active managers can see more mispricing opportunities in these markets than they can in domestic large caps, the opportunities turn out not to be exploitable. And that's the import of the whole theory of indexing and efficient markets: the grapes will always be just beyond your reach. If they weren't, someone would have picked them already.

--Dave
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Foreign Funds-Index versus Active

Post by YDNAL »

InvestingMom wrote:
Are there many bogleheads investing in active funds for their foreign funds? How about US small cap?

Code: Select all

............... 1 Year..3 Year..5 Year..10 Year..Incept.01/31/97 
MY Small Blend Fund 19.13%..19.06%..18.31%..12.71%..13.94% 

Mkt Cap %/of Portfolio 
Giant 0.00 
Large 1.55 
Medium 38.76 
Small 48.56 
Micro 11.13

Code: Select all

..................  1 Year..3 Year..5 Year..10 Year..Incept.10/03/60 
Vanguard NAESX Fund Inv 18.12%..14.72%.14.58%..09.79%..11.31% 

Mkt Cap %/of Portfolio 
Giant 0.00 
Large 0.00 
Medium 38.97 
Small 53.80 
Micro 7.23

InvestingMom,

You are reading strong generalizations, one way or the other.

Both funds shown are closely invested by market capitalization. My Small Blend fund, actively managed, is the best available in my 401K and fits my desired AA. It is much pricier than VG's Index funds, but most funds are anyways. That said, the returns tell the story of the past 10 years or so. We know.... past returns, blah, blah. At the end, what should matter to each investor is the available funds to them and how they fit in one's AA.

Regards,
Landy
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US-based foreign funds may not match Index performance

Post by grabiner »

An index, by definition, holds the average of all investors' holdings. A US-based index fund has about the same holdings as its peer group, because most US stocks are held by US investors. However, the average actively managed foreign fund may have very different holdings from a foreign index, because foreign-based funds are not included in that average. If the average diversified international fund holds less in Japan than the EAFE index, and Japan does poorly, than the average diversified international fund will outperform the index. It can happen on the other side too; Pacific Index is in the top 10% of its peer group over the last five years, which is equally abnormal for an index fund.

At the other extreme, this type of deviation cannot happen with a fund like Total Stock Market, which holds about the same stocks as its peer group and is usually within a few points of its peer-group returns. (M* says it underperformed by 7.7% in 2000, but that is partly fake; many funds which rode the Internet bubble did badly in 2000 and no longer exist.)

This is not an advantage of indexing over active funds in foreign markets, just an explanation of why active foreign funds can have strong outperformance or underperformance relative to an index.[/code]
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I agree

Post by grok87 »

dave.d wrote:I think part of the explanation for why active funds do no better in the small cap and international areas that they do elsewhere is that trading costs (bid/ask spread and market impact) are higher. Thus even if it's true in some sense that active managers can see more mispricing opportunities in these markets than they can in domestic large caps, the opportunities turn out not to be exploitable. And that's the import of the whole theory of indexing and efficient markets: the grapes will always be just beyond your reach. If they weren't, someone would have picked them already.

--Dave
I agree, but I think you are being a little too kind to active fund managers. :-) Most of these wounds from trading costs are self inflicted. The turnover for the average mutual fund is 92%. In other words the average fund pretty much turns over its entire portfolio every year.

What is the reason for this frenetic trading activity? Is it just managers naturally buying and selling as they see opportunities, with no ulterior motive? Hardly! One of the dirty secrets of the fund industry that Mr. Bogle has been particularly good at bringing to light is "soft brokerage". Basically mutual fund managers trade like jack rabbits, and massively overpay for the trading commissions (i.e they pay 5 times as much brokerage per share traded than they should), and then get kickbacks from the brokers to cover their overhead (offices, computers, bloomberg terminals, etc.) This almost sounds to unbelievable to be true, but sadly it is!

cheers
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Re: Index vs managed funds

Post by edge »

Taylor Larimore wrote:Hello Investing Mom:
I am curious are there many of you who subscribe to the belief that you can beat the market....over time....in foreign active funds or US small cap funds?
Each quarter Standard and Poor's publishes a "Scorecard" showing the percentage of index funds outperforming managed funds. You will see (report 1, page 5) that Small Cap Index funds outperformed Small Cap managed funds in all three domestic Small-Cap categories during the past five years ending 12-31-06.

International index funds (Report 14, page 18 also outperformed 78% of international managed funds for the 5-years ending 12-31-06:

http://www2.standardandpoors.com/spf/pd ... _Q4-sc.pdf

It is mathematically certain that the average index fund will have higher returns than the average managed fund in ANY asset class using the same stocks or bonds.

Best wishes.
Taylor
Hi Taylor,

I would like to point out that it your statement is not exactly correct and it is not a mathematical certainty as you suppose.

This is because the market does not consist solely of active and index mutual funds. It is theoretically possible in a market consisting mostly of wealthy individual equity owners along with a very few active mutual funds that the active mutual funds, on average, would beat a comparable index.

An accurate/correct statement could be: A dollar in an index will outperform the average actively managed dollar after expenses.
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Edge--"The Arithmetic of Active Management"

Post by Taylor Larimore »

Hi Edge:
I would like to point out that it your statement is not exactly correct and it is not a mathematical certainty as you suppose.
Nobel Laurate William Sharpe, makes this statement:
"Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs."
http://www.cannonassets.co.za/files/Wil ... gement.pdf

Best wishes.
Taylor
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Re: Index vs managed funds

Post by Doc »

edge wrote: I would like to point out that it your statement is not exactly correct and it is not a mathematical certainty as you suppose.
Hi Edge.

Taylor and I usually have a different take on what the original Sharpe quote implies but in this case I agree with Taylor.

Sharpe carefully defined his comments such that it is a mathematical certainly. Stated mathematically;

Average > Average - expenses (given "expense" are a positive number.)

Sharpe was very careful in defining his universe and index as being the same set which is what makes it a certainty. Your example does not have this strict restriction on the "universe" (set).

Where I differ with Taylor is that he claims that this Sharpe comment implies that index funds are superior and I claim it only shows that low expense funds including index funds are superior when compared to the average. Defining the set from which you derive that average is another problem. In many cases there are several different indexes that claim to represent the same set, small cap value is a good example as are several foreign indexes.
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Post by SpringMan »

Doc,
You do have some interesting insights into actively managed funds. Low expenses make some actively managed Vanguard funds attractive to me, Wellington and Wellesley admiral shares for example. Your comment about active funds that don't necessarily try to beat their index but protect assets in a down market intrigues me. Could you elaborate on that a little? Maybe you are referring to long/short funds. I would really be interested in hearing about some of the active funds you like. Many folks point at T Rowe Price Capital Appreciation fund, PRWCX, as never having a down year during the last bear market, but the management of that fund has changed recently. I tend to get frustrated when an active fund I own lags its corresponding index. I just dumped Northern Small Cap Value, NOSGX, for that reason. TIA.

Regards,
Best Wishes, SpringMan
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Post by DRiP Guy »

For myself, one passive index (FTSE/Xinhua China 25 Index FXI) has given me both my wild-n-crazy mad-money requirement, as well as some international exposure, in an area I feel may outperform the greater ex-US markets over the long haul. Of course, not everyone thinks the amazing run up will continue, at least unless they pay attention to the essentials, as well:

http://seekingalpha.com/article/47617-t ... ese-stocks


"Its weakness is that it contains only 25 companies, almost all state owned enterprises, and has 25% of its assets in its top three holdings which is a bit too much..."

http://seekingalpha.com/article/47663-w ... s-the-best


If I was starting today, I would probably pick GXC for broader diversification (still passive, just a SPDR). Hmmm.... I go from short term to long term on FXI in about a week... and since I turned into a boring buy-n-hold indexer with ~ 80/20 S&P/bond AA, other than this one excursion... [waiting for gleam in eye to subside...]

Image
GXC - young, but moving...


Image
Edited to add -- looks like they are identical returns for now but still like the idea of more companies in the market basket.
Last edited by DRiP Guy on Sun Sep 23, 2007 12:50 pm, edited 5 times in total.
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Doc
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Post by Doc »

SpringMan wrote: Your comment about active funds that don't necessarily try to beat their index but protect assets in a down market intrigues me. Could you elaborate on that a little? Maybe you are referring to long/short funds. I would really be interested in hearing about some of the active funds you like.
Most fund managers including index funds (see Taylor's link to standardandpoors above) tend to compare their performance to some index or market. They brag when the performance is good and give excuses why it isn't their fault when the comparison is bad. But not all do. You really have to dig deep to find these managers because the clues are often in the managers commentary, often in annual reports. You see terms like "performance over a market cycle", "growth at reasonable cost", and "protect capital in downturns and participate in upturns".

One of the main problems in finding these managers is that most or least many Diehards are too "frugal" to subscribe to Morningstars premium service. Many of the clues are in the analysts take. There also also clues in Morningstars "risk rating" which again Diehards tend to ignore because of the whole "index beats the average" concept. Another clue might be in correlation coefficients. If a fund has a low correlation with it's bogey an indexer immediate thinks it is a bad thing. Nobody wants tracking error. Why not? Tracking error may not be a bad thing for an active manager. I'm not saying that these "out of character" managers will out perform (something) only that there may be other objectives than exceeding some "average" return

We all have risk in mind when we look at our equity/fixed income allocation. But when we look at different alternatives for equity funds many people throw out all concepts of risk and look only at return and Taylor's standardandpoors comparison.

P.S. I'm not even sure what a long/short fund is so no to that question. All of my bonds funds are active funds. I like almost all of Vanguards non-index bond funds. The reason I don't like their index bond funds is because of specific portfolio issues for the most part dealing with risk not return.
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Post by adave »

I have done very well with Vanguard global equity - but nothing lasts forever and am slowly moving to a more indexed approach.

Indexing is easy and lets one concentrate on other things in life.
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Re: Edge--"The Arithmetic of Active Management"

Post by edge »

Taylor Larimore wrote:Hi Edge:
I would like to point out that it your statement is not exactly correct and it is not a mathematical certainty as you suppose.
Nobel Laurate William Sharpe, makes this statement:
"Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs."
http://www.cannonassets.co.za/files/Wil ... gement.pdf

Best wishes.
Taylor
Taylor, the following two statements imply two different mathematical points:

1) It is mathematically certain that the average index fund will have higher returns than the average managed fund in ANY asset class using the same stocks or bonds.

2) Properly measured, the average actively managed dollar must under perform the average passively managed dollar, net of costs.

1 is wrong, 2 is correct. Read them carefully.
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Post by Doc »

adave wrote:I have done very well ...

Indexing is easy and lets one concentrate on other things in life.
How did you define "very well", by total return? :D

I wholeheartedly agree with the second part of your statement. It is easy and it let's you do other things. Most people will do very well investing in low cost index funds if they also diversify and pay attention to their asset allocation.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.
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Post by hafis50 »

The Case for Indexing:European- and Offshore-Domiciled Funds, Vanguard 2008
Ten-year annualized excess returns versus market benchmarks: As of December 31, 2006

All regions: 220 better (25%)
Global: 109 (32%)
United States: 51 (24%)
Europe: 45 (20%)
Eurozone: 15 (15%)

All regions: 231 better (36%)
Pacific ex Japan: 31 better (23%)
Japan: 55 better (36%)
U.K.: 95 better (45%)
Europe ex U.K.: 28 better (44%)
Emerging markets: 22 better (31%)

Fixed income:
All regions: 54 better (5%)
U.S. dollar-diversified: 17 (14%)
Euro-diversified: 33 (5%)
Euro short-term: 4 (1%)
Global: 114 (66%)
Edited to add:
...the time period analyzed can affect the conclusions drawn. For instance, in a separate analysis not included here, we found that the shape and location of the five-year excess return distribution ended December 31, 2006, was similar to that shown in Figure 1 relative to the market benchmark. However, we also found that most of the outperforming funds were focused on small- and mid-cap stocks. These funds clearly outperformed the broad market for the five years due primarily to the overall performance of small and mid-cap stocks, which tended to outpace their large-cap counterparts for the period.
(page 6)
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