Ex-Hedgie Now On Index Crusade

November 05, 2013

When managing his hedge fund, Kroijer says, he always tried to visualise a well-connected competitor, a hypothetical portfolio manager, who was armed with the latest research reports, industry expertise, access to companies’ management, and knowledge of the latest market flows in the shares concerned.

“I would convince myself that we should not be involved in a trade unless we had an edge over them,” Kroijer writes.

And if a full-time hedge fund manager, backed by a team of well-trained and well-connected analysts, had such concerns, what chances do the rest of us have to outperform?

“If you want to have an edge, you can’t do it as a part-time job,” Kroijer says. “This is not something you can spend an hour a day on.”

When it comes to indexing, Kroijer is a firm believer in sticking to the traditional method of weighting stocks by their market capitalisation. For him, alternative methods of constructing indices are akin to the active management methods he cautions the rest of us against.

“I’m not at all keen on smart beta,” Kroijer tells me. “If you have an edge—good luck, you’ll get rich. But the vast majority of us don’t have it.”

But for all the conviction of the pro-indexing arguments, isn’t there an inherent paradox here? After all, someone needs to set the price of Microsoft, Google and Vodafone shares. Aren’t index fund investors free riders, benefiting from the decisions of those who do apply judgement to pricing stocks?

“Yes, index investors are piggy-backing off the idea that there is an efficient market, and that securities’ prices are set fairly,” Kroijer concedes. “For the same reason I only advise using indices in active, liquid markets.”

But we’re far from the point at which index-following funds stop working, he says.

“There’s clearly a saturation point after which indexing can’t work. But only around 15 percent of global equities are currently owned by index funds and ETFs, so I think indexing could still grow by three or four times before markets become inefficient.”

Kroijer says investors should shop around for the cheapest indexing option, but adds that ETFs may offer the widest choice.

“Giving individual investors access to the stock market in a cheap, diversified way has been a huge, positive development. I’m agnostic about whether that’s done by an index fund, ETF or some new vehicle that’s yet to be invented. But ETFs may give you exposure to a broader range of markets than retail index funds. ETFs are also easy to trade.”

And investors should welcome the increasing competition between the major providers of tracker funds, he argues.

“Should you choose BlackRock, State Street, Vanguard, Deutsche? It doesn’t really matter. Go with the cheapest. I’m glad they compete on price and this is going to leave people better off. The providers make a lot of their money on the more esoteric products and I advise sticking to the main indices. It doesn’t even matter which index is involved—you do need an index but you don’t need it to be expensive.”

Switching to a cheaper, index-based investment approach requires both self-awareness and a change of mindset, Kroijer reiterates throughout the book. But though indexing sounds simple, it’s easy to forget how revolutionary the concept really is and how much of a challenge it presents to the finance industry’s traditional commercial model, he tells me as our conversation comes to an end.

“You can create a diversified portfolio using just two securities: a government bond ETF to suit your maturity profile, and a world equity ETF. You then mix them according to your risk appetite. That’s a really simple, powerful combination and you’ll end up doing better than 99 percent of the world’s investors. But no one is going to get rich selling that product mix to you and so you probably won’t see it advertised.”

 

 

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