A Trojan Horse?
by Jamie Hyndman, Mawer Investment Management
November 30, 2012
Sometime roughly three thousand years ago, it is said that a great wooden horse was laid outside the walls of the city of Troy. The Trojans, enamored by the sight of such a gift, celebrated in what they viewed was a sure sign of their victory and greatness. But as night fell, it was clear that all was not what it seemed ā the clever Greeks had hidden a small cadre of men inside the faux horse, and under the cover of darkness, slipped into the city and opened the gates, leaving the great city of Troy exposed to the mighty Greek army. And, well, you know how that story ended.
The Trojan Horse is a cautionary, mythological tale that warns us that what we think we might be getting, could be something else entirely different. It is a lesson that applies well to investing, as throughout history investors have fallen in love with various companies or products, only to be deceived later on. Nowadays, it seems that many investors have fallen into a similar trap with passive investing.
To be sure, there is a place for passive investing in our world. Passive investing is based on the efficient market hypothesis, which states that prices reflect all publicly available information. It can be a sensible strategy for those that donāt have the resources or inclination to do the work necessary to identify active managers that do truly add value above and beyond passive indices. It may also be an approach that can be used alongside active investments to great effect. Yet this horse is by no means a panacea.
Some indices, for example, make little sense to track if you are a risk adverse investor. The S&P/TSX is one such index. How sensible is it to track an index that is dominated by just three sectors? Financials, Energy and Materials make up 70% of the S&P/TSX. While these sectors may do well during an economic upswing, we expect that all three would fare poorly should we experience economic malaise. And more generally, how much sense does it make to invest in a bad company or a troubled country simply because it is in the index? Many of the companies within the S&P/TSX for example are simply not wealth creating, and we suspect that investors that held a broad basket of Japanese equities over the last two decades would have been disappointed. When you spot a moldy strawberry at the grocery store, it does not make sense to buy that particular package of strawberries.
The concept furthermore ignores the potential for temporary mispricing in the market. Since passive investing blindly accepts the valuations of individual securities, owners of a passive index may at times find themselves owning an index that is dominated by overvalued securities. The technology bubble in the late 1990s was a great example of an era that saw major indices littered with overvalued securities. Some of you will remember that, at its height, the now defunct Nortel represented over 30% of the TSX. Regardless of where the market goes and how irrational it may become, passive investors are towed along for the ride.
A final point must be clarified as it relates to the benefits of passive investing. Despite their reputation, passive products are not costless and have varying degrees of tracking error relative to the underlying securities that they are supposed to mimic. As an example, the Canadian version of the iShares MSCI World Index Fund has an MER of 0.46% and had a tracking effort of 0.37% in 2011. In other words, the cost for an investor in this product was close to 0.83%, not an insignificant sum.
As an active manager, we admit we have some bias in writing this. We also concede that passive investing can and does play an important role in the portfolios of some investors. Nevertheless, with the drumbeat for passive investing growing ever louder, now seems like an appropriate time to cast a warning ā donāt wheel a Trojan horse into your house.
Jamie Hyndman
