Why traditional passive investing doesn't work

Life isn't as easy for fund managers as it used to be. The financial crisis has shown them to be not quite as clever as they once liked us all to think they were. The Retail Distribution Review has forced their rapacious fee structures out into the open. The European Union has been saying unkind things about capping their bonuses at 100% of their salaries. And the passive investment industry keeps coming up with evidence that proves just how bad the vast majority of them are at their jobs.

There was more of that evidence this week. First came a study from a group called InvestingNerd (yes, really) in the US. It isn't exactly a new area of research, but they've looked at the average performance of active fund managers over the pastten years and found that it has been dismal: a mere 24% of the 7,630 funds in the survey (and remember, this doesn't include the ones that chucked it in along the way) managed to outperform the index over the period.

There is all manner of similar research available to those who look. There is also an obvious conclusion: reject the high-cost incompetence of active fund managers and buy cheap exchange-traded funds or index trackers instead.

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Regular readers will know I don't entirely agree with that, for several reasons. The first is that 100% of ordinary index trackers will underperform the index. Thanks to their costs the fees they charge you and the costs they incur in trading in and out of stocks it is impossible for them to match the performance of whatever benchmark they track. So even more passive funds underperform than active funds. The margin of underperformance is smaller, but you get the point.

The second is that there is no such thing as passive investing. Why? I've got two reasons for this as well. The first is asset allocation. You might decide you can't be doing with any active stock pickers, but someone still has to decide which markets your money is going to be in the US? Japan? Latin America? Emerging markets bonds? UK commercial property?

And second because in choosing the average tracker you are choosing an investment strategy by default. You are effectively choosing to be a capitalisation-weighted momentum investor. And that's a really rubbish strategy.

How do I know? Partly because it is blindingly obvious. If you buy an index that is constructed in such a way that the greater a company's market capitalisation, the more of the index it makes up (this is how the vast majority of indices are assembled these days only oddities like the Dow Jones and the FT30 are still price-weighted), you effectively end up buying high and selling low.

Think back to the technology bubble of the late 1990s. Passive investors then were, as researchers from Cass Business School put it, "effectively forced" to buy bigger and bigger stakes in obscenely overvalued companies, with no history of profits or even sales, as their prices rose. They ended up under-exposed to stocks with "long and proud histories of earnings and dividend growth".

Active managers who benchmarked themselves to traditional indices found themselves caught in the same trap to have a hope of not massively underperforming, they had to give in and hold tech stocks. The same happened with bank stocks in the UK indices before the financial crisis. We all know what happened next in both cases, and it wasn't good.

But I also know because this week brought some rather good analysis from the same researchers from Cass which shows that while the average fund manager can't seem to beat a traditional index, anyone tracking a non-traditional index probably can.

The research itself is academic (for which read impossibly difficult to make yourself concentrate on), but its essence is pretty straightforward: every other conceivable way of weighting a stock market index has outperformed the market capitalisation method over the long term.

So if you had set up an index that weighted stocks by something more fundamental to corporate health than just the share price say, dividend payouts (the more the payout, the more of the shares the index holds), total sales, net book value (the total value of the companies' assets), annual cash flows; or some combination of the lot and held that instead of a conventional index, you would have outperformed very nicely.

Here's how nicely: from 1969 you would have made 9.4% a year in the study's market cap weighted index (all the indices used the same 1,000 stocks one way or another), but well over 10% in all the others. The best of the lot turns out to be the sales-weighted index, which returns an annualised 11% over the full period and came out top in every decade except for the 1990s, when the market cap index actually did best.

All this tells us a few useful things. It tells us that traditional passive investing, using indices weighted according to market capitalisation, works best in the kind of long bull markets that ignore fundamentals. It tells us that fundamental indices deserve more attention and more funds.

And finally, it suggests that if you are choosing an active fund manager you might want to choose one who at least claims to pay more attention to the sales and cash flow the second best performer among the fundamental indices of a company than he does to market capitalisation.

This article was first published in the Financial Times.