T HERE are many paths leading up the mountain of financial success. Who has not been tempted to try some of the shortcuts? The classic example is dollar averaging. Enthusiasts for dollar averaging argued that it made sense to buy more shares when the prices fell in order to average down the cost of one's purchases. But the real reason for the popularity of dollar averaging was that it represented a mechanical alternative to market timing based on judgment. In the wake of the market decline that began in 1929, a great many investors noted for their ability to time the market successfully fell into disrepute. Many investment clients felt that their advisers had not merely failed to exercise good judgment in anticipating the market crash, but had actually exercised bad judgment in urging more exposed positions in the months and years prior to the crash. Clients sought protection from the kind of judgment that could prove so disastrous, and they found it in dollar averaging and other more complicated types of plans. Some academics have theorized that dollar averaging works fairly well when the market is oscillating around a shallow trend, but works badly when the market swings sharply in one direction or the other. In any case, it is a matter of historical fact that those disciples of dollar averaging who bought progressively fewer shares as the postwar bull market unfolded ultimately became disenchanted. Dollar averaging actually did yield performances superior to those based on judgmental market timing, but only in a particular market climate. Because investors failed to understand that, when we moved into a climate that worked against dollar averaging, they rejected it as an unconditional failure. Now a new species of formula investing has emerged-the Index Fund. Advocates of index funds argue that passively managed funds will outperform conventional, active managers basing purchases and sales on judgment. The prospectus of one major index fund contains the following statement: Since the Trust portfolio will not be 'managed,' the Trust has no investment adviser, pays no advisory fee and is expected to have a relatively low operating expense ratio. The prospectus goes on to assert that the Trust holds some 400 stocks representing 98 per cent of the market value of the Standard & Poor's Composite Stock Index. Used this way, the index fund represents a threat to the very profession of security analysis. But the experience with dollar averaging in the 30's and 40's can teach us a good deal about the index fund. The index fund, like dollar averaging, represents a mechanical substitute for, or alternative to, judgment. The index fund idea appeals because, after a number of years in which the bulk of actively managed equity portfolios have failed to outperform the market indexes, it imposes a discipline on the portfolio manager that prevents him from exercising bad judgment in securities selection while enforcing a high level of diversification. It is a response to a particular set of investment experiences that undermined the public's confidence in conventional money managers. The current success of the index fund in outperforming active portfolio management based on judgment is, like the success of dollar averaging, largely the result of a particular market climate, a climate in which the stocks strongly favored by the market indexes-particularly those stocks with higher levels of specific risk and lower levels of liquidity than the principal stocks in the institutional universehave performed well. The enthusiasm for index funds, although the result of genuinely superior performance in a particular market climate, is unconditional; when the current market climate gives way to one in which the institutional universe of common stocks performs better than the better known market indexes, however, investors will reject the index fund concept as an unconditional failure. Irving Kahn, an Associate Editor of this journal, is with Lehman Brothers, Inc., New York.
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Jan 1, 2001
Gen-Huey Chen + 3
Open Access
