Is Indexing Less Risky?

Tom Bradley of Steadyhand Investment Funds wrote an insightful blog post yesterday about a television commercial for ING Direct’s Streetwise Funds. The woman in the ad dismisses active management as “educated guesses” and then asks, “Why take the risk? That’s not you. With the ING Streetwise Funds you don’t guess. You invest in the whole market, which reduces risk because you’re diversified.” Here’s how Bradley responded:

There are lots of issues around active versus index investing, but there’s no issue that actively managed funds are diversified. The reality is, “educated guessers’” portfolios are generally less volatile than indexed ones and have no more risk of long-term capital loss (which is minimal in both cases). To leave the impression that the Streetwise funds are safer than other portfolios is a dangerous and misleading message.

Bradley is absolutely right. There are many reasons why index investing has proven to be a winning strategy, but less risk is not one of them. Some do-it-yourselfers may build poorly diversified portfolios, but retail mutual funds generally don’t make concentrated bets. The long list of poorly performing equity funds in Canada aren’t lousy investments because they’re undiversified or overly risky. The problem is almost always that they’re just too expensive.

Paul Merriman, who also has a lot of investing wisdom to share, recently made a related argument. (Merriman does a regular series of podcasts called Sound Investing, which are available free through  iTunes. I highly recommend them.) He pushed back against the idea that market timing is riskier than a buy-and-hold strategy. That idea sounds reasonable at first blush, but it cannot be true if risk is defined as exposure to the equity markets.

As Merriman explains, a market timer repeatedly moves money from equities to cash and back again, so they must be out of the market at least some of the time. A buy-and-hold investor, on the other hand, remains fully exposed to market risk at all times. Therefore, she must be taking more risk than the market timer. Most market timers fail to beat the market, but again, it’s not because they take too much risk.

I worry about these misunderstandings, because investors who are new to the Couch Potato strategy may have unrealistic expectations about what it can achieve. Switching from actively managed funds to index funds or ETFs is almost guaranteed to lower your costs. Over the long term, it’s likely to deliver higher returns. But if your portfolio has the same asset allocation it had before you embraced indexing, you haven’t lowered your market risk. Indexing is not inherently safer than active management or market timing.

6 Responses to Is Indexing Less Risky?

  1. Tom Adams September 24, 2010 at 9:20 am #

    Index fund look particularly good when costs are converted percentage loss of the risk premium.

    About the only way to end of overly concentrated is via ignorance about the concentration of the funds you invest in. You are promoting that very ignorance by claiming that retail funds are generally not concentrated. There is plenty of concentrated retail funds and plenty of diversified index funds. Learn about the specific fund you invest in and ignore such generalizations.

    Both a market timer and a buy-and-holder can limit their risk via the selection of the stock and bond funds that they invest in. But the buy-and-holder is the only one who can optimize risk-adjusted return by minimizing costs.

  2. Canadian Couch Potato September 24, 2010 at 9:47 am #

    @Tom: You’re right to advise people to look at the specific funds and ignore generalizations. But that was part of my point. It’s ING that was making the huge generalization that index funds are less risky than actively managed funds. In fact, the passive versus active management debate has little to do with the amount of market risk an investor is exposed to.

    Yes, many retail mutual funds are highly concentrated, but that has nothing to do with the fact that they’re actively managed. Sector ETFs are very poorly diversified, too, despite passively following an index. The iShares technology ETF (XIT) is the most glaring example. It holds just five stocks, each making up at least 13% of the fund. A mutual fund would not even be allowed to have a concentration like that.

  3. Sean September 24, 2010 at 11:34 am #

    It all depends on the underlying index. If you put 100% into Claymore oil & gas, should you be surprised at the poor returns? Some indexes are commissioned by the fund companies themselves. Market timing does make your portfolio less tax efficient. After all, it’s only the after tax after expenses and after inflation returns that matter while minimizing risk.

  4. Tom Adams September 24, 2010 at 12:37 pm #

    I agree with your point that index funds advocate should not go around saying that index investing or buy and hold investing is less risky.

  5. ABC September 25, 2010 at 3:57 pm #

    For many of us the concept of financial risk is something we experience in our guts. It’s the bad feelings we get when we are loosing money. We probably understand risk better now that in the last ten years we have known two of the five worst bear markets since the Great Depression.

    Risk is defined by TD Waterhouse as “the chance that an investment’s actual return will be different than expected. This includes the possibility of losing some or all of the original investment.”

    Risk can be measured by calculating the standard deviation of the historical returns or average returns of a specific investment. Here’s how the standard deviation is defined: “A statistical measure of the range of a fund’s performance. When a fund has a high standard deviation, its range of performance has been very wide, indicating that there is a greater potential for volatility than those with low standard deviations. ”

    How does an e-index fund compares with an actively managed mutual fund?

    Using the comparative tools available under WebBroker to compare the e-series Canadian equity index fund, tdb900, with its actively managed cousin, tdb161, shows that the index fund is less volatile under all time periods available:

    Standard deviation for tdb900 index fund vs tdb161 actively managed version:
    for 10 year: 17.79 vs 18.11
    for 5 year: 17.05 vs 21.60
    for 3 year: 20.36 vs 25.79
    for 1 year: 13.99 vs 17.09

    But a comparison of the index fund to the average standard deviations for the entire category paints a different picture:

    10 year: 15.8 for the index fund vs 14.9 average for the category.

    This suggests the index fund is more volatile than its colleagues. But note that the instrument report a different, lower figure for the e-fund in this type of comparison, as opposed to the 17.79 reported in the previous comparison above. It is suggesting that we can’t quite rely on the data provided.

    For other time periods, the volatility of the e-fund is very similar to the category:
    5 year: 17.05 vs 17.2
    3 year: 20.36 vs 20.2
    1 year: 13.99 vs 13.7

    The conclusion that seems to emerge from the data offers some support for the CCP’s opinion that ING is pushing the envelope in stating that index funds are less risky than active ones.

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