2.3 Value of passive index

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Do curso por Indian School of Business

Investment Strategy

29 ratings

Indian School of Business

Investment Strategy

29 ratings

Curso 4 de 5 em Specialization Financial Markets and Investment Strategy

Discover the basic concepts of needs analysis, investment policy, asset allocation, product selection, portfolio monitoring and re-balancing. We will look at the types of institutional investors - pension funds and insurance companies. You will learn the client management life cycle and dive into portfolio management as a process. You will learn the basic concepts, principles, and the major styles of investing in alternative assets. Finally, we study the impact of digitization on investment strategies.

Na lição

Index Investing

After completing this module, you will be able to understand what index investing means and you will also be able to calculate the value of a passive index. You will be able to define Beta and Alpha and can also find out a better investment among a given set of investments.

2.1.1 Introduction to Index Investing - part a11:48

2.1.2 Introduction to Index Investing - part b13:22

2.2 Supplement to Index Investments4:38

2.3 Value of passive index8:18

2.4.1 Introduction to Beta and Alpha - part a9:48

2.4.2 Introduction to Beta and Alpha - part b7:37

2.5 Beta vs Alpha1:34

2.6 Which is the better investment5:39

Conheça os instrutores

Vikram Kuriyan
Clinical Professor of Finance
Director, Investment Lab

[MUSIC]

I want to use these sets of slides, Berlin clip put together by John Bogle.

[MUSIC]

To demonstrate the value of passive index.

[MUSIC]

These slides cover the 25 years from 1980 to 2005.

[MUSIC]

And what you have is on the left you have the S&P 500 index,

on the right, you have an average fund.

Let's just assume it's an actively managed fund.

And on the extreme right, you have a column which compares each

fund's performance as a percentage of the index profit.

So, what you see over this time period,

1980 to 2005, the S&P 500 Index,

produced a gross return of 12.5% compounded.

So, $1,000 invested in the index.

Compounded to $17,920, almost $18,000.

So, it is an 18 time return on investment on the passive index.

Now, it is difficult to get the actual return of the index.

You need to invest in a fund and a fund has expenses.

So, you compare The Vanguard

index fund because this chart was produced by Vanguard.

It was also probably one of the few index mutual funds out there at that

point in time in the 1980's.

At that point in time their cost was 20 basis points.

So, we see the fund lag is minus 0.2%.

It is mainly cost and maybe a little bit by way of transaction costs

which come from rebalancing So,

you subtract 20 basis points from 12.5% and

you come with a pre-tax return of 12.3%.

And what you see is that the dollar compounded over

long period of time is no longer $17,920.

It's $17,080.

Small decrement.

We'll now move over to the second column.

And here we have the fund lag from the average fund.

That's because most active funds are expensive.

The average fund lag, 250 basis points.

Subtract that from 12.5 and you get a pre-tax return of 10%

The $1,000 now confounds to $9,820.

So, now if you compare the fund profits as a percentage of the index profit.

For the average fund, you're only getting 57% of the index as a return.

That is a dramatic short fall.

But now the actual results to investors Is even worse.

Why?

Because of timing and selection penalties.

Most investors choose the wrong funds.

And most investors choose the wrong time to be in the market.

We can estimate what these returns drag, from timing and

selection penalties are by studying the dollar returns on by

masters has opposed to the theoretical fund returns, because

investors are not actually invested in these funds at all periods of time.

A drag on performance from timing and selecting the long fund.

Is about 270 basis points.

So, the pre-tax return of 10% now drops to 7.3%.

The investor return, that's what the investor actually gets.

On the index fund, he's got 12.3%.

On the active funds, the average investor ends up with 7.3%.

His $1,000, over these 25 years,

compounds only to $4,820.

The fund percentage as the percentage of the index profit now drops to 28%.

But this is not all, this is not all, there's inflation to consider.

And over this period, the inflation lets us take the stated rate, who's 3.3%.

So, you subtract this number from both sides of the investor return.

And the real return drops to 9%.

For the index fund and 4% for

the average actively managed stock fund,

so, $1,000 invested in 1980

ends up to being $1,670 in real terms.

And this number is just 22%

of the actual fund index.

So, you can dramatically see through these charts,

that the cost to investing actively for

the average investor is tremendous.

Whereas, by investing in a passive index fund.

He has a transparent product.

He knows exactly what he's getting in all periods of time.

And he's able to get the market return,

which over the long haul is a very compelling number.

By deviating from a passive investment strategy and

going into an active strategy, the cost to an investor

all well north of 70% of its potential return.

I hope I've convinced you by passive indexing,

there's a strong baseline strategy for most investors.

[MUSIC]

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