If You Can't Beat Them, Join Them: An Argument for Index Funds in Thailand .

As a follow up to the last issue of Money & Wealth, where we discussed about the merits of long-term investment in the stock market, in this issue we shall put forward an argument for index funds as the preferred investment vehicles when investing in the stock market. As part of our argument we shall shed some light on the evolution of index funds in other countries and present statistical evidences both overseas and in Thailand as to why the majority of fund managers do not outperform their index benchmarks. Although, we have written about index funds before in the 7 th issue of M&W but it is worthwhile to refresh our memory again as to why they have become so popular in recent years.

How it all began. The pioneers of the indexing concept were William Fouse and John McQuown of Wells Fargo Bank. During 1969-1971, they had worked from academic models to develop the principles and techniques that led to index investing in a $6 million account for the pension fund of Samsonite Corp., the luggage maker. By 1972, competition began to catch on when Batterymarch Financial Management of Boston and the American National Bank in Chicago created funds based on the Standard & Poor (S&P 500). After a slow start, the concept of indexing has not only steadily gained acceptance by investors but became the fastest growing segment of the entire mutual fund industry in the US with 25% market share of the estimated $50 billion cash inflow into equity mutual funds in 1998. In the case of Thailand , the pioneer of the first index fund was SCB Asset Management Co., Ltd. The firm came out with an open-ended fund that tracks the SET Index Fund in 1997 and TMB Asset Management Co., Ltd. soon followed with a fund that tracks the SET-50 Index. Currently, there are altogether 7 index funds in Thailand .

The success that indexing has enjoyed in recent years has been based in part on recognition that acquiring and holding a low cost, broadly diversified portfolio of stocks with identical weightings to the market index and minimal portfolio turnover has proven to be a winning strategy over the years.

As Table 1 below illustrates the growth of $10,000 investment over the past 30 years from 1967 to 1997 between S&P 500 Index vs. the average US general equity funds. As you can see from the chart that during the period under review the average equity funds only managed an annual rate of return of 10.8% compared to 12.5% pa. from S&P 500 Index. A difference of 1.7% per year may not seem very much but when compounded over 30 years the sum came out to be $125,000 from an initial investment of $10,000. As in the case of Thailand , we do not have statistics going back 30 years but as

Table 2 illustrates that during the past 5 years from 1998-2003, only 19 out of 70 equity mutual funds or 27% managed to outperform the SET Index. It is debatable whether this trend in Thailand will continue for the next 30 years but thus far, the signs are in favour of index funds with an average investment return of 21.27% pa. vs. 19.09% pa. for the average equity mutual funds.

Essentially, there are three main reasons why the average fund managers do not outperform their respective benchmarks. The first reason being the law of “average”, which states that all investors, as a group, cannot possibly outpace the total (cost-free) return on the entire stock market . In layman's language, not everyone can be a winner and historical statistics have shown that losers have outnumbered winners. Secondly , in stock markets which are relatively efficient, well run and regulated like in most developed countries such as the US, Europe and Japan, information tend to move freely and quickly whereby providing conditions where each share will be “correctly” valued, in the sense that all information will be fully absorbed into the share price.

Thus, the share price can, until new information is released, be considered to be at an equilibrium value i.e. not too cheap and not too expensive. Therefore, in order for someone to gain superior return or outperform the market/index, that person must have access to two things: first, he/she must know something that the market or everyone else does not and secondly, he/she must know the information before other people do, so that he can act on the advance knowledge of that particular information. But as you may be aware that in an efficient stock market where there are thousands of securities analysts doing in depth research on all of the listed companies, it is highly unlikely that “new” information will be kept a secret for long. Moreover, we are now living in an electronic and internet age, where information travels at “lightning” speed and will be absorbed so quickly that share prices will move to a new equilibrium level straightaway once new information is made available.

As for the second notion that certain people will get to know certain information before the rest of the world does, there are now laws against such practices. Listed companies are now required to temporarily halt the trading of their shares before any major news regarding their companies are announced to the public, so that everyone will get the information at the same time and have sufficient time to digest the news before deciding what to do next. In addition, penalties for those people with privilege information, “insiders” as they are known, can be quite severe if they are found to be guilty in using inside information to their benefits from their positions inside the company.

The third reason, and most probably the most compelling of all is the expenses that are incurred by actively managed mutual funds, which can range between 1-1.75% of the funds' net asset value (NAV) per year.

AsTable 3 illustrates, only 44 out of 200 equity growth funds have outperformed the Wilshire 5000 Index during the 15 years period under review ending June 1998. But what's is truly amazing is illustrated in Table 4.

By taking the same set of statistics but looking at the fund returns on a gross (before expenses) basis, about 50% or 93 out of 200 funds actually outperformed the index. When we compare the gross returns of these funds with what would be a normal distribution of results i.e. the random results of a coin-flipping contest. The probability of picking winning funds managers that actually outperformed the index is about 50/50 just like flipping a coin but for fund managers in aggregate, the heavy handicap of cost implies that one is better off investing in index funds which have much lower expenses of less than 0.5% of NAV per year.

In the case of Thailand , we use the same method to compare the net performance of equity mutual funds during the past 5 years between 1998-2003. But the results as illustrated in Table 5

are much more disturbing in the sense that the distribution between the best and worse performing funds do not fit into a “normal” distribution pattern. By international standards, an actively managed fund should not out perform or under perform the benchmark index by more than 5%. But in the case of Thailand , during the 5 years period ending 2003, about 33 out of 70 funds or nearly 47% under performed the SET Index by more than 5%, while at the opposite end of the spectrum 11 out of 70 funds out performed the SET Index by more than 5%. One reason for this massive divergence in relative performance could be due to the fact that Thai fund managers engage in market timing much more than their counterparts in the US and many of them do not have risk measurement models to keep track of their portfolios. This does not bode well for fund investors because fund selection process will be much more difficult. Due to the relatively high portfolio risk of Thai mutual funds, it is more than likely that those funds that have out performed the SET Index by more than 5% during the past 5 years can easily under perform the benchmark over the next 5 years.

Picking winning funds is as predictable as picking race horses. This year winner is unlikely to repeat his success next year.

Out of 70 equity mutual funds during the past 3 years between 2001-2003, of the 17 funds who were in the top quartile in 2001, only 5 remained in the top 25% for a second year (2002) and none of these 5 funds could obtain a top quartile ranking in 2003, making it 3 years in a row. It is rare for any single fund manager to remain in the top quartile for long in any asset class. Many changes can occur within a fund that investors are simply not aware of. Key personnel may leave, management may change, the investment philosophy may get altered. For this reason, M&W Stars Rating continuously monitors fund managers and makes recommendation based on long-term performance which tend to be more reliable.

Based on the above evidences, index funds should be a core holding in our portfolio basically for three reasons: they are the lowest risk equity funds that one can buy, they are cheaper than actively managed funds and most important of all they will probably outperform all other equity funds in the long run. This finding is as true in Thailand as it is in other countries like the US . Therefore, it is hardly surprising that world leading fund managers such as Warren E. Buffett, Peter Lynch and Charles Schwab have all recommended that most investors would be better off in an index fund and M&W concurs with this analysis.