Are you an ambidextrous investor?

Posted by on October 29, 2010 @ 9:19 am in Investing

If you’ve heard of Pat Venditte—a minor league pitcher in the Yankees organization—you may know he has an extra tool in his arsenal. It’s not another pitch, but another arm.

He’s ambidextrous and changes his pitching arm depending on the batter he’s facing. He still has to deliver on the pitch, but he has a choice—and never has to plan his strategy from a single approach. The ability to change from right to left can be a competitive edge.

How does this relate to investing? Decisions around investing are often posed in all-or-nothing frameworks: all index or all active, or somewhere in between?

There’s an argument for an all-index portfolio. Vanguard research shows that, historically, the management costs for such portfolios have been lower—and costs, in turn, have been a big factor in driving investment performance. But is that the whole story? It might be enough for some investors, but if you’re a stand-out investor—one of the few truly “ambidextrous”—having the skill to identify an effective fund manager might be a competitive edge for you.

In a recent Vanguard publication, Building a global core-satellite portfolio, the authors reached a couple of conclusions based on the research of U.K., Australian, and U.S. equity markets. They found that indexing can be valuable for all investors and that, over the period analyzed, investors benefitted from keeping a majority of their portfolios in market indexes.

Traditionally, there’s been a belief that indexing works best in efficient markets—that is, markets where data is readily available—while active fund managers have an opportunity to outperform in more inefficient markets. This led to a traditional portfolio construction of a core of U.S. and ex-U.S. large-cap securities with satellite investments in areas such as small-cap and emerging markets.

The authors suggest that an investor’s skill level in identifying managers, not a fund’s asset-class location, is the most crucial factor in constructing a core-satellite portfolio. They contend that the process isn’t about investing in active funds in inefficient markets but that it’s about identifying talented low-cost managers wherever they may be. I won’t review all of the analysis here, but you may find it worthwhile to give the report a thorough read.

For many investors, the thought of selecting active fund managers who have the skill to outperform in any market (and to do so at a low cost) is daunting enough to keep them huddling around index funds. What’s your pitch?

Notes:

• All investments are subject to risks. Past performance is not a guarantee of future results.

• The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

• Prices of small-cap stocks often fluctuate more than those of large-company stocks. Foreign investing involves additional risks including currency fluctuations and political uncertainty.

• Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

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