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A myth about indexing

By Barbara Whelehan · Bankrate.com
Tuesday, June 22, 2010
Posted: 10 am ET

Besides the first letter of the Greek alphabet, alpha is a highfalutin term bandied about by geeky financial types. It's a risk-adjusted measure of excess return on an investment. Investors who believe they can beat market indexes -- in other words, most mutual fund managers -- strive for alpha.

An article called "Playing the right game" at ai5000.com, a website for institutional investors, explores the existence of alpha and sheds light on the debate between active vs. passive investors. As you probably know, rather than try to beat the market, passive investors use an indexing strategy to achieve market returns.

The article concludes that alpha exists, though it is rarely achieved. Furthermore, a symbiotic relationship exists between both active and passive investors that enhance the market's efficiency. But most investors would probably do best using a low-cost passive approach.

The richest money manager

An investor who indisputably achieves alpha hands down is -- you guessed it -- Warren Buffett. In an effort to understand his investing success, I'm reading "Warren Buffett and the Interpretation of Financial Statements" by Mary Buffett and David Clark. Mary must have pretty good access since she was Warren's daughter-in-law for a dozen years.

The book came out in 2008 and explains in simple terms, reminiscent of the Dick-and-Jane children's book series, how to analyze a company's income statement, balance sheet and cash-flow statement the way Warren Buffett does. It uses a lot of repetition to drive home certain points. One of the points it drills home is that Warren looks exclusively for companies with durable competitive advantage.

For example, in the chapter on intangible assets, it says: "What Warren could see, that no one else could, was Coke's durable competitive advantage and the long-term earning power that came with it. Earning power that, over time, would help make him the richest man in the world."

Even though the book is easy to read, I'd have to read it two or three times to retain all the information it contains. And then, it's not likely I'd be as adept at discovering companies with durable competitive advantage after poring over their financial statements. So, for now at least, I'm content to invest in Berkshire Hathaway (the baby shares). But in my 401(k) plan, where I can't buy stocks, I have both index funds and actively managed funds.

Passive investors should realize, though, that indexes are not as static as they might think. In fact, they can change quite a bit from time to time. For example, Standard & Poor's announced last month that it's changing its definition of a U.S. company. As a result, the S&P Total Market Index will delete 20 companies and add about 100. This index is the universe from which S&P selects stocks for the Composite 1500. But the firm said it will not reconstitute the S&P 500 Index because of turnover concerns.

Also, Russell Investments announced it will reconstitute its indexes, effective Friday, June 25. Somewhere in the neighborhood of 260-plus new companies will be added to the Russell 3000 -- including Berkshire Hathaway.

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