Why passive investment may not work in HK stock market

January 22, 2019 14:27
John Bogle's investment theory worked very well in the US market, but the strategy may not be ideal for Hong Kong, argues an expert. Photo: Reuters

John Bogle, the founder of Vanguard Group and a major proponent of index investing, passed away last Wednesday in the United States at the age of 89.

The passive investment approach he advocated has been extremely successful, and has generated good returns for investors.

Billionaire investor Warren Buffett paid tribute to Bogle, saying that “if a statue is ever erected to honor the person who has done the most for American investors, the hands down choice should be Jack Bogle.”

Bogle believes passive investment is the best way, since frequent trading incurs costs. Therefore, investors should buy and hold index funds rather than trading individual stocks,

Bogle divided investment returns into two parts. One is investment return, which is around 5 percent a year on average. Investment return comes from stock dividend and earnings growth. It might go up a bit to 6-7 percent but rarely would it drop below 2 percent unless there is a recession.

The other part is speculative return, which comes from valuation gain, Bogle pointed out.

“For example, if the price/earnings multiple were to go from 10 to 20 over a decade, that would be a 100 percent increase and be 7 percent added to the return each year, so it can be very substantial,” he explained in an interview previously.

Figuring out the valuation change can be very tricky, and picking the winner also proves to be too difficult for many; so we might as well just focus on the investment return part -- this is Bogle’s basic theory.

Passive investment has done well over last five decades. Nearly one third of US stocks are traded via ETFs nowadays.

But can the same be said about the effectiveness of such approach if applied to Hong Kong and mainland China market?

Sadly, the Hang Seng Index and China Enterprises Index only produced annual return of 4 percent and 1 percent on average respectively, over the past five years. By contrast, the Nasdaq index posted an annual return of 14 percent during the period.

A passive investor would be quite happy with Nasdaq’s double-digit return, but the same investor would be much less impressed by the low single-digit return from the Hang Seng Index and China Enterprises Index.

Why does passive investment suit the US market more?

Because only the fittest survive in a free economy like the US. Good companies excel, while bad ones exit the index. Therefore, the index is always vibrant and manages to climb steadily over the long haul.

Take a look at the components of the two Hong Kong indices, especially the China Enterprises Index. There are lots of of mainland banks, insurance firms and oil companies in the index constituents. Many of these firms have already hit the peak before 2007. But they keep dominating the index due to their large market capitalizations.

How can one expect good performance under this condition?

There is another thing I do not agree with Bogle, who probably never foresaw the tremendous growth potential of the tech sector, and the winner-takes-all nature of the industry, which results in winners going up much more than the broad market and occupying increasing weight in the index.

As long as growth still comes from the tech sector, Bogle’s passive approach may be less than ideal.

This article appeared in the Hong Kong Economic Journal on Jan 21

Translation by Julie Zhu with additional reporting

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Columnist at the Hong Kong Economic Journal