Eurozone crisis demonstrates value of index investing, says Vanguard

Jan 24th, 2012 | By | Category: Fixed Income

Vanguard’s European Chief Economist argues that the ongoing uncertainty in the eurozone demonstrates the value of an index investing approach.

Peter Westaway, whose experience includes lengthy stints at the Bank of England and HM Treasury, says that markets may have priced in risks correctly, or they may have underpriced or overpriced risk, but by owning the entire market investors can ensure that they receive the market return (less expenses) regardless of how the crisis unfolds.

Peter Westaway, Chief Economist, Europe, at Vanguard.

Peter Westaway, Chief Economist, Europe, at indexing giant Vanguard.

Peter Westaway, Chief Economist, Europe, at Vanguard, writes:

Is the euro crisis over? Certainly not, indeed we may not be able to say that with any confidence for a number of months, perhaps even years. But in the end, we believe the euro area should eventually emerge stronger with its current membership intact. To be sure, the conviction of our belief is not as high as we would like and the risks remain skewed to the negative.

The immediate risk relates to Greece and the restructuring of its debt which if handled badly could lead to damaging contagion and in the worst case, fragmentation of the monetary union itself

If that stage can be successfully negotiated, the second priority for policymakers is to lower further sovereign yields in Italy and Spain, a precondition for restoring solvency in those countries; failure to do this could stretch the ability of those governments to fund themselves and would likely lead to serious impairment of banking sector balance sheets, dragging Europe into an even deeper recession as a result.

But the policy tools are available to help avoid this bad outcome. The European Financial Stability Facility (EFSF), perhaps augmented through leverage, and later this year the European Stability Mechanism (ESM), should provide short-term support to the euro area’s impending financing needs.

And to provide a credible backstop, the European Central Bank (ECB) is also likely to need to carry on providing ample liquidity to the banking system and to intervene more aggressively in sovereign markets. As agreement is secured on the long run fiscal governance issues, so it is more likely that the ECB will we more willing to play this role and help to bring yields down as needed.

Of course, even then, the crisis would not be over. More years of continuing fiscal consolidation and painful structural reform in the periphery will still be needed with all the attendant economic and political risks. By the time that period of adjustment is complete we are likely to see a new policy infrastructure up and running, with enhanced fiscal union perhaps involving eurobonds. Only then will the euro area be truly sustainable. At that point, we might be able to declare the euro area sovereign crisis over.

So what does this mean for investors?  It is precisely this ongoing uncertainty that demonstrates the value of an index approach. The markets may have priced in these risks correctly, or they may have underpriced or overpriced risk, but by owning the entire market investors ensure they receive the market return (less expenses) regardless of how the crisis resolves itself.

Active managers, on average, have historically been unable to accurately apply their forecasts or predictions relative to what has already been priced in, and therefore have underperformed lower cost, lower risk, broadly diversified index tracker funds.

At Vanguard we believe we believe the best defence against volatility and uncertainty is diversification. Holding a broadly diversified portfolio—across asset classes, market sectors, and geographical regions—can be an investor’s strongest hedge against risk. Successful investors understand the need for patience and take a long-term perspective. /

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