Do index funds really out-perform?

Do Index funds really outperform active funds?

A perennial industry debate that sometimes surfaces in the media. Recent newspaper articles utilised a somewhat shallow comparison over time periods of 5 years and less of both forms of investing. Their conclusion was that index funds outperform by a margin of at least 0.5% per annum inferring investors are thus not receiving value from active managers, and are thus better off just indexing their savings.

Extreme care should be taken in using this data and the conclusions being drawn that there is no value in active management. Here’s why;

1. The time frames are not long term in nature in the comparison and many assumptions and generalisations exist. They use periods of less than 10 years. These short periods allow a lot of volatility to alter up or down the result' depending on what month end date is used. Always use time periods that match as close as possible to the lifetime of your investment For most this will be at least 10 years.

2. This short time period doesn’t cover an entire investment cycle. We are living through one of the greatest bull markets in history. In these circumstances index funds will perform relatively well as it is the market that is rising, not the performance of the individual stocks and thus no skill required. What happens when this run ends? Markets of course also contract and with no judgement being employed, there is no possibility of cushioning these market pull backs or sideways movements that can, and will, last years.

3. Comparing fruit salad with apples, then pears, then pineapple, then Bananas etc. Not a fair comparison. An index is like fruit salad- a mix of all types of industries and sectors. Active covers an entire range of almost anything that can be investing in an asset class (every form, of fruit imaginable). Many active managers also tend to focus on a narrow sub sector (e.g. mid caps). Naturally the former will at times out-perform a singular focus and style as a result (and visa versa). It also assumes a manager is aiming to out-perform a benchmark of a 'market' result. This may be usable for wholesale investors but for 'Mum and Dad' investors the continued utilisation of wholesale measures can be counterproductive to achieving the investment goals they should be focused upon.

4. The problem with this form of comparison is that it also infers an either/or choice. This precludes a blend of both passive and active, so as to enjoy the benefits of both.

No proper in-depth analysis has ever been published that considers these crucial nuances, however I am approaching research analysts in the industry encouraging them to take a more thought through approach. Let’s see if they take the bait!

What the debate is failing to consider?

First there is a large cohort of active managers (usually the larger ones with big business brands to protect) whose holding closely mimics that of the major indices. The 'safety in the crowd' mentality. Given the typical extra 0.5% p.a. charged by them for actively managing money, this amount would indeed detract from the overall active manager pooled result (whose performance by in large, mimics the Indices in question less this 0.5%). This would obviously drag down the overall active manager result.

Second, active managers adopt a ‘style’ or philosophy that tends to outperform in certain market conditions, and under perform others. Utilising active management of which styles are present in a portfolio at any time manages this impact on performance well. This is called style blending and can be adapted to the current economic outlook and stage of the investment cycle.

Third, it is not just positive excess returns an active manager aims to deliver. Often it is the management of losses on the downside (the reduction of it and how fast a rebound is experienced). This also adds value to Mum and Dad investors and longevity of an investor’s savings. Remember in falling markets index managers will ALWAYS feel the full negative impact, and this can easily outweigh a 0.5% p.a. cost saving. Many active managers have the opportunity to fall less in these times.

Like all fads, and this one is gaining strong momentum, switching investments to just save fees can actually reduce your wealth, not increase it. In America index type flows currently outweighs active flows by 5:1.

You should know......

Index funds were included at higher weightings in Australian and new Zealand investment and super fund model portfolios mainly in the last decade via large advisory groups, mostly to increase their margin between what investors pay and they what they then have to ‘pay-away’ to third party fund managers. This they will never confirm of course, but it is relatively easy to discover if it is true for any fund you are invested in. Simply obtain the date that the manager significantly/introduced index funds into your ‘model portfolio (balanced, growth etc) then check if the ongoing fee also dropped by a similar amount of the saving. Often not. This went to the institutions shareholders and with Industry Funds - to their running costs. I know I used to work within 3 such well known institutions!

One last thing to note; the sheer weight of money moving into index funds globally means they have the ability to raise the price of all equities they are being distributed across regardless of whether this re-pricing is justified at an individual stock level. This can actually present opportunities for active managers seeking miss-priced opportunities that ‘dumb’ money can produce and its happening right now.

Overall this is not an either/or decision that needs to be made. It can make sense to use an index fund to cheaply gain market exposure for some upside and perhaps as a hedge against more focused investment bets made elsewhere in a portfolio. In other words - a blend. By blending various active styles and different types of sub sector focused funds, at different points of the investment cycle, this often produces superior risk adjusted results. None of this is considered in the media articles nor disappointingly in the research so far completed.

Happy investing!