Despite the ongoing growth in the popularity of index investing, some investors continue to believe that ‘this time is different’. Investors often point to a broad range of market and economic risks faced today, believing them to be best-managed by a professional investor who has the skill and flexibility to actively navigate a portfolio through challenging times.
Some oft-heard examples from investors continually favoring active management include:
- Interest rates are low globally and are even negative in certain regions; an active manager can position the portfolio in higher-yielding investments.
- The equity market in Australia is highly concentrated in the banks and miners, and an active manager can provide greater diversification.
- Interest rates are headed higher, and an active manager can guide the portfolio through what will surely be more volatile and challenging stock and bond markets.
- Markets are going to be volatile, and we may be headed for a bear market, so an active manager can minimize risk.
- Returns are expected to be low going forward, and an active manager is needed to boost returns.
- And last, that settling for a passive, or indexed, approach, relegates the investor to settling for ‘average’ returns by just matching the benchmark.
These are all very valid issues that investors of all types face today, with a great deal of uncertainty regarding the eventual outcome. However, the evidence suggests that this uncertainty isn’t necessarily best navigated by being more active. Over short and long-term periods of time, through various types of market environments, and across most major categories of investing, passive investing has demonstrated that it is anything but average.
As shown in Figure 1, over the last 10 years (a sufficiently long time period to draw meaningful conclusions) across Australian large-caps, property, international funds, and fixed interest, less than 40% of funds in each category outperformed their respective benchmarks. The median underperformance ranged from 0.24% to 0.91%. (Small-caps were the exception, where active managers have enjoyed some success.)
Looking more closely at the year-by-year experience, similar conclusions can be drawn. Again, the evidence points to, across most categories, generally consistent outperformance of index strategies (small-caps, again, were the exception). In fact, in the Australian large-cap category, more than 50% of funds underperformed the passive index in 8 of the last 10 years (2006-2015). In the "Property" and "International Equity" there were no calendar years where more than half of funds outperformed the index, and the fixed income index outperformed more than 50% of funds in 9 of the last 10 years. This period includes instances of rising and falling stock markets, periods of rising and falling interest rates, and periods of heightened volatility and others of relative calmness.
One of the key reasons for the success of index investing is cost, or, to be more precise, lack of cost. Across categories, index funds and ETFs charge investors less. In many cases, the difference in cost between index funds and ETFs and the higher costs of typically active strategies is the primary reason why the average active fund in Figure 1 underperformed its index.
Sometimes the opposition to passive investing is understandable, particularly considering that many in the investment profession have a lot to lose as low-cost, diversified, passive investing gains in popularity, because simplicity can be perceived as a threat. Talented active managers do exist, but the challenge is to identify them in advance, something that this evidence suggests is extremely difficult to do and that usually results in below-average results. In contrast, passive investments have historically demonstrated an ability to generate much more than average results when compared to their peers in a range of different market environments, some every bit as challenging and complex as we face today.
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Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia. As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment. |
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