An elementary challenge for investors is to decide whether to invest in actively-managed investment funds, index-tracking funds or a combination of both.
Investors face this challenge when investing in their own name, through a self-managed super fund, a large super fund offering an index investment option, a family trust or in another way.
Some investors respond to the challenge by adopting a core-satellite approach. This typically involves holding the core of a portfolio in low-cost traditional index funds and/or exchange traded funds (ETFs) tracking broad share market indices such as the S&P/ASX 300 index and the MSCI World ex-Australia Index.
In turn, investors following core-satellite approach typically hold smaller "satellites" of favoured actively-managed funds and directly-held investments such as shares.
Vanguard in the US has published the latest version of a key investment brief, The case for index-fund investing, that explains the relative characteristics of index funds and actively-managed funds.
As part of their research, the report’s authors – Christopher Philips, Francis Kinniry, David Walker, Todd Schlanger and Joshua Hirt – examined how a range of actively-managed funds available to US investors (US and non-US share funds and US fixed-income funds) performed against their stated benchmarks over the short and long term to December 2014.)
Critically, the researchers assessed fund performance on an after-fee basis, using Morningstar data. And the researchers analysed fund performance over one, three, five and 15-year periods.
Their research paper, which builds upon previous research in the US and in Australia, had a clearly-stated objective: "to explore the theory behind indexing and to provide evidence to support its use". (For further reading, see The case for indexing in Australia (PDF), a research brief published January 2013 with a focus on Australian equities and fixed interest.)
The latest paper opens with a straightforward explanation. "Indexing is an investment strategy that attempts to track a specific market index as closely as possible after accounting for all expenses incurred to implement the strategy".
As the researchers write, "this objective [of index funds] differs substantially from that of traditional investment managers whose objective is to outperform their targeted benchmark even after accounting for all expenses".
The words "even after accounting for expenses" are particularly significant because higher fees handicap an active manager’s ability to even match its chosen index.
In essence, the researchers show that:
- The average actively-managed fund among those surveyed underperformed various benchmarks including their own. "To take one example, 72 per cent of US large-cap value equity funds underperformed their benchmarks over the 10 years ended December 31, 2014." The case for indexing also tended to be strong over longer and shorter periods.
- Reported average performance for actively-managed funds can "deteriorate markedly" once no-longer-surviving funds are included in the comparisons. (Funds that don’t survive usually merge with other funds or close following poor performance.)
- Persistence of continuing strong performance among past top-performing, actively-managed funds is "no more predictable than a flip of a coin".
A central message for investors from the research is that low-cost index funds have a greater probability of outperforming higher-cost, actively-managed managed funds – "even though index funds generally under-perform their targeted benchmarks [after costs]".
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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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