Active and index funds - the arguments for and against the two strategies

With the debate between active and index funds continuing to gather momentum, Benjamin Levy examines the role of both strategies in a post GFC climate.

Any downturn in markets always acts as a spark for fighting between proponents of active and passive asset allocation.

On the one hand, index fund managers point to the fall in share values as proof that active asset allocation is unreliable, while active management companies claim that only active managers can find true value in volatile markets.

Research houses line up across both sides of the divide as well, brandishing data to support their point of view.

But the old fight of index versus active is changing, with new blended investment approaches such as core-satellite strategies emerging as a third player on the scene, while some industry professionals believe the time has come to revamp the index funds approach to deliver better returns.

Others believe that a similar approach to core-satellite strategies would be best.

So which side should advisers listen to? Is there a middle ground for asset allocation?

Active versus passive

The global financial crisis (GFC) was the catalyst for renewed conflict between index funds and active management.

As active funds plunged in value along with the rest of the market, financial planners, “at the coalface of investors seeing their wealth destroyed, and copping a fair bit of emotion from clients,” abandoned active management in favour of index funds, according to Vanguard’s head of retail, Robin Bowerman.

“Advisers felt disaffected that the active management piece hadn’t delivered, and that from an index perspective, it was true to label, it tracked the market,” Bowerman says.

Although the financial crisis is largely over, the conflict between index funds and active management continues. A number of investment research houses have urged an active management approach in the last 12 months.

Both van Eyk and Morningstar, who spoke at the Self Managed Super Fund Professional’s Association of Australia conference in 2009, said active management has the potential to deliver better returns in volatile markets.

Stephen van Eyk warned investors at the time against indexing and said good active managers could add as much value as investors were currently making. Van Eyk Research had switched from a core of index funds with active satellites to a core of active managers with index satellites, he said.

Zenith Investments also made the recommendation to follow active managers following its Australian large cap sector review later in 2009. Of the total 138 large cap companies, 91 outperformed the benchmark in the last 12 months, the report said.

“Now is not the time to be abandoning active management with the current and foreseeable market conditions set to favour stock-picking skill,” the research house said.

However, some investment houses have come down on the other side of the divide. Standard and Poors’ (S&P) annual index versus active funds scorecard, released in early 2010, showed that index funds outperformed the majority of active managed funds across both equity and bond categories over a five year period.

Research released from Mercer in July this year also showed that the average domestic active fund manager failed to outperform the index after fees in the last financial year.

While active managers outperformed markets by half a per cent, the impact of fees led to underperformance. The returns were well below the long-term average of 1.3 per cent for active managers, Mercer said.

Bowerman echoes the report, concluding that advisers have become disillusioned with the fee structure of active managers because of the financial crisis.

“Where I think a lot of advisers were disillusioned through the GFC, was that they were paying active fees and they were getting either index or worse, so I think one of the things the GFC exposed was that the higher the fee on the active fund, the greater chance it could underperform,” Bowerman says.

Advisers have continued to move away from a pure active investment approach since the GFC, Bowerman says.

Some in the industry believe that the growth of “synthetic” engineered products like exchange traded funds; hedge funds and private equity may put an end to active management.

Speaking at a recent Russell Investments Summit in Melbourne, chief executive Andrew Doman said the “real news” of the industry was the rapid and profound shift towards structured, synthetic engineered products, a shift that was important as an industry to understand.

This shift could force active managers into irrelevance, he said.

“The implications for active fund managers are very, very significant. You can certainly paint a picture where it’s hard to see how active fund managers fit directly into this new regime. They certainly need to respond immediately to the demands if they are going to retain relevance going forward,” Doman said.

Paul O’Connor, director and co-head of S&P’s wealth management services and the author of the SPIVA report, says each investment approach has its strengths in different economic cycles.

“From about 2004 to late 2007, as there was strong growth in equity markets, everything was rising, the poor quality companies and the better quality companies, so that active management really wasn’t adding much value.

"Then obviously as the financial crisis hit, we started to see significant dispersions again in returns between better quality active and passive managers over one year periods,” he says.

“When you look at these results of passive versus active, you have to overlay a qualitative understanding of the period of assessment, and what the economic cycle is doing,” he adds.

S&P is more comfortable with active fundamental analysis considering the issues the world is facing post the financial crisis, including fears of a double dip recession, O’Connor says.

“That’s really a risk management viewpoint,” he added. Active or passive management may also perform better in different sub-sectors of the share markets, O’Connor continues.

“A lot of it comes down to sub-asset classes, say for example, the S&P 500, is considered one of the more efficient equity markets, and in those types of markets, there are incidences were its harder for active managers to outperform,” O’Connor says.

Any investment house looking to outperform the market in such situations need to have real conviction in their manager’s abilities to give them an edge, O’ Connor says. “Global property and emerging markets are more ideal asset classes for active managers to outperform.”

Core/satellite strategies and the death of pure index funds

In light of the ongoing fight between index funds and active management, some have urged the industry to move beyond knee-jerk fighting and adopt a blended approach.

“The debate has to move on a bit between active in the red corner and in the blue corner, index,” Bowerman says.

“We should expect that in various market cycles, indexing will outperform, and at other times, active will outperform.

"People get too adversarial with the idea of this is the best way to do something forever, to me it’s much more about getting the right blend and balance of markets for clients,” he says.

The best-blended approach is to follow a core-satellite investment strategy, a method that is growing in popularity among advisers, according to Bowerman. “Investment is actually about how advisers use a core satellite approach, how the two are blended together,” he says.

Vanguard is seeing a greater number of advisers moving to the core-satellite strategy in a search for market performance and lower costs, Bowerman says.

“Independent boutique advisers have been working this way for many years, that’s how we first got traction with them,” Bowerman adds.

Using an index core with active satellites allows advisers to pick active managers where they have high levels of confidence that those managers can outperform, he says.

Jeff Rogers, chief investment officer of ipac, agrees with the outlook for the core-satellite approach.

“In Australian equities it was rarely done and we’re seeing people doing a lot more of it, in global equities it was almost most often done, but the core index piece was reasonably small. Now you see that grow as well.

“It’s partly to do with some disappointment in experience through the GFC in terms of what active managers delivered, partly just because of fee pressures, [because] people want to spend their budget in other areas like alternatives and some other asset classes,” he says.

Although planners have a lot of money in domestic and global equities, they don’t need to spend all their fees there, and one way of lowering their fees is altering the weightings between their index core and their satellites, Rogers says.

Other investment houses that have fallen in behind the core-satellite approach include Alpha Structured Investments.

Speaking to Money Management last year, Alpha director Tony Rumble said that financial advice that combined a core-satellite approach would become the norm in the future as investors realise active managers can’t often outperform the benchmark after fees.

However, the investment approach has been criticised recently, with Morningstar co-head of fund research Tim Murphy saying there has been evidence of planners picking high alpha, high risk and high cost funds as the satellite investments, essentially using the satellite funds as the gambling portion of the strategy.

The core-satellite approach was problematic if implemented in the wrong way, Murphy says.

Rumble also warned at the time that satellite investments should be carefully selected.

Regulatory changes and investor’s demands will ensure that indexing will continue to be at the core of any investment strategy.

Bowerman believes that allocations to index funds would rise as commissions are removed as an incentive for advisers to choose active managers.

“As advisers move to fee-for-service — which will accelerate under the Bowen reforms, with a ban on commissions — index allocations will rise, because when you remove that distortion around fund distribution payments, at that point the only proposition for advisers is only about the asset allocation decision, not the investment selection, Bowerman says.

The Cooper review will also have an impact, with super funds moving to indexing as a way of cutting costs, he adds.

“The Cooper review has modelled a passive index model versus an active portfolio, and it’s talking about very dramatic cost savings for investors, and I think you’re going to get this strong focus on the cost when you combine the Bowen recommendations for a ban on commissions and transparency of fees,” he adds.

“Indexing has a role to play in that point, and advisers have a role [as well] in building out active satellites where they can add more value,” Bowerman says.

David Price, managing director of Strategy First Financial Planning, says more financial planners would switch to passive management as they become “frustrated with the promise of active management that never delivers”.

Strategy First “fundamentally doesn’t believe in active management, Price says.

“There is little evidence that active stock picking can be done consistently over time,” Price says.

“If you then also overlay all of the tax and fees that are associated with active management, as it flows through to the retail investor, it’s a very poor result.”

Price, who used to be an active fund manager, switched to index investment five years ago due to his frustration with active managers.

“We were trying to do the right thing, do all the research, reading all the research reports, meeting with the fund managers, trying to build portfolios, but consistently being disappointed with the results that were being generated for our clients,” he says.

However, the core of any core-satellite strategy doesn’t necessarily have to be passive, according to O’Connor.

“We look at some of the larger lower-error tracking managers, who are active managers, and we compare them to the passive manager.

“These are managers holding large amounts of stock that would have volatility similar to the index but perhaps have exhibited some ability over the long term to add some incremental value.

"So that’s the debate that we have with clients, about that incremental value, about our conviction looking forward, that the manager for the added fees can actually add value in their minds,” he says.

“That’s an interesting area that I think is increasing debate and discussion, that core does not have to be passive. Core to my mind is just an anchor exposure to an asset class, a lower risk anchor exposure.”

Emerging trends

It is clear that a desire for better investment returns is driving changes to the structure of index funds.

Rogers believes that the original index fund approach of investing proportional to the market cap should be altered to take into account additional information such as company sales, total earnings and dividends, and use that as the lead indicator of weighting.

Ipac adopts this fundamental index approach.

“The original index funds are very much the cap-weighted market benchmark captured through an index fund, which is either delivered through a unit trust or an ETF (exchange traded funds), and it’s a very simple rule based approach to holding an index portfolio,” Rogers says.

“But if it’s a rule based approach, then the passive manager can take on a whole set of additional rules. In some sense you can think of this second generation of index funds as taking on board a little bit of the easily available factual information that would be part of an active manager’s toolkit,” he says.

While index funds were changing to offer a standalone active investment view, some planners are adopting this “active index” approach to the core-satellite investment strategy, Rogers says.

“One approach is to say I do want core-satellite, but that core doesn’t have to be the standard core, it could be I think that tilting towards fundamentals will win in the long run so I’ll put that in, and then I’ll find some managers who are really good at picking some stocks.

"One’s playing out over the longer-term and the stock pickers will play out over a different time frame.”

However, the dominant strategy was still a plain, vanilla index core, Rogers says.

Colonial First State owned fund manager, Real index Investments, adopts a fundamental index fund strategy.

“Our assumption is that markets aren’t perfectly efficient, and therefore if you weight according to price, you’re going to be overweight on overvalued companies and underweight on undervalued companies, and over the long run that causes a return drag,” Realindex chief executive, Andrew Francis says.

“Advisers haven’t believed that markets are perfectly efficient, and therefore they don’t like the concept of being stuck into bubbles and having their portfolios maximum exposed to bubble-type environments,” he says.

Realindex weights their portfolios by sales, cash flow, book value and dividends, and build their index funds accordingly, Francis says.

However, Francis disagrees with their approach being labelled an active index approach, and said Realindex is simply rebalancing.

“If your frame of reference is cap weighting and that markets are perfectly efficient, then that label might be correct, and we might look active compared to that cap-weighted index.

“However a cap-weighted index, as against the underlying fundamentals that we’re building our index on, is totally active, because the market is constantly changing its mind, its mood, its expectation.

"So we’re using five years of backward looking data and using our fundamental index and the economic size of companies to build an index and rebalance ourselves to that economic footprint,” he says.

Francis believed that there is no real definition as to how an index fund should be built.

“Has there ever been a definition that an index fund has to be cap weighted? No. There hasn’t been. An index fund is transparent, it’s replicable, its objective is to capture an opportunity set, it’s the same things that a fundamental index fund does,” he says.

Strategy First follows yet another alternative investment strategy, using an index strategy but working with portfolio design company Dimensional Fund Advisers (DFA) that structures portfolios to get exposure to small and value stocks.

“In the share markets in Australia and around the world there is research that suggests that value stocks and small company stocks outperform large stocks and growth stocks over time,” Price says.

Strategy First began by using indexing strategies for lower costs and better after tax returns in asset classes like fixed interest, cash, and listed property trusts, areas where active managers were proven to underperform. That expanded to global and domestic shares, and eventually they brought in DFA, Price says.

While DFA wasn’t an active stock picker, it did buy and hold in particular universal shares to get diversified low cost market exposure for their clients, Price says.

“As a planner, when you’re sitting in front of a client, it’s a very hard thing to do to continually apologise and make excuses for your active managers,” Price says.

“The active managers have to buy and sell stocks and try outperform, but we, out of all the funds that are available, we need to pick the ones that are going to do well during our client’s timeframes. So it might be Perpetual for the last 10 years, but what is it going to be for the next five years?

“So it’s just that added layer of uncertainty, and even the research houses meet the managers and do the best they can and they give them rankings and ratings, and that sometimes doesn’t work out. Basis Capital is a perfect example.”

But it is clear that the index investments have a long way to go yet. S&P, in their recent equity indexing strategies report, said there is more work to be done for beta-linked products to increase their market share.

“The US experience, where penetration of these products is far higher, suggest that there is plenty of potential for these offerings to increase their share of Australia’s managed funds market, particularly if their manufacturers can successfully distribute and promote them to investors.”