Extending the reach of index investing

Peter Gunning

Advisers seem to either love or hate index funds. By contrast, active managers enjoy a strong following.

But there are plenty who will extol the virtues of each management style.

The question is, which is the better style of manager for bear markets?

It would be fair to say the jury is well and truly out with no sign of a verdict.

AXA Investment Management chief investment officer Mark Dutton said there was a role for index funds, but the adviser has to understand what role they play.

“Index funds are a pure way of getting market return,” he said.

“But the adviser should look for diversification of the portfolio in other ways as well, such as using active fund managers.”

Ipac chief investment officer Jeff Rogers said before using either an index fund or an active manager, the adviser has to know the motivation for investing.

“The rationale for index investing is at what stage the index fund captures the risk in a market,” he said.

“Are the risks embedded in the index and are they the ones you want to live with.”

Rogers said the composition of a market such as Australian equities is affected by certain sectors, such as banks, which account for 40 per cent of the index.

An index could also have global companies with a major listing here, but are also on other indices.

“By accident, the structure of the Australian index has become made up of major companies such as News Corporation,” he said.

“The index is built around some risks that are captured in the index, so if you buy an index fund you are buying risk with these exposures.”

Peter Foley of Agile Financial Services, part of the Matrix dealer group, said using an index fund can be the set-and-forget option in a client’s portfolio.

But there are still risks.

“Using index isn’t necessarily being risk averse,” he said.

“There is still market risk and this component can often be bigger than the 2 per cent to 4 per cent outperformance you get from an ungeared Australian manager.”

But while active managers are designed to outperform the index, this is not always the case.

Russell Investment Group chief investment officer Peter Gunning said in Australian equities there has been a significant return for the past four to five years, but some local active value managers have struggled in the past 12 months.

“There is a cycle for active management doing well,” he said.

With some active managers underperforming, there is a need to pick those adding alpha or the adviser may as well put the money in an index fund.

However, Gunning accepts that index managers do look attractive to investors when Australian equities have been returning 20 per cent or more in recent times.

Vanguard Investments head of retail Robin Bowerman said he was surprised active managers claim they outperform index managers, especially when a bear market prevails.

According to research by Vanguard’s US parent, between February 2000 and 2003 the Dow Jones Wilshire 5000 delivered a negative 37.2 per cent return while the index achieved minus 2 per cent.

Looking at the 1987 crash, the Dow Jones was down 29.8 per cent while the index achieved minus 1.1 per cent.

“An index fund will outperform an active manager in the long-term and very few active managers outperform before a crash,” Bowerman said.

“There is a belief that active managers can accurately time market declines and upturns, but the figures show this rarely happens.”

Bowerman said many advisers believe active managers can shift funds out of stocks in time to curb portfolio losses.

The problem is by shifting out of stocks that had growth potential, the manager can end up becoming an indexer by default. And the investor is paying a higher active manager fee for what is, in effect, an index fund.

“They could end up investing in 40 to 50 per cent of the index, which is increasing the business risk of the manager as they move away from their investment style.”

However, Rogers argues that just sticking to the benchmark index robs the investor of potential returns that are outside the index.

“There are stocks you have never heard of that are not in the index, such as some of the uranium miners,” he said.

“These stocks may not be that important individually, but as a collective group they are a good source of outperformance.”

Rogers accepts there are times when holding an index fund is good, as active managers do struggle in the later stages of a bull market.

“I agree there are times when the way a market is going one would want to load up with an index fund,” he said.

“But there are some cyclical indexes where the active manager works and in the area of IPOs [initial public offerings] where the active manager can make money as opposed to the indexer, who can’t hold the stock as it is not in the index yet.”

Rogers said in bull markets, the active manager is getting active exposure and the index.

Foley said while there is a place for indexing, he favours growth style managers for clients with a longer time frame moving towards retirement.

“By mixing a growth manager with a trading trust, such as Portfolio Partners’ high growth shares trust, you will get growth, but also reduce the risk because of the low correlation,” he said.

“The question is whether the costs of the active manager outweigh the cheaper index funds.

“My answer is index funds charge about 0.5 per cent MER [management expense ratio] compared to an active manager charging about 1 per cent more.

“But if the active manager is giving more than 5 per cent alpha, it is not hard to see the attractiveness of taking an active approach.”

Foley argues there are also extra variables on international shares such as investing in emerging markets.

International index funds follow the MSCI index, which has more than 50 per cent of the stocks in US equities and a small amount in emerging markets.

Many active managers weight their portfolios to emerging markets with a small exposure to the US.

Foley said he likes active managers with exposure to Asian markets, which represent a large part of global growth, but are a small part of the MSCI index.

“International is when the value of active is apparent, as you can see the difference from investing outside the index,” he said.

But employing an active manager can be expensive, especially in international funds where the manager is not domiciled in Australia.

Another issue is using an active manager that returns mostly from the index.

Rogers said Ipac was looking at what it is paying for active managers and how that relates to performance.

“We are looking at some alignment on how much we’re paying for the active manager component and what of the portfolio is index returns,” he said.

“It is about being cost effective while getting a broad exposure.”

Rogers said it was good to challenge the managers to see where they are adding value and what that value is costing.

“We like managers being active and not just achieving market exposure,” he said.

“It is about finding ways to pay less for what is index component and payment for adding incremental value.”

Foley said using active managers needs a lot more monitoring to ensure they are not reverting to becoming an index manager.

“Things change at active managers, the classic case was when Greg Perry left Colonial,” he said.

“With some fund managers, their skills are science, but a lot of it is a good feel of the market.”

Foley said that sort of ‘feel of market’ makes an active manager more attractive than an index manager that just follows the market.

“It is the sort of thing Matrix’s research committee looks at, as you can see when somebody is losing the plot,” he said.

Foley said this is why it is important to monitor active managers more than an index manager.

“If things go wrong, you need to go and have a talk with them,” he said.

“However, when you do find a good manager, you don’t see them that often.”

There is another test Foley assesses active managers on.

He likes portfolio managers who get on with their jobs and are not getting mentioned in the media every day: Greg Perry never gave interviews whereas some of his competitors, whose performance wasn’t even near his, were regularly quoted.

“The good managers are nerds who you don’t hear of. The not so good are always talking on the market,” Foley said.

“I do like to see a manager who works to succeed at their investment style.

“Likewise, if the manager is an indexer, then I like them to be an index manager.”

Foley said with active managers, Matrix is always looking for changes in style and changes to personnel.

While some advisers prefer either to use index or active managers, there is a strong argument for blending either style in a portfolio.

In fact, Vanguard is a believer in using its index funds as the core manager and using active managers as satellites to deliver exposure to alternative market sectors.

“We have no problem with an adviser recommending us and then using an active manager in areas such as small caps,” Bowerman said.

“But what you have to make sure is the active manager is not a closet indexer who will be charging active fees for an index return.”

Dutton also agrees the active manager will deliver that extra return that the adviser is looking for.

“The active manager is looking at achieving a different return to the index fund by investing outside the index,” he said.

“This will deliver the diversification in an asset class the planner is looking for.”

Dutton said AXA Bernstein takes a different view to markets compared to indexers and that is why it is delivering extra performance over a longer time frame.

“Active managers such as Bernstein have a medium to long-term investing time scale, but many people think it is short-term,” he said.

“Bernstein has never had a negative return in five years in its flagship fund, which, despite what people think, has a long-term timescale.”

Gunning said there is a reason for blending active and index funds and it is risk.

“You go down that route because the active manager will add value,” he said.

“We have looked at that proposition, but our research is looking at whether by taking more risk you are adding value.”

Gunning said ultimately it was down to the client’s risk profile and some investors wanted both alpha and beta components in their portfolio.

“Indexing is not an absolute return, it just goes up and down with the market,” he said.

“There is a known cost for the active management, it is just the upside is unknown.

“At Russell, our clients have both active and passive strategies.”

Rogers said Ipac had looked at blending active and index funds in a portfolio.

“We do merge managers in some portfolios, but there does have to be a cost constraint if the opportunities are not adding value to the portfolio,” he said.

“But it is also about constraining risk.”

Rogers said Ipac might use an active manager that is good in small caps and index the Top 50 stocks while using another active manager for the rest of the market.

“It is still conforming to the structure of the portfolio, but we are focusing on index-enhanced portfolios.”

Rogers sees good opportunities for index-enhanced portfolios.

“I think that there is growth in using index and active managers together, but you need to find the middle ground where they work together,” he said.

“At Ipac, we have the ability to find these managers and give them mandates due to our scale.”

While some advisers will never be convinced of the virtues of index over active, or vice versa, the use of both styles in a portfolio is gaining some consensus.