Whether to use active or passive (index) management is an important decision for most investors.
Various protagonists have argued the merits of one over the other for decades.
Unfortunately, there is no simple answer that is appropriate for all investors.
The adoption of an active or index approach to stock selection should be based on their individual investment circumstances, their risk profile and also their psychological make up.
Investors who choose to rely on index managers do have choice.
There are excellent firms that are skilled at providing index management services to the people who prefer that style of management.
However, index investing is not without issue. It is a style of management that does entail compromises from an investment perspective and it is important that investors are aware of them so that they can make an informed decision when choosing between active and index management.
One advantage proposed by supporters of index management is that there is a greater certainty of achieving close to index returns.
Index investing is an inherently mechanical approach to portfolio construction, so returns should be close to the underlying index that is being replicated.
However, you can’t access the index for free, so, after all the investment and management costs associated with accessing the index manager are accounted for, your return will most certainly be less than the index.
Sure, the typical index manager does not explicitly seek to obtain returns superior to the underlying index.
However, it is hard to be enthusiastic about an index approach that guarantees that your, after fees and tax return will more than likely be below the index return you are attempting to replicate.
While on the issue of tax, it is often proposed that index managers have lower portfolio turnover than active managers, which leads to lower transaction costs and potentially lower capital gains.
This is a valid argument as there are many active managers that are guilty of excessive portfolio turnover and a lack of awareness of the cost and tax consequences of their actions.
However, index managers don’t have a monopoly on low turnover.
There are many managers that are active stock selectors but do so with low portfolio turnover. This is certainly the case for managers that are assessing companies on their investment merits with a long-term investment time frame in mind.
There are some active managers that can have portfolio turnover of less than 10 per cent in a year, a level that is typically associated with index managers.
Supporters of index management also propose it delivers a broadly diversified portfolio, thereby minimising stock specific risk and portfolio concentration that active management can entail.
For example, a global shares index portfolio will contain hundreds of stocks spread over many industries and countries.
However, the diversification gained from an index portfolio will only be as good as the diversity of the index that is being replicated and, in some instances index replication will fail the diversification test.
Take the S&P/ASX 200 Property Trust Index as an example. One stock, Westfield, accounts for approximately 30 per cent of that index.
Investors who are accessing the Australian listed property sector via an index approach will therefore get a portfolio that is dominated by Westfield.
Depending on how much they have allocated to Australian listed property, their ‘diversified’ investment strategy may have as much invested in Westfield as they do in the entire Japanese share market.
Now, Westfield is clearly a quality, well-run organisation. However, is it sensible to be so reliant on the fortunes of just one trust for returns, which an index strategy involves?
A similar comment can be made about an index-based Australian shares strategy because the Australian share market is also very concentrated.
BHPBilliton’s index weighting is currently close to 10 per cent and the four largest banks collectively account for another 19 per cent.
This means a client who has allocated 40 per cent of their investment portfolio to an Australian shares index manager will have approximately 11.5 per cent of their portfolio in five companies — one miner and four banks. In market circumstances like this, it is questionable whether index management provides much portfolio diversity.
These examples also highlight a quirk associated with index investing.
That is, you will have a portfolio that will tend to be skewed towards the largest companies. In effect, index investors own more of the companies that have the most positive price momentum and less in the companies with less favourable or negative price momentum. So much for the investment rule ‘buy low, sell high’.
Index managers also don’t differentiate between companies on the basis of their quality or future prospects. This isn’t intended to be a criticism of index managers because they don’t do fundamental company research, their job is to replicate the index composition.
However, the index weighting of a company can sometimes bear no relation to the quality of the company, the attractiveness of its prospects or whether its pricing by the market is rational and realistic.
For example, by early 2000, ‘technology’ oriented companies accounted for nearly 40 per cent of the US S&P 500 index value.
Many of these companies had inherently questionable investment credentials (limited track record, poor management, shallow financial foundations, and so on) yet index investors were fully exposed to them and their ultimate demise after the collapse of the speculative tech boom early in 2000.
Anyone who was invested in an Australian share index fund in the late 1980s/early 1990s had a similar bad experience when many of the ‘entrepreneurs’ in the index such as Bond Corporation, Qintex, Ariadne, Adelaide Steamship and Linter collapsed under their respective mountains of debt.
True, some active managers also chose those companies for their clients but with an index approach, portfolio inclusion was automatic.
It’s not just a question of what an index-based strategy includes in a portfolio. It’s also a question of what you may miss out on via index management.
In many ways, an index management approach can compromise portfolio efficiency by limiting the opportunity set.
The departure of News Corporation from the Australian market index calculation in 2004-05 is such an example.
When News shareholders accepted a recommendation to shift the company’s home country of incorporation from Australia to America, the local index provider responded by progressively transitioning News out of the Australian market index calculation.
As a result, index managers jettisoned News from their Australian portfolios even though News remained listed on the Australian market and shares could still be traded freely. As a result, Australian share index investors have been denied access to News while active managers have been free to choose.
Similar issues prevail in the bond world.
Index managers of global bonds can find they are buying more and more bonds of the world’s most indebted countries.
Governments running large deficits are forced to fund them by issuing more and more debt, so their share of an index grows larger. Is it sensible to buy more of these bonds just because the issuing country lacks fiscal discipline and, in doing so, expose yourself to the increased probability of credit rating downgrades as the level of government debt grows?
Active managers can chose to ignore the index composition and invest elsewhere.
Many index managers of global bonds track the Lehman Brothers Global Aggregate Bond Index.
This is an index laden with investment grade bonds, but it excludes other bond categories such as inflation-linked securities, emerging markets debt and high yield.
These debt securities have different risk and return characteristics that can help investors diversify and access alternative sources of return. Not so for index managers who, in this case, are slaves to the index provider’s narrow definition of a bond.
And that is really at the heart of many of the issues associated with index management.
Index management is a form of investment slavery. An index-based portfolio mirrors the market’s pricing and treatment of individual securities, which isn’t always rational or correct. It also reflects the decisions taken by individuals within the index provider, who are (not surprisingly) making decisions in ignorance of an individual investor’s needs, goals and preferences.
John Owen is a research analyst at MLC .
