Index vs active: performance anxiety

Active fund managers are a competitive collection of souls.

So it is perhaps not surprising that a number of them are lining up to explain why index funds are apparently a curse on the investing world.

As an index fund manager in Australia, Vanguard has a clear — and vested — interest in this debate. But it is important to understand the strong commercial interest that active managers also have in influencing the debate.

At the moment, the marketing heat is being turned up because a number of things are increasing the focus on the index approach to managing money.

These include a series of independent research reports showing indexing in a favourable light — or rather highlighting that active managers have underperformed relevant market benchmarks (over a five-year horizon). In recent months, perhaps partly as a result of the global financial crisis, a number of large institutional funds have publicly changed allocations away from active strategies in favour of indexing, while retail adviser market industry flow data is showing that indexing is gaining market share.

The fallout from the global financial crisis probably has some way to go to work its way through the regulatory system, but what is clear is that disenchantment with active management has prompted many advisers and institutions to vote with their feet and their clients’ dollars.

So it is probably not surprising that the active versus index debate is back on the agenda given:

• Standard & Poor’s index versus active (SPIVA) scorecard found that, over the past five years, 66 per cent of active managers failed to deliver returns above the S&P/ASX 200 index for the five years to June 30, 2009.
• The same report showed that five-year performance figures for international shares are even more dramatic, revealing that the index outperformed 76 per cent of international equity funds.
• The report also determined that for fixed interest — traditionally regarded as well-suited to an index approach — the index outperformed more than 90 per cent of active funds over three and five-year periods.
• A recent Morningstar report (International Equities Wrap Up, August 2009) reviewed the performance of international equity funds open to Australian investors. It assessed 47 fund manager strategies and 922 funds. Morningstar found that less than one-third of the active managers outperformed the Vanguard index fund over three, five and seven years to the end of March 2009. Although the report acknowledged the deficiencies of looking over the shorter, one-year timeframes, Morningstar analysts concluded “some active managers did earn their keep, but on average, active management caused more harm than good”.

But this is rapidly becoming an emotive and ultimately circular debate. In some ways it harks back to the early days of index funds in the US, when one large brokerage firm famously described them as ‘un-American’.

It is time to put this debate into a more relevant and meaningful context.

It is not about index versus active. It is about high cost versus low cost. Indexing after all is just one of many ways to invest — inside the active management camp a plethora of choices around investment styles and approaches exist. Indexing represents only about 15 per cent of the way the total industry manages money, which begs the question why so much effort is expended on this issue when the various active styles account for 85 per cent of the market?

It’s not ‘us and them’, it’s ‘us and us’

In the US we offer investors both index and active funds. The research tells us that we should expect periods where index funds outperform active funds and vice versa.

Certainly in the S&P study in the first six months of 2009 the active managers beat the index return. Morningstar’s one-year numbers tell a similar story. That should not be a surprise — although it perhaps highlights the risks and challenges of chasing short-term outperformance.

Surely if the events of 2008 taught us one simple thing, it was that you ignore the power of markets at your peril. And cap-weighted indexes represent the total market — and its subsequent return — and offer advisers a powerful yet easy-to-understand tool to work with in building client portfolios.

Regardless of side of the debate on which you sit, the critical importance of the asset allocation decision is widely accepted. It drives most of a portfolio’s variation and return.

We also know that economic cycles will drive market performance — for example, when small companies are doing well it should not surprise if small cap active managers are beating the market benchmark.

The challenge for investors — and particularly the adviser community — is to look beyond the ‘them versus us’ argument and focus on using a core of low-cost index management in a portfolio to lock in market returns for risk and cost control reasons while understanding the styles and characteristics of the active positions that have the potential to deliver real outperformance.

Core investing approach

A ‘core-satellite’ approach to portfolio construction is about understanding what you are investing in and blending the best of both worlds. We advocate a core-satellite strategy as a way of incorporating either actively managed funds or direct investments.

In a practical sense this is a substitution game. Starting with the market returns as your baseline, you substitute active satellites where your confidence level is high that a manager can deliver outperformance. In the institutional world they call it separating beta and alpha.

This strategy appeals to advisers and investors who are attracted to the distinct philosophies of active managers, or those who like to invest directly in shares or property but understand the value of capturing market returns and the benefits of broad diversification.

Indexing is simply an investment approach that empowers advisers to capture market returns cost-effectively in a transparent way and reduces the risk of active managers underperforming.

At a time of increasing public pressure on fees and transparency — issues where more regulatory change is clearly coming — using low-cost index funds as the core strategy can be an efficient way to implement your asset allocation strategy and reduce the overall costs to the end investor. The development of the exchange-traded fund market in Australia opens another avenue for advisers and brokers to access index funds.

The role of active managers is to do just that — take active positions based on their skill and expert assessment of markets. What is the point of investing in active managers (and paying high active fees) if they operate with tight constraints around index weights?

One thing is certain: in any given year some active managers will outperform the index — sometimes by considerable amounts. But the real challenge for advisers is selecting them before they outperform.

Let the debate continue on the best ways and relative portfolio weights of combining index and active investment approaches, but the notion that it is one way at the exclusion of another surely does a disservice to the most important audience of all — the very investors we are all striving to serve.

Robin Bowerman is head of retail at Vanguard Investments.