Indexing can be a powerful strategy when used alone or mixed with active fund managers.

Indexing as a standalone strategy

When used as part of a buy and hold strategy indexing provides a low-cost way of achieving diversified exposure to investment markets. The success of indexing as a standalone investment strategy can be mainly attributed to its lower costs and, to a lesser degree, the limited opportunities that exist for active fund managers to exploit market inefficiencies.

The performance statistics show that few active managers have historically been able to sustain above index returns after costs over the long term. A study conducted by Morningstar Research in Australia and commissioned by Vanguard Investments, measured the consistency with which funds added value against an index over the five and seven year periods to 30 June 2005. Morningstar's study found that while some funds can beat a benchmark over a period of time, few can demonstrate that they have achieved this with any degree of skill. For example, over the five years to 30 June 2005, only 31 per cent of retail Australian equities funds consistently outperformed the benchmark and only 8 per cent demonstrated skill. Skill is judged by both the level of excess returns over an appropriate benchmark and the consistency with which this has been achieved every month.

The study also found that fees had a considerable impact on the ability of funds to add value against a benchmark. Basically, funds that charge higher fees found it much more difficult to add value compared to cheaper funds.

Core/satellite strategy

Adding index funds to an active investment strategy can improve the risk/return balance and reduce the overall costs of investing. Indeed, many investment experts believe indexing is the best starting point for any investment strategy. Building on a core of broadly diversified index funds, an investor can select actively managed funds, or purchase direct holdings in other assets such as shares or property. This is known as a core/satellite approach to portfolio construction. This approach has been widely accepted, with eight out of Australia's top 10 super funds use indexing as part of their portfolios.

The core/satellite approach is based on the premise that asset allocation is the primary determinant of portfolio return variability, with security selection and market timing playing minor roles as espoused in Brinson, Hood and Beebower's landmark paper, "Determinants of Portfolio Performance" (1986). Brinson, Hood and Beebower analysed quarterly return data of 91 large pension funds over the period 1974 to 1983. Its main conclusion was that 94 per cent of the variability of total portfolio returns is explained by the strategic asset allocation.

Brinson, Hood and Beebower's findings were confirmed by more recent research conducted by The Vanguard Group, Inc. in the United States. Vanguard's study found that, on average, 77 per cent of the short-term variability of a fund's returns can be attributed to its benchmark (asset allocation) strategy. However, the result for each fund depends on its degree of active management. For example, a fund that implements its strategy with index funds and rebalances the asset allocation to benchmark, will clearly have a very high outcome. However, one that uses only active management with high tracking error portfolios will have much more variability of the actual fund return. As a result, in the latter case, the benchmark could be expected to explain a lower proportion of the fund return variability.

The analysis also shows that, on average, more than 100 per cent of the long-term performance of a fund is determined by its strategic asset allocation. This implies that, on average, market timing and security selection have been unable to overcome the higher costs such as, increased operating expenses and trading costs, associated with active management.

The benchmark portfolio produces a higher average return, than the actual portfolio - interestingly, with less risk. On average, the benchmark portfolio's return volatility is 87 per cent of the actual fund's volatility.