News & Commentary

The Case for Indexing 31 Aug 10

Articles RSS

Historically, index funds have performed favourably in relation to actively managed funds over the long term, as a result of indexing’s low cost, broad diversification, minimal cash drag, and potential for tax efficiency. In any market these factors combine to represent a significant hurdle that an active manager must overcome just to break even with a low-cost index strategy over time*.

Many investors, however, find the prospect of outperformance too alluring to resist. Not satisfied with average market returns, these investors choose active management in the hope of achieving outsized returns. Typically, active managers believe that their extraordinary skill, perhaps mixed with good luck, will generate above average returns. But aspirations aside, how have these active managers actually performed in the Australian managed investment fund market?

This note highlights some of the important points from a recently published report form Vanguard’s Investment Strategy group, ‘The case for indexing: Theory and practice in the Australian market’

We find several distinct features among active management performance that present significant challenges for retail and institutional investors in Australia, including:

  • Wide magnitude of return dispersion
  • Difficulty of picking a winning manager
  • Significant risk–return trade-offs
  • Limited persistence of returns
  • Tendency for higher manager fees to produce lower levels of returns



We analysed data for wholesale and retail Australian Equity funds from Morningstar over a 10 year time frame to 31 December 2009.  This aggregate data demonstrates that the indexing theory holds for the largest available subset.  Looking at returns relative to the index benchmark (active return), we found that there is significant dispersion of the returns of all managers over multiple time frames.  Over 3 and 5 years less than 1-in-3 managers managed to achieve returns greater than their stated benchmark.

The 10 year result showed around 2 in 3 managers achieved returns greater than the benchmark, however this primary analysis only includes funds that survived over this period, an embedded bias called survivorship bias.




Analysing the data further by including all the funds that were available at the start of each time period, we can see the degree of bias and the difficulty of selecting a successful manager.  The data shows that of 224 funds available 10 years prior to December 2009, 165 survived, with approximately 26 percent closing during this time period.  By including these closed funds in the 10 year analysis the probability of remaining an ongoing concern and outperforming is less than 50 percent.  The more recent 3 and 5 year data indicates that around one quarter of the funds survived and outperformed.

 

An investor may think that there is a 1 in 2 chance of achieving excess market returns (on a dollar weighted basis) and be willing to accept these odds.  However, this does not take into account the level of risk, often excessive, that is required to achieve outsized returns. 

The chart above plots the returns managers achieved and the risk (variability of returns) over the five years to the end of 2009.  In a rational world, an investor may be willing to take more risk to achieve greater returns and vice versa, shown by the upper right and lower left quadrants.  So a manager may claim a greater than market level of return, but if there is higher risk associated with this, the investor is only being fairly compensated.

The best case is greater returns with lower risk shown by the upper left quadrant. Over the study period only 17 percent of managers achieved this outcome, so the initial equal likelihood proposition is actually a 1 in 6 chance of beating the market as defined by higher returns and lower volatility.

The worst case outcome is the lower right quadrant, where returns achieved are lower than market with greater than average risk.  Almost 1 in 3 managers in the study group fell into this category.  It is important to consider not only whether a manager achieved greater than market returns, but the associated level of risk, which if high could produce adverse outcomes.




Another consideration is whether managers can consistently capitalise on any skill in their process.  To evaluate consistency, 165 funds that survived the 10 years to the end of 2009 were assessed over two five-year periods and ranked on returns from best to worst performing over each period.  Of the funds that were in the top quartile in the first five-year time interval, the graph shows their ranking at the end of the second five-year period.  The results show that around 27 percent of top quartile managers remained in the top quartile.  Chance alone would suggest that 1 in 4 managers would repeat this achievement and that there is not a larger than average number of managers that can sustain consistent performance.

Further, but not shown in this chart, of the managers that were in the fourth quartile at the end of the first five years, a higher than expected 33 percent remained in the bottom quartile at the end of the second five-year time frame.  This was the largest group in the second time frame and suggests that there is more persistence in managers with low returns.





Finally, we looked at the effect of cost on investment returns.  The relationship between the net investment returns over the ten years to the end of 2009 and the manager’s stated expense ratio shows that there is an inverse relationship between these elements.  That is on average, the greater the stated manager cost, the lower the net returns.  Net returns are an important consideration and this outcome is not surprising as fees represent a significant hurdle for any manager to overcome.  Index funds have expense ratios lower than most active funds and this is a significant feature of this style of investing.

Conclusion

Indexing as an investment strategy is grounded in academic research.  By choosing an index fund that mirrors an entire market, investors – whether individuals or institutions – can efficiently capture the long-run average trajectory of the Australian managed investment fund market.

A number of features of active management performance present challenges for investors, including but not limited to the magnitude of dispersion, difficulty of picking successful managers and the limited persistence of manager performance.  Therefore, on average indexing’s low-cost advantage offers the opportunity for long-term outperformance relative to a majority of actively managed funds.*

To request a full version of this paper, please click here.

 

*Note however that past performance is not an indication of future performance and that Vanguard’s products are designed to closely track the market returns before fees, expenses and taxes. Investments are also not guaranteed and may rise and fall. 

 

 

* To receive articles for financial advisers by email once a month, register with FASTnews.


What can I do next?


Bookmark and Share

Call us on 1300 655 205
GENERAL ADVICE WARNING

Vanguard Investments Australia Ltd (ABN 72 072 881 086 / AFS Licence 227263 / RSE Licence L0001335) is the product issuer. We have not taken yours and your clients' circumstances into account when preparing our website content so it may not be applicable to the particular situation you are considering. You should consider yours and your clients' circumstances and our Product Disclosure Statement (PDS) or Prospectus before making any investment decision. You can access our PDS or Prospectus online or by calling us. This website was prepared in good faith and we accept no liability for any errors or omissions. Past performance is not an indication of future performance.

We are the trustee of: Vanguard® Personal Superannuation Plan ABN 81 550 468 553.

© 2012 Vanguard Investments Australia Ltd. All rights reserved. "Vanguard", "Vanguard Investments", "LifeStrategy" and the ship logo are the trademarks of The Vanguard Group, Inc.