Research

Myths about indexing

Myth 1: All index mutual funds are managed equally

Myth 2: Indexing is a self-fulfilling prophecy

Myth 3: Indexing cash flows moves markets

Myth 4: Index funds always underperform in a bear market

Myth 5: Equity index funds are tax-inefficient in a bear market

Myth 6: Indexing only works in certain market segments

Myth 7: Higher management costs are not equivalent to higher returns

 

There are many myths and misconceptions about index funds in the market place since they became part of the investment scene in the early 1970s. Some investors believe all index funds are managed equally; others believe they "move" the sharemarket. A common myth is that these funds always underperform in a bear market.

What this article will do is look at seven myths and misconceptions about index funds and explains why they are exactly that. But before doing so it is important for you to understand how indexing works and why these funds have been so successful for more than three decades.

Two key factors underlie the success of index funds: lower costs for the investor and, to a lesser degree, understanding why active fund managers, when stripped of all the advertising hype about higher returns, are less able to outperform the market than many investors believe possible. This is particularly so during bull markets.

One way to understand how markets work is to think of them as a sum-zero game: one person's gain balances out another person's loss. Put another way, the aggregate returns of all investors (positive or negative) equals the overall market return. It always balances out.

It is important to understand this is how the market works because it explains why the ability for active fund managers to outperform the market is limited. We know index funds match the market return (up or down) so, in aggregate, must actively managed funds. For every active fund manager who gets it right and outperforms the market there is an active fund manager getting it wrong. For the investor who chooses the fund manager getting it right (at least for now), that's fine. But bad luck for the investor who gets the fund manager who is underperforming.

However, saying the aggregate returns of all funds balance out for a sum-zero game is only true before costs. On aggregate, all funds lose slightly because all funds have costs. But index funds have lower costs than actively managed funds which can only lead to one conclusion: on aggregate, index funds must have higher returns than actively managed funds. There can be no other outcome.

There are two other factors at play ensuring index funds have higher aggregate returns. First, studies show active fund managers believe in their own market predictions and trade more stocks to achieve this outcome. But the only guaranteed outcome is higher transaction costs from higher stock turnover. Second, the efficiency of financial markets means most information about listed companies is quickly in the public domain. This means there are few opportunities for active fund managers to profitably exploit information not available to the broader investment community. Indeed, a prime responsibility of market regulators is to ensure all investors have access to the relevant information at the same time.

Myth 1: All index mutual funds are managed equally

An index fund manager adds value by minimising costs and thereby improving the fund's returns over the long term. The difference between the best and worst fund tracking the key US index, the S&P 500, over one year is a staggering two percentage points. Ways that managers can cut costs are:

• Trading securities efficiently to limit transaction volumes and costs.
• Minimising transaction volumes and costs by determining the best solution when the fund has conflicting objectives. For example, only holding some stocks in an index (called partial replication) reduces costs but increases tracking error. By contrast holding all stocks decreases the tracking error but increases costs.
• Using a combination of investment vehicles to minimise costs while replicating the index. For example, futures, options.

Myth 2: Indexing is a self-fulfilling prophecy

This argument says cash flows into index funds in turn flow into the stocks making up the index, thereby driving share prices higher. But this simplistic argument is fallacious for two reasons:

• Active fund managers, comprising about 90% of the market, determine share prices. Index managers buy afterwards to replicate the index at the closing day's prices.
• The superior performance of the S&P 500 index during the 1990s (where this argument gained credence) was largely due to the returns of the top 50 stocks in the index. But if index funds, which buy a proportionate share of all stocks in the S&P 500, were driving index returns, then the other 450 stocks would have performed equally as well.

Myth 3: Indexing cash flows moves markets

For cash flows in and out of index funds to cause markets to boom or bust means there would have to be a correlation between cash flows and index returns. However, studies show there is no such correlation. In the US, for example, there were net cash flows into index funds during the two-year bear market between 2000 and 2002, highlighting the fact these funds, while increasing substantially, are still a relatively small proportion of the sharemarket's total capitalisation.

Myth 4: Index funds always underperform in a bear market

This myth is based on the false premise that active managers can accurately time market swings - up or down. However, research shows active managers rarely get the cycle right by switching to defensive stocks or cash before a market falls or into growth stocks before a market rises. Remember, also, active managers have to switch at a lower cost than the benefit gained from switching to a more defensive portfolio.

Myth 5: Equity index funds are tax-inefficient in a bear market

Many investors believe managers of index funds will be forced sellers during any sustained market downturn and as such will be liable for capital gains tax. This myth assumes money moves out of index funds during market downturns; in reality index funds have more money coming in during market downturns. It also assumes that these funds are liable for large capital gains tax during market downturns; again, the converse is true: their capital gains tax commitment drops when the market is falling.

Myth 6: Indexing only works in certain market segments

It is a common perception that while index funds work well in efficient markets, active managers are better positioned to succeed in markets that are less efficient. While there is an element of truth in this proposition, it ignores one important factor: the cost of the research and investment strategies needed to succeed in less-efficient markets. When it is considered that these markets are often characterised by low liquidity (making it difficult to sell or buy), poor regulation and higher trading costs, then it is difficult for active managers to succeed. Big returns are possible, but they come with high costs.

Myth 7: Higher management costs are not equivalent to higher returns

It is the old argument about value for money applied to the investment industry - the higher the fee, the better the return. In fact, the opposite is true. Research by reputable consultancies such as Kanon Bloch Carre shows lower-cost funds outperform the high-cost counterparts.

Conclusion

The 2000-02 bear market in the US brought with it the predictable prophecies about the death of indexing and the renaissance of stock selection. Nothing could be further from the truth. In 2002, actively managed funds experienced net withdrawals of $US27.1 billion of their asset base. By contrast, index-linked funds enjoyed a net inflow of $US13.8 billion. Even allowing for the higher percentage of assets in actively managed funds, the trend is undeniable - index funds continue to grow because they offer better performance long term.

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