The recent performance of active managers doesn’t mean they should be dumped in favour of using index funds, says David Wright.

A number of trends have emerged from the global financial crisis (“GFC”), not the least of which has been the large inflow of investor money into index funds. While this has been very noticeable, it is not unusual following a period of negative returns in investment markets – we have seen this type of adviser and investor behaviour previously following bear market conditions. There appear to be two primary reasons for this trend to index funds.

Firstly, there is often dissatisfaction with active managers in a negative return environment with many advisers and investors believing they have not “done their job” by producing negative returns. This is often an unfair assessment, particularly in severe negative return markets, such as those experienced throughout the GFC, as it’s virtually impossible for long-only managers (managers that cannot short sell) to provide positive returns in that kind of environment. In addition, many people do not benchmark the active managers properly when assessing their returns. While obviously no investor likes to experience negative returns, the high-quality active managers with experienced investment teams and strong investment processes delivered strong outperformance of their underlying market index over this period, albeit still delivering negative absolute returns. Investors must understand that is a “good” result in extreme bear market conditions.

The second main driver of the strong investment inflows into index funds is fees. Index funds generally have a lower management fee than actively managed funds. There’s no doubt some of the inflows into index funds have come about because clients have put pressure on financial advisers to reduce the costs of managing their portfolio in an environment where they have experienced large negative returns. One way to reduce overall fees is to use cheaper funds, with index funds being the most obvious choice. While this trend is understandable, given the pain many investors have experienced, the rationale for moving to an index fund on this basis alone is not driven by investment merit. In fact, the current investment environment may be the worst time for investors to switch from actively managed funds to index funds. The table provides some statistics on the performance of active managers in the different asset classes.

As can be seen, there are some asset classes where a larger proportion of active managers have outperformed the underlying index (all data is net of management fees). These asset classes include Australian Equities – Large Cap Funds, Australian Equities – Small Cap Funds and somewhat surprisingly, Australian Real Estate Investment Trusts (REITs). Interestingly, over the past two years as the GFC took hold, a greater percentage of active managers in these categories outperformed the relevant index and, with the exception of Global REITs, all asset classes experienced an improvement in the percentage of active managers outperforming their respective index benchmarks. This illustrates that the value of active management comes to the fore in difficult market conditions. The asset classes where active managers have struggled to outperform their index benchmark over the two periods measured include: Global Equities – Hedged, Global Equities – Unhedged, Australian Fixed Interest (Bonds), International Fixed Interest (Bonds) and Global REITs.

It is also interesting to note that two of these asset classes are those where currency has an influence on returns (Global Equities – Unhedged and Global REITs). Historically, due largely to the smaller absolute return available and the impact of retail fund fees, active managers in the fixed interest asset classes have found it difficult to outperform. This has largely driven the proliferation of diversified fixed interest funds and other fixed interest funds where the return potential is greater and more diversified than investing in government-bond-based fixed interest funds.

Characteristics of index funds

Many people are not fully aware of the characteristics of index funds, believing them to be simple to understand, given that they are simply designed to track the respective underlying index. From Zenith’s experience, people are often surprised when index funds are at the top of the performance tables in extended bull market conditions and believe this provides clear evidence that active managers cannot outperform their index. In fact, this phenomenon is logical as an index fund will continue to track the underlying index irrespective of the valuations of the securities in the index; whereas any active manager with a disciplined valuation process for investing in securities will not invest in those securities that they assessed as overvalued. In an extended bull market, it is these very securities that drive the index performance and therefore an active manager will not participate in this appreciation as they aren’t invested in the expensive securities.

This results in index funds outperforming in these market conditions. In addition, while most people understand the concept of investing in an equities-based index fund, there is much lower understanding of the implications of investing in a fixed interest-based index fund. To clarify, the largest weights in an equities index fund are essentially the companies with the largest market capitalisation (size). In an equity index, as a company’s share price appreciates relative to other companies in the index, the weight of that company in the index increases. Therefore one could argue that as an index fund investor your investment is more heavily exposed to the largest and/or better-performing companies. For fixed interest index funds, the concept is the same in that the largest securities by issue size (equivalent of market capitalisation) make up the largest weights in the underlying index.

This actually means that the governments or companies with the highest issuance of debt make up the largest weights in a fixed interest index. As a result, investors in a fixed interest index fund effectively invest in those entities with the highest level of debt, which is clearly not always the strongest governments or corporations from a fiscal position. It is therefore important that investors understand the implications of what they are investing in, even in relation to index funds.

Portfolio Construction

So it is clear that there are pros and cons to the use of both active and index funds, which has direct implications for how they can be used and combined within portfolio construction. As illustrated by the table, index funds provide an optimal exposure to the more efficient asset classes of Australian and international fixed interest, where active managers struggle to outperform (particularly after retail fees). While a lower proportion of active managers also tend to underperform in global equities due to the more efficient developed markets of the US, UK and parts of Europe, Zenith believes there is strong merit to including quality active global equities managers in portfolios as there is likely to be increased potential for outperformance as the less efficient emerging markets of China, India, Brazil and others account for a greater share of the global equities markets.

In addition, those active global equities managers that do outperform tend to outperform by a considerable margin. Increasingly, investors are keen not to pay active fees for market performance (or beta,) so one application of index funds is to use them as a passive and lower-cost “core” exposure to an asset class and combine with a higher alpha (excess return) focused manager to provide the potential outperformance. This is a popular and sound way of combining index and active funds. There are multiple applications for the use of index funds within portfolios, but it is important to use them effectively and not as a result of an incorrect assumption that active managers have not done their job; or worse still, as a result of pressure to reduce fees in response to poor returns, rather than choosing funds on their investment merit.

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