Want to know a secret? There is an embarrassing little statistic that most fund managers would rather the fund buying public not know about:
Historically, the majority of managed funds have failed to even equal, let alone "beat" passive index tracking funds. For example, one of the top performing United States funds over the last 20 years has been the Vanguard Standard and Poors 500 index fund, only a handful of the thousands of active funds available to the public have equalled or surpassed its return, and those that have have managed to do so only by a small margin.
Of course unless you have been investing for a while and have access to impartial research, you probably haven't heard that before, because index funds rarely advertise, rarely make the top of the performance tables over a short period of time, and since they generally pay nothing in commissions they have been completely ignored by financial planners/advisers.
An index tracker fund is a fund that avoids the whole concept of research and analysis and simply mimics a widely followed index. They employ no researchers or portfolio managers at all, much of their trading is carried out automatically by computers and follows closely the performance of the chosen index. The simple goal of an index tracker is to hold every stock in an index such as the ASX All Ordinaries Index or every bond in the UBS Warburg Australian Composite Bond Index. There is no attempt to outperform the index, there is no attempt to buy more stock in any company that is considered particularly desirable and no attempt to reduce holdings in any stock that underperforms.
Index funds don't perform quite as well as the index itself, because any real world investment strategy has costs such as brokerage and other trading expenses, but you have to realise that as a whole investors will be unable to achieve performance higher than 100% of market returns. Some investors will achieve higher returns, but only because they didn't buy bad stocks that others bought. On the whole, all investors will achieve a return that is equal to 100% of the average market return, minus the costs they incur in buying and selling. To maximise your return you can either hope to achieve returns greater than 100% of the market return, by selecting investments carefully and eliminating less sound issues, or settle for getting as close to 100% as possible by simply keeping costs down. The latter approach is the one that index funds take.
An active fund is different, it employs researchers and risk analysts and traders. Based on strategic views taken of the economy by their economists active funds may choose to increase holdings in certain sectors to take advantage of anticipated favourable business conditions in that industry or interest rate movements affecting a specific asset class.
Active funds are committed to being among the very few investors that will substantially outperform everyone else. It is impossible for all investors to be above average, so logically for every strategy that works really well there will be people following other strategies that don't work at all. The challenge is to identify ahead of time which strategy is going to be among the lucky few, and history says that this is not an easy feat.
Not all actively managed funds try to time the market, but many do, trading aggressively in a manner quite contrary to their talking heads on television insisting that investors should take a long term view. The turnover of many actively managed funds is often a few hundred percent, meaning that on average the entire portfolio is bought and sold every few months.
There is a spectrum of funds ranging from full index trackers ("core funds") through to fully active funds that ignore indexes completely.
The term "core' is often applied to index funds or funds that are not entirely different because it is suggested that an index should form the core of a portfolio. An active fund that is close to core allocation is essentially an index tracker with small, limited modifications in asset allocation or a small amount of trading.
The further an active fund progresses away from being based on an index, the less the portfolio will have in common with a base index. There are a very small number of "unique" active funds, that assemble their portfolios without bothering to mimic standard benchmark indexes to any great extent, but most start out with "neutral" index weightings and make only small changes. In between these active funds and the true index funds there lie thousands of managed funds that keep close to indexes but make small bets for or against certain stocks and sectors and funds that adhere to somewhat different core holdings than indexes.
There are also pseudo-index trackers or "improved" index funds that set themselves the modest goal of only slightly beating an index fund. They achieve this by trying to reduce costs even further (usually with cost cutting measures such as reducing the number of stocks held), or by taking very small active bets, leaning away from supposedly less desirable stocks and putting a bit more into more desirable ones.
There are two big advantages that index trackers have over active funds. Firstly, an index tracker has a very low MER. They incur no research expenses, they do not advertise (but rely on common knowledge of their existence as well as corporate support), their prospectuses are usually much less glossy (Vanguard's prospectus is black and red ink, on cheap paper, Dimensional Fund Advisors' prospectus is black and white, printed on A3 paper stapled in the spine and folded into A4 size (with no cardboard jacket), Barclays Global Investors index funds prospectuses are printed in black and white on A4 paper, with a single staple in the top left corner, but the grand masters of cheap prospectuses don't even offer them in hard copy, some index managers only make their prospectus available via download from their web sites). Index funds usually pay no commission to financial advisers (which is why your financial planner probably hasn't mentioned them).
This low MER is a huge advantage to investors. All things the same, a fund with a MER that is one percent lower will give returns 1% higher for investors. Over very long periods of time an extra one percent will amount to massive differences in your final result.
A second big advantage is their tax efficiency. Stocks tend to stay in indexes for a very long time, meaning that index trackers will also hold stocks for a very long time. Very aggressive active funds with a high turnover will give a constant stream of capital gains distributions to investors who will incur taxes over the whole period. As you know if you buy a stock but don't sell it, you never incur a capital gains tax liability.
In the short term there always appear to be large numbers of active funds that outperform index trackers, you rarely see an index fund up the top of the list in any particular year. What the managed fund "pop charts" don't show is after tax returns over a longer period. An index fund has low fees and greater tax efficiency and when these are accounted for, over longer periods index funds tend to rise to the top.
Although in any given year there will be a lot of funds beating the index, the trouble is that the next year most of these funds will fail to beat the market and the index beaters will be a different set of funds. If you look at a longer time frame to see if any managers consistently beat the indexes the list thins out dramatically.
Certainly there are active funds that outperform indexes over time after fees and taxes, but they are in the minority. The majority of funds lie in that middle zone of "active, index-like" where only small differences exist between the portfolios of these funds and the index they base themselves on. These tweaks rarely have a great lot of effect in any one year, let alone over many years, so they essentially have the same returns as an index tracker, but with higher fees and more distributions.
When an active fund manager sets themselves the goal of beating the index by 2% per annum (an optimistic goal, if history is anything to go by), and yet they charge 1.5% more than an index fund does in fees, and they trade a lot which reduces their tax efficiency and increases their market costs, and they keep changing their strategy, then this margin of extra performance is wasted away.
In numbers crunched by Vanguard, who of course have a marketing interest in making this information known, it is quite obvious that the majority of active funds fail miserably to outperform their indexes by a wide enough margin to make up for their shortcomings. In the period between 30 June 1995 and 30 June 2000, after fees and charges Vanguard index trackers outperformed 53% of Australian Diverse Share Funds, 89% of Australian Listed Property Funds, 80% of International Share Funds and 91% of Australian Fixed Interest Funds. (source: Vanguard "A Guide to Understanding Indexing")
Even more depressing numbers are shown in the Vanguard Prospectus (call them on 1300 655 101 to order a copy, ask for the "Plain Talk Library" booklets as well). These show active funds in an even worse light, with more sectors examined and worse results shown. Over a different time period (1 October 1994 to 30 September 2000, 62% of Australian share funds were beaten by an index, 85% of all Industrial and Imputation Share Funds, 100% of all listed property securities funds, 90% of all international share funds and 100% of all Australian Fixed Interest Funds. Internationally, Index Funds reign supreme, with trackers rarely failing to embarrass the best active fund managers. I'd love to see this study repeated over a much longer time period and by someone other than an index fund manager. Unfortunately very few databases are kept, at least that are publicly available showing the effect of fees and taxes on investors, all of those big impressive numbers that head up the full page ads in the investment magazines are before fees and taxes.
Where some active funds often do shine is often in specialist sectors where selection becomes particularly important, such as health care and technology. The US NASDAQ index is full of garbage, stocks that would never be accepted into indexes managed by Dow, Morgan Stanley or Standard and Poors. NASDAQ isn't really a technology index, it is just that listing requirements for NASDAQ are less strenuous than other exchanges and the index has a higher proportion of really lame companies. You consistently see many specialist blue ribbon technology trusts outperforming NASDAQ and other indexes as well as other sector specialists because this is an area where selection (if you can pull it off) pays big rewards. All I am saying here is that if you can select a good active fund you can do very well in these sectors, in the next section discussing indexing vs market efficiency I will explain why even in these sectors index funds will still be better than the average manager.
Indexing does not work because there is anything good about the index stocks, an index is just a bunch of stocks usually picked by capitalisation and differs very little from any random basket of stocks. The great advantage of an index fund is that there is low turnover and low costs. When picking active funds I look for these two features as well, read about how I pick active funds in " choosing a good active fund".
Then I go and say that notwithstanding my statement that stock selection is possible, I still come out and tell people to index. What is the deal here?
Index funds would outperform the majority of active funds whether the market was efficient or not. The success of index funds is not due to market efficiency.
How so? You must realise that institutional investors account for the majority of trading activity today. They control the most money, their trades are so big that it can take months for them to enter and exit positions in full. Most trading activity is therefore between the fund managers, they mainly trade with each other.
It is simple really, professional fund managers account for such a large proportion of trading activity that to a first approximation you could say they operate in a closed market, other players do not matter. Therefore, fund manager trading activity is a zero sum game. If one fund buys a value stock that greatly outperforms, this is only because some other fund manager sold it to them and that other manager has missed out on these high returns.
Ok, there are debates about the validity of calling a benchmark index "the market", but it is probably fair to say that whatever definition you use to define the market the whole thing is going to be a closed system and for every manager that does extremely well, all others will need to do just a little bit worse for not holding the stocks the top manager held.
So if there were no costs to worry about, logically we would assume that fund manager returns would be distributed equally (though not necessarily perfectly symmetrically) about an average, and that that average would be quite close to the index. In a costless market, efficient or not, index funds would sit right in the middle on the 50th percentile.
But as we've already said there are costs. There are transaction expenses (which I talk about in greater detail in the article on choosing active funds) and management fees. If all active funds are more expensive than index funds then index funds won't lie on the 50th percentile any more, they will rise up in the ranks. Taking into account the higher costs of active funds it is not hard to understand why index funds rise up to the point where they beat not 50% but 75% of active funds.
If trading volumes and costs continue to trend upwards, as they have over time, it is theoretically possible that index funds will rise even further in the pack. If management expenses ratios and trading costs were to continue to rise and rise, one day 100% of active funds would be beaten by the index funds.
None of this necessarily implies that you should aspire to copy the index exactly. Rather than indexing in the true sense there are some that go for "passive" management instead. A manager I use often, Dimensional Fund Advisors (DFA) runs, among other things, a low price-to-book ratio "value" fund and small cap fund. (I would call them "index funds" except they don't mimic any index in particular, you can call them "enhanced index" or "tax managed passive" or similar names if you want).
These are not benchmarked around any particular index, DFA do not worry about "tracking error" (having performance that precisely follows every up and down tick of the index being replicated), they go for a tax managed passive approach where the goal is to "capture the performance of an asset class" as opposed to the stated objective of an index fund which would be "to replicate the performance of the XYZ index with less than a 0.1% tracking error".
A few paragraphs ago I mentioned that in inefficient markets like small capitalisation markets, the NASDAQ, small countries etc there was potential to select top performing investments. This is true, undoubtedly the more inefficient the market the better the opportunities for astute investors. However, even in a highly inefficient market, low cost index funds will still outperform the average manager (average weighted according to fund size), and for every Mario Gabelli (a world famous American small cap value fund manager) there will be correspondingly bad performances from other managers that didn't buy these stocks and instead held the stocks that Gabelli didn't. My argument merely says that if you want to go hunting for active managers that you should look for them in inefficient markets. On the whole though, indexing will still beat most active managers however inefficient a market may be.
Obviously in highly efficient markets where mispricings are rare, such as major large cap indexes in leading economies, there are fewer mispricings to exploit and thus it is probably impossible, even in theory, to identify superior active managers. I thus would never buy a large cap American active fund based on the S&P500 for example, there are too many cheap index trackers out there to make that gamble worthwhile.