Episode Details

Over the past decade, investors and large institutions have been deserting expensive active fund managers in return for using their cheaper index equivalents.

According to Morningstar, investors in the US withdrew $USD204 million from actively managed investments (net) in the 2019 calendar year. However, low cost index funds continued to grow in popularity receiving (net) $USD162 million of new money. The transition away from active management into low-cost index funds has been happening for over a decade.

Whilst it is true that traditional market cap indexing has outperformed many professional managers over long periods of time, it does have its shortcomings, particularly in markets other than bull markets.

It is my thesis that investors would be well advised to employ a selection of fundamentally sound indexing methodologies. Doing so can reduce a portfolios risk and potentially expose it to higher future returns.

What are the recent stats of index versus active?

Index funds are popular for good reasons. As I have written about previously, index funds typically produce better returns over the long run and charge much lower fees.

For example, only 16% of active fund managers have produced better returns than the index over the past 15 years in Australia (and only 11% in the US). However, it is important to note that the same fund managers have beaten the market each and every year. In fact, active fund managers may only outperform for one or two years. Statistics show that their outperformance almost never persists for longer periods of time.

According to data published by S&P Dow Jones, 81 Australian fund managers where in the top quartile in terms of performance for the 2015 year. Only 11 out of 81 remained in the top quartile a year later i.e. 2016 calendar year. And only 5 out of 81 were able to string three good years together (i.e. were in top quartile in terms of performance for 2015, 2016 and 2017). It is clear that ‘picking’ an active manager that will outperform is a very difficult thing to do, as it is likely you will need to chop and change fund managers every 1-2 years.

Three types of index methodologies

Indexing strategies typically fall into three categories:

1. Traditional market cap indexing – this is the type that you are probably most familiar with and has been popularised by Vanguard since the mid-1970’s. Market cap indexing spreads your investment across an index proportionately according to a company’s value (compared to the index’s aggregate value). For example, if you invest in the ASX200, 8.2% of your money will be invested in CSL, 7.6% in CBA and so forth.

2. Factor-based indexing – factor-based index methodologies uses measures other than a company’s market value (which is linked to its share price) as a means of diversifying your investment. These methodologies seek to break the link with price. The thesis is that price does not always accurately reflect a company’s risk and future returns. Examples of these mythologies include fundamental indexing and Dimensional.

3. Equal weight indexing – This is probably the most unsophisticated indexing approach. It invests an equal amount of your money in all companies that are included in an index. For example, if you invest in the ASX 200 index, then one