Large v small cap may be better metric than index v active

A recent announcement by Australia's largest industry super fund, and a comparison of investments returns achieved by active fund managers compared with the relevant share indices, should prove interesting for investors in general and self-managed superannuation funds (SMSF) trustees in particular.

AustralianSuper recently provided details about its decision 12 months ago to build an internal investment management team rather than use external fund managers. AustralianSuper hired 23 staff including investment managers, trading staff, analysts and operational specialists for this.

The first investments to be taken over by the investment management team included Australian equities, direct property and infrastructure investments. The aim of the exercise was to cut the costs that come with using external fund managers.

Mark Delaney, AustralianSuper's deputy chief executive and chief investment officer, said: "There are a number of significant benefits to this project, primarily a cost reduction of up to 15 basis points. The amount of savings will grow as the fund grows."

This idea of reducing investment costs is one of the reasons people set up SMSFs. They are thus able to make direct investments in shares and property, and have a greater sense of control over their super investments. Moreover, this set-up can result in decreased costs and greater confidence in the performance of their fund.

There is a long-standing debate as to whether active fund managers add value compared with an investment in index funds. Active fund managers are meant to use their investment expertise and market inefficiencies to pick stocks that will outperform the market. An index fund buys all the shares that make up an index. An example of this is Vanguard's Index Australian Shares Fund, which is made up of the top 300 ASX-listed companies.

Active fund managers have higher management costs than do index funds.

A sad fact of the investment industry is that there are fund managers who say they are active managers when in fact they are not. In these cases many investment decisions are made because of changes in an index, not because of a change in the investment worthiness of a company.

A report that S&P released this week provides some valuable information to help investors make up their own mind. The report, titled S&P Indices Versus Active Australia Midyear 2013, details how well active fund managers compared with the index in several investment categories. The indices included the S&P/ASX 200 Index and the S&P/ASX Small Ordinaries Index.

The comparisons between active managers and the indices were done over periods of one year, three years and five years. The scorecard for active fund managers operating in the top 200 Australian shares index showed that 74 per cent of them outperformed the index over the past 12 months, but for the three- and five-year periods the index outperformed more than 60 per cent of active fund managers.

When it came to the managers investing in the small companies, a very different picture emerged. In this situation the index was outperformed by 94 per cent of active fund managers over a 12-month period, and by 88 per cent over a three-year period and 82 per cent over a five-year period.

The conclusion from these results is that individuals and SMSF trustees investing in large-cap stocks should seriously consider allocating some of their investment portfolio to index funds.

In addition they should closely assess whether the fund managers they are using are active managers, or are benchmark huggers who make many decisions due to changes in an index and therefore are not adding any value.

Max Newnham is the founder of smsfsurvivalcentre.com.au