Reckon you can beat the market? Don't bank on it

Exchange traded funds (ETFs) listed on the stock exchange have become very popular with Australian investors, and they often underpin the portfolios of robo-advice providers.

The reason for this popularity is that ETFs offer a low cost style of investing, often with fees below 0.5% annually. And by spreading investors’ money across a range of underlying shares, ETFs offer plenty of diversity even if you don’t have much capital to invest.

A key reason why ETFs can afford to charge such low fees is because they aim to match a given sharemarket index rather than beat it. This so-called ‘passive’ or ‘index investing’ approach means no teams of researchers trying to second guess the market. It can also result in less buying and selling of investments in the fund’s portfolio, which helps to lower trading costs.

But some investors aren’t so sure. There are those who feel that investing should be about beating market returns through ‘active’ investing. In other words, trying to pick tomorrow’s winners. That’s fair enough – it’s a very appealing idea. The catch is that outperforming market returns is extremely difficult, and it’s almost impossible to achieve year after year.

If you’re not convinced, S&P Dow Jones Indices has been the de facto scorekeeper of the active versus passive debate since 2002, when it began publishing its SPIVA Scorecard. This Scorecard reports on the performance of Australian active funds against their respective market benchmarks over time.

The latest SPIVA Scorecard for Australia shows that in 2021, 42% of Australian share funds using an active approach failed to beat market returns. Over the last three years, 62% of active funds weren’t able to outperform the market. And over the last five years, three out of four active Aussie share funds earned below market returns.

To rub salt in the wound, an actively managed fund will likely charge higher fees than index-based ETFs. Fees vary between funds but MoneySmart says you could pay up to 2.5% annually.

The thing is, investors pay fees no matter whether a fund makes a gain, a loss, or whether it beats the market or doesn’t.

For the record, I’ve been keeping an eye on the SPIVA results for a few years now, and the same results have applied – in much the same way, over time. Confirming this, the SPIVA report notes “we have consistently observed underperformance for the majority of Australian active funds in most categories over the longer periods”. The upshot is that it’s a pretty compelling argument for ETFs that follow an index.

Sure, we’d all like to earn above-market returns. But it’s just so hard to do, and it can come at the cost of higher fees that knock the cream off the top of any higher returns.

Paul Clitheroe is Chairman of InvestSMART, Chair of the Ecstra Foundation and chief commentator for Money Magazine.

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