The ins and outs of index investing - Pt 1

‘Active’ managed funds cost far more than index funds but are they worth it? In the first of a two-part series, Richard Livingston unveils a strategy that combines the low cost benefits of an index with the outperformance of an active approach.

Key Points

  • Index investing is cheap and worth a look, especially as active funds don’t generally outperform when the additional fees are accounted for
  • The core-satellite approach offers an opportunity to get a low-cost entry into the best of both worlds
  • The world of ETFs and index investing examined in detail in part 2   

The Myths

We all want good performance from our investments. But most of us believe that, at least in the area of managed funds, we have to pay for it. That’s why many managed fund investors pay up to 2% a year for an active fund manager, compared with less than 0.5% in many cases for an index-tracking fund.

Often the deck is stacked against the active fund investor. You’ll pay the fees but the chances are, you won’t get the performance.

Some investors, through bitter experience, look instead for cheaper options that track the index. But even here myths are plentiful. Some say exchange traded funds (ETFs) are better than managed funds, others insist the opposite. Yet more worry about the shortcomings of ETFs so frequently discussed in the media.

Let’s look at the reality, and examine why you should generally avoid active funds and how ETFs and index-trackers can be used in a strategy that can offer out-performance at a much cheaper price.

The motives

Previous articles such as Why a SMSF may not be for you have addressed the battle between financial advisers and fund managers to charge fees on your retirement savings. The battle lines in this case are not so well drawn. Here, the financial incentives are more dependent on the investor’s circumstances.

An advisor that has moved clients from externally managed super funds into SMSFs might argue the case for ETFs or index funds. For an advisor's clients without SMSFs, managed funds might be more attractive, not least for the juicy trailing commissions historically paid by fund managers. The motives for that choice may well have more to do with what’s best for the advisor rather than what’s best for you.

The pitch: passive versus active management

Your first decision concerns the relative merits of active versus passive investing.‘Passive’ management (or index investing) is where, rather than trying to outperform a particular index, a fund aims to replicate it. A passive index fund, for example, might hold the shares that constitute the ASX 200 or ASX 300, in the same proportions as the index.

This eliminates the risk of underperforming the market and makes the pitch ‘low cost’—index funds often charge less than 0.5% a year. The argument is that this cost saving is more valuable than the financial benefit to be gained from the skills of the average active fund manager.

‘Active’management is the more traditional model, offering the chance to outperform the market due thanks to skillful fund managers. Fees might be 1% a year but can be 2% or more. The pitch is essentially emotional—no one likes to settle for the average. Funds management marketing plays on our optimistic tendencies.

The reality: active versus passive management

A quick Google search delivers paper after paper of academic material on the merits of each approach. Let's summarise the main findings:

  1. After costs, many active fund managers won’t outperform their benchmark index. To merely match the performance of a passive fund, an active fund manager must beat the index by the extent of the additional fees. Frequently, they don’t;
  2. Many actively managed funds, especially the larger ones, virtually track the index anyway. Despite the pitch of being actively managed, the larger funds are in effect tracking the index. The larger they become, the more they mirror the index;
  3. There are skillful fund managers worth paying more for but it's hard to identify in advance who they are. That’s especially true for smaller investors, who have less access to detailed information on managed fund performance;

This brings us to the conclusion: For most investors, actively managed funds aren’t worth the cost. For smaller investors at least, the argument is moot anyway. Through lack of time, access to information and skills, retail investors are consistently poor at picking winning fund managers.

So why not eliminate the ups and downs of the active fund, reduce costs, simply track the index and benefit from its long-term appreciation? That’s the index fund pitch. But you need not choose one or the other—there’s a cost-effective way of getting the best of both worlds.

The core-satellite strategy

Rather than pay a fund manager 1 to 2% (or more) to largely hug the index and seek a bit of outperformance at the fringes, the core-satellite strategy suggests you hold a ‘core' investment in a passive index fund or ETF with lower costs. Then you hold ‘satellite’investments in shares, specialist funds or alternative investments with less correlation to the market but a greater chance of outperformance.

Table 1 shows the top 10 portfolio holdings at 31 March 2012 for the Colonial First State Australian Share (Core) Fund (an actively managed fund) and the Vanguard Index Australian Shares Fund (a passive, index fund).

  Colonial %   Vanguard %
Table 1: Top ten holdings - Colonial First State (Core) vs Vanguard Index Fund
1 BHP 12.75%   BHP 10.40%
2 CBA 8.73%   CBA 7.40%
3 ANZ 7.25%    WBC  6.30%
4 NAB 5.37%   ANZ 5.80%
5 Telstra 5.17%   NAB 5.20%
6 Rio 5.17%   Telstra 3.90%
7 WBC 4.86%   Wesfarmers 3.30%
8 Wesfarmers 4.38%   Woolworths 3.00%
9 Newcrest 2.80%   Rio 2.70%
10 Origin 2.59%         Newcrest 2.10%
  Total 59.07%     50.10%*
*Note - weightings estimated (only 50.1% total disclosed by Vanguard)

The holdings aren’t dissimilar, although the costs for investing in each fund are. In each case, the top 10 holdings account for more than half of each fund’s size (and therefore performance). The main differences are that Colonial doesn’t hold Westpac, prefers stocks with bigger market caps and charges 1.86% of your total balance for the benefit of these insights.

The ‘core-satellite’strategy suggests you're better off holding the Vanguard Fund and paying 0.35-0.75% on your total balance. If you held the same views as Colonial, you can buy its preferred stocks on-market as part of your satellite holdings and avoid the extra fees.

The cost saving is substantial. Assuming for a moment each of these funds consisted only of their top 10 holdings, an investor placing $100,000 in the Colonial Fund would pay $1,860 in fees a year.

If instead the core-satellite strategy was applied with a portion in the Vanguard Fund and the remaining funds used to purchase direct share investments to achieve the same allocations as Colonial, the cost would be about $400 per annum.

In practice, you can’t directly replicate the Colonial Fund due to lack of timely information, the impact of higher transaction costs (especially on the smaller shareholdings) and the difficulties in shorting shares if you want to 'invert' the Vanguard stocks not seen favorably by Colonial. But your $1,400 a year cost headstart is probably going to more than make up for any performance slippage (delivering better overall results).

There's a second benefit to the ‘core-satellite’strategy. Your satellite portion allows you to focus on investments more likely to produce outperformance—direct shares, boutique fund managers, alternative investments etc.—safe in the knowledge that your core index investment will track the market.

This fits in with the reality of life as a small investor. Most of us simply don’t have the time or inclination to sort through the entire world of fund managers, make our selections, monitor performance against the benchmark and try to work out whether their performance, or lack thereof, is due to luck or skill.

Core-satellite enables you to get the instant diversification of a low-cost index fund (or ETF) and focus your (often limited) time and energy on the satellite component.

The pitch: Index funds versus ETFs

Let’s focus on the core part of the strategy; the index investing component and how to develop it.

Should one consider an unlisted index fund like the Vanguard fund or a well-known listed ETF equivalent like the SPDR S&P/ASX 200 Fund (ASX Code STW), a fund listed on the ASX that holds the shares in the ASX 200 (with the same weightings as the index). Vanguard also offer a listed ETF (ASX Code VAS) which tracks the ASX 300.

Finding an indexed fund or ETF that replicates just about every index imaginable is easy enough. Shares, property trusts, bonds and commodities are all covered (both Australian and international).

The case for ETFs is largely that, because they’re listed, they can be bought or sold through a normal share trading account. The benefit of index funds, according to Warren Buffett, is that they aren’t listed, so you won’t have a broker tempting you to trade them at exactly the time you should sit on your hands.

The reality: Index funds versus ETFs

The choice between index funds and ETFs is a matter of personal preference. You may want the option of buying and selling through your trading account, in which case ETFs stack up. Or you may simply prefer to send in a form at your leisure and not feel obligated to watch stock prices.

The cost differences aren’t that great. ETFs offer lower ongoing costs but involve brokerage. Neither is it as easy to make small, regular contributions as one can with index funds. In the end, the choice is one of convenience and style rather than cost. Pick the method that best fits with how you like to invest.

The problems with ETFs

Saying that ETFs have inherent problems is a bit like saying shares are poor investments. It all depends on which one you buy. For every Westfield Group there’s an ABC Learning; For every SPDR S&P/ASX 200 Fund, there’s an ETF offering short exposure to an index leveraged three times over.

Some ETFs are actively managed, rather than passively tracking an index, and more exotic ETFs have issues such as ‘tracking error’(where an ETF fails to track its benchmark). But if you’re focusing on the simple indexed share and bond investments you don’t have too much to worry about, although checking with your financial advisor before acting (assuming you have a good one) is sensible.

Mythbusted?

Actively managed funds tend not to outperform the index, which is why you’re generally better off with an index fund for most of your portfolio and using the core-satellite strategy for the remainder. In Part 2 later this month we will explore the world of index funds and ETFs and whether it is full of traps and pitfalls for ordinary investors.

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