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The endless index versus active investing battle

The index versus active investment debate is almost as old as the investment industry itself.

“Active investing” sounds impressive, while “Passive investing or as it should be known index investing” sounds lacklustre. But index investing could rightly be called “common sense investing”. It’s sometimes known as “evidence-based investing.”

Looking at the evidence, it’s easier to be a supporter of index investing than active investing.

Index investing makes promises it can keep: it aims to give investors the market return. On the other hand, active investing claims to be able to beat the market.

It often doesn’t.

Most active managers are unable to reliably and regularly beat the index/market return. The table below makes this clear.

Percentage of large cap funds that underperformed their local equity index to June 20181

  Over 5 years Over 3 years Over 1 year
USA2 76.49 78.64 63.46
Australia3 68.69 67.32 57.63
Europe4 74.3 62.82 58.83

Thinking of finding that fund which consistently performs at the top? Even harder to do. Out of 550 domestic equity funds that were in the top performance quartile in September 2016, only 7.09% were still in the top quartile at the end of September 2018 5.

Few, if any, can outperform the market for the long-term.

Despite this, active funds charge higher fees. This too affects returns, even on those occasions when the active investments finish ahead of the market return.

Why are the periods of outperformance from active funds rarely sustained?  Because the active manager is essentially claiming to be able to see the future and the ability to select companies with superior future earnings performance. That’s a big ask in a world with many uncontrollable factors.

Outguessing the market is hard to do.

Not only do predictions go awry, but fund managers may simply mistime the market, by holding the right securities at the wrong time.

The theory of market efficiency is simple. Eugene Fama, the 2013 Nobel Prize winner, defined a market as “informationally efficient” if prices always incorporate all available information. And, in the broad sense, they do.

How many times has a company’s share price weakened after a strong profit announcement? That’s because of a market belief that the strong profit is as-good-as-it-gets. Investors as a whole are less optimistic about the particular company’s future profit outlook.

Human reactions can be hard to predict.

The combined return earned by all investors in any market is the market return. It cannot be more than the market or less than the market. In other words, active investing is a zero-sum game.

One active investor may win, by outperforming the market, but another has to lose, by underperforming the market.

It is certainly possible to outperform the market, but not consistently, not in the long-term, and not without higher costs and greater risks.

Given all of this, is it any wonder that investment legend Warren Buffett is such a supporter of index investing?6

In 2007, Warren Buffett bet a million dollars that an index fund would outperform a collection of hedge funds, the ultimate in active funds, over the course of 10 years. He won that bet. Possibly the most grateful of all was a charity called Girls Inc who collected the proceeds.

It’s no wonder that investing in index funds has become increasingly popular.

So, it seems that more and more people are seeing the wisdom of the index investment approach. It just makes sense, and it’s supported by evidence.

Investing broadly in a market and keeping fees and expenses as low as possible is more likely to be rewarding over the long haul than chasing an illusion.

Claiming to be able to beat the market is a tall order. Actually, just about impossible, especially on a long-term basis.

On the other hand, it’s possible to enjoy the market’s gains coupled with low fees by going down the index investment path. It just makes sense.

References


1 https://us.spindices.com/spiva/#/reports/regions
2 Large cap US equity funds underperforming the S&P 500 (data ex SPIVA)
3 Australian equity funds underperforming the S&P/ASX 200 (data ex SPIVA)
4 Europe equity funds underperforming the S&P Europe 350 (data ex SPIVA)
5 SPIVA Persistence Scorecard September 2018
6 http://fortune.com/2017/12/30/warren-buffett-million-dollar-bet/

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