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Index funds invest in the bad and the good

Here’s a pithy marketing one-liner for you: ‘Most active fund managers underperform the index’. Combine the argument with the removal or mitigation of structural biases towards fee-paying products, and a massive business has emerged in index funds and index ETFs.

The promise of diversification, a low cost and access to overseas markets are the top three reasons for the popularity of index funds, but their growth and popularity belies the fact that broadly diversified cap-weighted equity index funds guarantee ‘average’ returns for a generation of investors.

As passive index investing becomes ever more popular, the arguments that justify the switch from active to passive management weaken and then break down. Retail investors are none-the-wiser, and trust those recommending this approach because it’s cheap.

Tellingly, they are cheap

Index investing, in particular when it is directed to cap-weighted equity indices, is dumb investing. When Warren Buffett recommended index investing to the masses, he made the point that it suits the 'know-nothing investor'. That is, the investor who has no interest in understanding a business or valuing it.

If you are reading Cuffelinks, you are not a know-nothing investor. And if you are an advisor, your clients are relying on you and paying you to be a ‘know-something investor'. There are plenty of reasons to avoid index investing and the ETF structures used to promote them, but those reasons haven’t hampered their growth.

ASX-listed ETFs are at a record high of over $17 billion and according to a January 2015 'Australian ETF Review', ETF trading activity also broke the record for the largest month-on-month gain in funds under management as growth reached $955 million. Meanwhile, the number of exchange-traded products trading on the ASX exceeds 100 and the number of ETF investors in Australia grew by 46% in the 12 months to October 2014, to 146,000. More than 180,000 investors are expected to have adopted the structures by the end of calendar 2015. Meanwhile the number of financial advisers employing ETFs has reached the record level of 7,000.

Of course strong market performance is having a significant impact on index investing’s popularity. The adoption rate can reasonably be expected to be highest when the market is at a crest and lowest when the market is on its knees – precisely the opposite of a successful investment strategy.

While exchange-traded and index funds have been heralded as one of the most important financial innovations during the last decade, promoters fail to warn investors of their limitations.

Dangers of popularity

As index investing grows in popularity, so does the blind purchase and sale of large baskets of shares with no regard for their underlying fundamentals. How such an approach to equity investing can be recommended to an investor requires careful examination. Most dangerously, as index investing grows in popularity so too does the divergence between stock prices and fundamental values.

Three risks for index investors increase – the risk of permanent capital impairment, volatility, and the certainty of average performance.

Index investing is justified on the basis that the market is efficient and stock prices always reflect fair values. Therefore index investors ride the coat-tails of analysts who have done the work to determine values and disseminate that information. As the number of index investors increases, so does the amount of blind buying and selling. This ‘squeezes out’ sensible value-based investing and reduces the influence of the narrowing pool of analysts required to establish the valuations the efficient-market-index-investing proponents rely on.

More frequent periods of greater divergence between price and fundamental value will occur, and in those periods, active managers have the opportunity to make much larger returns for their clients.

As index investing grows in size so does the ability for marginalised active managers to outperform. The argument that passive beats active – the reason for the migration to passive forms of investing – weakens.

In the long run, sensible investing beats blind investing

I have frequently used the following example to make the case for smart active investing.

In 1919 Coca Cola listed on the NYSE at US$40 per share. A year later the stock was trading at $19.50, the result of rising sugar prices and a perpetual contract Coca-Cola had with its bottlers to supply syrup for $1 per gallon. What would have happened if a single share of Coca-Cola was purchased in 1919 at $40 and held through all of the frightening subsequent economic and financial developments, including the subsequent decline to $19.50 in 1920, then through the great crash of 1929, the subsequent depression of the 1930s, World War II, a baby boom, dozens of other wars and skirmishes, an oil crisis, assassinations, the fall of the Berlin Wall, innumerable recessions, booms, busts and scandals, as well as a war in Vietnam, two in Iraq and the market crashes of 1974, 1987, 2000 and the Global Financial Crisis?

Holding that single share, accepting all of the subsequent stock splits and reinvesting all dividends, would now equate to over 252,000 shares and the investment would have a market value, at $US40 per share, of over US$10 million.

It goes without saying that there would have been many periods and windows where the S&P500, the Russell 2000 and the Dow Jones indices outperformed the share price of Coca Cola. Indeed over the last two years the S&P500 has returned 35%, while Coca Cola has returned negative 5%. And over the last five years, the S&P500 has returned more than 72%, while Coca Cola has returned 50%.

But over the very long run - the period over which investing in a slice of a business makes perfect sense - sensible value investing in quality businesses will beat an index. The index is forced to be in both high and low quality companies. A $40 investment in the S&P500 index in 1919, is now worth just $540,000, compared to the $10 million for Coca Cola.

Australia is replete with businesses generating poor returns

Many advisers and commentators despair that the S&P/ASX 200 price index remains below its all time high, some eight years later. And yet, without thinking about why this is the case, they advocate index investing.

The reason the index remains below its high despite an unprecedented amount of artificial, and temporary, support from low interest rates, is that the index is dominated by businesses generating poor returns on shareholders’ equity capital. Mediocre businesses generate mediocre returns on shareholders’ equity, and over time, share prices reflect this, ensuring small minority shareholders receive a return similar to that of a 100% owner of the business.

As an example, I have previously explained the terrible performance of Virgin Australia over the last decade. It has required massive capital injections, holds $1.7 billion of debt and the share price is a quarter of its level ten years ago. An investor in Virgin shares would have experienced a proportional economic calamity over a decade to the individual who owned the entire business. Every large cap Australian index fund has paid the consequences of this poor investment.

But airlines aren’t the exception. A cursory examination of share price performances for many so-called ‘blue chips’ reveals many equally disappointing performances. Companies like AMP, NAB, Boral, Leighton, Lend Lease, BHP, Rio and Telstra might have paid dividends but their capital return has been disappointingly flat to negative over a number of years, even over a decade or more in some cases.

These blue chips make up the major cap-weighted stock indices and it is the blind buying of these diversified and cheap indices through index funds that will ensure their investors receive similarly mediocre returns.

Final thoughts

The blind buying of mountains of stocks simply because they are in an index will drive mispricing that active managers can rely on to outperform the same index. As more investors flock to the index, the argument trotted out that most active fund managers fail to beat the index will become less true, if not false. The hitherto reason for investing in the index breaks down, just as active managers reward their investors with greater outperformance over the long run.

And keep in mind that it isn’t true that most managers underperform their benchmarks after fees. In Australia the vast majority of active small cap managers beat their index. Their index is full of junior mining exploration companies that lose money or dilute, with frequent capital raisings, the ownership of the company for incumbent shareholders. Simply exclude those companies from a portfolio, buy the rest, and hey presto, you’re beating the index over the long-run!

Poor quality companies aren’t the exclusive domain of small cap indices. There are rubbish companies in every index. Cap-weighted indices are constructed by aggregating the performance of companies based usually on their size or on what they do. They aren’t selected because they are highly profitable at what they do. And they aren’t selected because they are expected to produce strong share price performances over the long term for their investors.

Indices were not originally designed as investments but simply as a measure of the market's activity. A cap-weighted index is not constructed with the intention of producing a solid long-term return for investors.


Roger Montgomery is the Chief Investment Officer of The Montgomery Fund. This article is for general education purposes and does not address the specific circumstances of any individual.

Ramon Vasquez
December 15, 2016

Thank you to Mr Montgomery and commentators ...

If one thinks of the market as a whole and its long term cyclicity , does it not make sense to take a
suitable , or perhaps several , index fund and just trade the market as a whole without the botheration of individual or sectoral selection ?

One could just use one's normal method and stock selection and apply such to a single index fund , or group of funds , at a much slower pace of course and certainly at a much lower cost .

l have found that l have always been able to guess at near tops and near bottoms throughout the years , so an exclusive use of index funds would be ideal in my own case .

Respectfully , Ramon .

December 08, 2016

One should also consider the fact that when investing in a particular fund, say the Montgomery Fund, the performance of the fund is closely linked to the man in charge or the Chief investment officer. In order to outperform the index over a long period of time, you will need to ensure that the Man in Charge will stay with the Fund for such a long period of time and have a significant stake in the business. Only a rare breed of funds are fortunate enough to have someone like Buffett at helm for such a long period of time, so for average investors, it is simply much wiser to invest in Index.

And what is wrong with achieving Average return of 10%+ P.A over the long term ? Yes, 22% P.A Compounded return by Buffett is impressive but 10%+ P.A achieved by index is still well ahead of inflation and beats property by a mile.

One should also note that most active funds charge a management fee + performance fee, so the fund manager can always take on more risk for "short term" outperformance without acting in the shareholder's interest.

Michael Howson
January 29, 2016

I have just looked up the link to Roger's ETF article and associated comments I now more fully appreciate the quality of this forum. regards Mike H

April 28, 2015

I found the article and the subsequent discussion quite informative and have saved it for future reference .

I'm not in a position to comment in an informed way about the actual topic at hand, however I would like to comment on two aspects of your article and I'm surprised that no one has chosen to comment on at least one of them.

Firstly, your choice of investing in coca cola in 1919 as an example on which to build your arguement around. I would have thought this is a good example of one of the main issues facing anyone seeking to back test an approach to share investing and that is survivorship bias.

How many other companies existed in 1919? How many of these no longer exist? In 1919 how would you have know to buy coca cola?

My second gripe (a more personal one) is the putting down of an alternative approach to investing to promote another. The reality is there are many differing ways to invest and used appropriately most of them can succeed. I have spent considerably more time researching share investing than property investing and am yet to make any significant money from shares, however the use of simple use of gearing, support, resistance and trend following has yielded me several million from the property market.

There are times when the stock market will provide better returns than property and the use of funds would appear to be a good way to approach it for those of us without the time of ability to make informed choices for themselves.

For me , the most important decision is when to get in a particular market . In property , I use the ten year average for capital cities and then look at which ever market is underperformance , hence my decision over the last years to buy in Sydney With our last buy being in 2013 .

I note that the ASX is currently underperforming and given that part of my investment strategy is based on a fundamental belief that australia, its economy, its property and share market will continue to exist and perform well in historical and global terms, then a period of under performance is for me a sign that a period of overperformance is on its way.


April 27, 2015

Chris, thanks for your feedback. It’s hard to present a clear and agnostic point in the debate about active vs. passive management because biases play such a huge role in the way people receive the information presented. I also think that often when people compare the two they forget that index funds rebalance, and that some active managers have very low portfolio turnover. It’s never an apples to apples comparison, and so I don’t envy your position in trying to explain in intricacies of Third Link when it’s thrown in the same bucket as every active fund out there.

My point was only ever that benchmarks and relative returns have their limitations as useful measures of success. Using them though, your performance has been impressive and is great case for the active management argument. Thanks for explaining the issue with a better data set.

Chris Cuffe
April 27, 2015

MrMcGee, I am very impressed with the level of detail you have picked up on.

Explaining the performance over time, with 2 different benchmarks in operation for different periods, has always been a challenge. If you have a look at the performance section of my web site you will see how I have tried to achieve this, without misleading people. See

April 27, 2015

Hello again Graham. Re your comment, Index Linked was beaten to the post in the Chairman’s Handicap by Enpingle, who paid $21.50 (a Black Swan, perhaps?). Perplexity came in fourth. Interestingly, when I looked up Index Linked (because I thought you were having a gag at first) on this was the horses’ description, “Index Linked is regarded as a racehorse with above-average ability”. I couldn’t help but laugh! I figure you checked all this already, but wanted to let you know the curiosity didn’t go unnoticed.

Graham Hand
April 27, 2015

That is hilarious: “Index Linked is regarded as a racehorse with above-average ability”. I wonder if the tipster has any idea how funny that is.

Ken Ellis
April 26, 2015

I agree with Ramani and would suggest that the older, low fee LICs are the best examples of using index as a core and adding a small number of the speculative.


April 25, 2015

At its core, Roger's thesis rests on the definitional truism: indices represent the underlying population. Hence his conclusion that index funds invest in under-average stocks is self-evident, because any normal grouping must contain them.
For greater credence, Roger should have canvassed the alternative: do active managers avoid 'baddies'? The record here is less than inspiring. Given unrelenting fees, some times bordering on the criminal.
No argument with Roger that it is best to invest sensibly, by avoiding underperformers. How does one find them as neither hindsight nor time machine is yet to be invented (blame Stephen Hawking)? Add the conundrum that today's baddies are tomorrow's stars; tax does unspeakable things to ultimate outcomes, even if they are a given, which they are not; and investor goals morph over life, with the odd personal catastrophe making plans awry.
To cap it all, epistemology: 'all knowledge is imperfect'. There is a large element of faith even - especially - in those who purport to act rationally.
All this is enough to drive one to mind-numbing substances, or their investment equivalent: dumb indexing. Many acolytes of activism have felt dumber - for their poorer results, they see the manager richer. As promised, active style is the key to (them) building wealth!
A core - satellite approach (indexing at the core, with as few or many satellites as one's risk preferences dictate) would stand the average investor in good stead, especially over time. Treat the satellites as the Melbourne cup flutter and preserve sanity. Take heart: everyone can't be below average.
I await the index lobby's response.

Stephen Romic
April 24, 2015

If advisers and investors had the knowledge and resources to build and maintain a robust manager selection process, indexing would cease to be the reasonable default position. In the absence of such knowledge and resources, it continues to be sensible.

Graham Hand
April 24, 2015

Without naming any specific managers as that will lead to accusations of favouritism, but since Chris Cuffe is a founder of Cuffelinks, I will note this. His Third Link fund, which uses a 'fund of funds' approach based on fund managers that Chris selects, has delivered outperformance for six consecutive years financial years, even after the fees have been donated to charities. There are Australian fund managers with good long term performance - but that does not mean they outperform the index every year.

April 25, 2015

Sorry Graham, but that’s not exactly a level playing field.

In his Cuffelinks article dated May 23rd 2013, Chris’ states when describing the Third Link Growth Fund that, “If you invested in these managers directly in the same proportion as Third Link, then for most periods, the fees would be materially more compared to accessing them via Third Link.” Which is not irrelevant, and goes some distance to explaining the fund’s performance. He also willingly admits that most funds with a ‘fund of funds’ structure underperform their benchmark. Taken as such these are two overwhelmingly good reasons to invest with Third Link if an individual is inclined towards a fund of fund’s structure.

However, it’s also worth mentioning that the benchmark against which the Third Link Fund is measured was changed in 2012 (which nicely illustrates the point I made earlier) and if it were not, by my account the outperformance of Third link would be somewhat lower than is advertised.

The Morningstar Multi Sector Growth market index has returned 16.77% over two years and 15.87% over three (since Third Link switched their benchmark). Comparatively, the Third Link Fund has returned 16.8% over two years and 17.7% over three. So while Chris and his fund have no doubt outperformed the ASX 300 accumulation index (the new benchmark), had the original yardstick remained in use the relative return would be quite different.

I give much credit to Chris, his funds, their funds and the group’s collective social conscience. You’re really remarkable. However with relative returns the devil is usually in the detail.

There are Australian fund managers with good long term performance, as you say. Just as there are indexes with good long term performance. It's easier to pick the indexes (and they don't retire!!)

Chris Cuffe
April 26, 2015

Hi MrMcGee

Thanks for your comment but it's not quite right. The reason I changed from the benchmark being the Morningstar Multi Sector Growth Market Index to the S&P/ASX 300 Accumulation Index was because I altered (after feedback from many, and after advising existing investors) the way in which the fund was managed. Up until that time I could invest in any asset sectors (domestic equities, international equities, REITs, fixed interest, cash, infrastructure etc) which I did, and hence why the Morningstar Multi Sector Growth Market Index was considered the appropriate benchmark. But at the start of February 2012 I could only invest in Aussie shares, and hence why the benchmark became the S&P/ASX 300 Accumulation Index. This means when I could invest in any sector I fairly consistently beat the multi sector benchmark (after fees) and when I could only invest in Aussie shares I have fairly consistently beat the Aussie shares benchmark after fees. So my claim of persistence alpha after fees is a valid claim.

Specifically on Third Link's performance, let's look at all rolling 12 month periods since inception. Using this as the measurement, there have been 70 observations since inception and in 9 cases out of this 70 the fund has been below benchmark after fees. However, if we look at rolling 2 year periods, there are 58 observations and the fund has beaten benchmark after fees on all 58 occasions. I believe this is an impressive result and a great case for the "active" argument.

Stephen Romic
April 24, 2015

Investing in index funds is (probably) becoming the default position for investors and advisers for the following reasons:
1. Adding consistent risk-adjusted value from stock/security selection isn't a walk in the park; it's difficult; every active manager says they can do it; very few, in fact do. Active managers require sustainable insights (which is not attained easily) against the aggregate market in order to add value. Then there's the impact of high FUM due to commercial success to contend with.
2. Manager selection (i.e. choosing the 'right' active managers) isn't a walk in the park, either. Firstly most 'active' managers are only active in marketing. Most are in the business of product manufacturing and they dominate the industry. The first challenge is to separate product manufacturers (who hold out to be active mangers) from legitimate money managers. The second challenge is to address and overcome the conflicts of interest within the business models of the “independent” research houses and investment platforms which largely control what investment products are broadly made available. The third challenge is to find a robust and transparent process that evaluates the efficacy of the remaining active managers.
It is therefore reasonable and logical for advisers and investors to default to an index based approach. In doing so, they are: (1) reducing the complexity of portfolio management & administration; (2) reducing fees; and (3) increasing returns, on aggregate.
I do agree that the opportunity set for active managers must increase as indexing gains popularity and indeed dominates. However, the above mentioned structural flaws need to be addressed before any meaningful ‘return’ to active management can be expected by self-directed investors and (non-institutionally aligned) advisers.

John K
April 24, 2015

After several decades of investing in companies that lost me a small fortune and index beating fund managers that suddenly hit a very bad losing streak, I put most of my retirement savings into Index Funds. I am almost NEVER tempted to sell at the wrong time and can happily live off my dividends in a relaxed frame of mind for ever.
If there was a formula for selecting a "future" index beating fund manager someone would be out there selling it. I much prefer average returns and a good nights sleep than attempting to beat the market.
Having never managed to be a top performer in sport or any other aspect of life I'm perfectly happy with diversified mediocrity.

April 24, 2015

Index investing, because it guarantees ‘average’ returns for a generation of investors, makes it dumb? How so?

If the index is used as it’s intended to be used – as a benchmark – then it can be replaced. You make this point towards the end of your article when you compare the returns of active small cap managers against their ‘chosen’ benchmark. The relative successes and failures of these active small cap funds would be modified if their results were pitched against the All Ords, obviously. So how, and why, should we choose a benchmark? What is average? And how do we define it?

If we used the Montgomery Fund as our benchmark for out-performance for example there would inevitably be a ‘best’ and a ‘worst’ company held within that selection of equities and, logically, 50% of active managers would “beat” the benchmark and 50% would fail, provided their selection of equities differed from that of the Montgomery Fund. If the Montgomery Fund is weighed against the ASX top 20 however, there is the possibility that each and every equity held within it is “better than average”, which is empirical, and possibly irrelevant. In my view this sort of makes the conversation about out-performance futile. You will always outperform someone!

The point I’m making – while being obviously facetious and meaning no disrespect - is that if the benchmark, any benchmark, is simply the average results of a group of unknown individuals whose outcomes do not matter to your own, then why do they matter at all? We’re not spending relative returns. And shouldn’t this bring the point home that what is right for the investor is whatever policy holds the greatest chances of them reaching their financial goals in the time frame they have available?

Broadly I agree with the technical points you’ve made about index funds and their limitations as an investment. People need to be clear why they invest in any asset. But if the investors time frame is long, and what matters to the individual is “[t]he promise of diversification, a low cost and access to overseas markets”, and this strategy allows them to stay the path (which is the real kicker!), then I fail to see how index investing is “dumb”.

Mary S
April 26, 2015

I agree with Mr McGee's comments regarding index funds and their ability to help investors in staying the path.

Another factor is that many index funds ("true" index funds, that is) have low fees which are an additional boost to beating active managers.

Active managers often charge fees of a couple of per cent - so the active manager has to outperform its benchmark by the fee at least, for the investor to be ahead - which when compounded over time can impact performance significantly.

Another thing is that although some managers can outperform, how do you choose them in advance, prior to the outperformance, so you reap the benefits? Hindsight is great, with respect to saying that some manager has had a certain outperformance over the last few years, but that does not mean that performance will be replicated going forward for the next fews years.

The "SPIVA" study which looks at the performance of index versus active managers, time and time again, shows that many active managers do worse than their benchmark. Of course, some do better, but never the majority.

So, good luck in choosing the manager that persistently offers good performance over many years.

Geoffrey Gibson
April 24, 2015

Mr Montgomery’s piece sounds like special pleading – with a bad title. All investors invest in the bad and the good. What do the records show about who comes off better between those in active and those in passive investments? Graham, Zweig, Malkiel and Buffett have no doubt about the answer.

April 30, 2015


Buffett is not infalliable - take a look at his investment in Tesco.

David Witt found that out the hard way when he got hounded down (disgustingly) for "daring to ask" for a dividend, like Oliver Twist when he asked for "more".

Buffett's arrogance shines through, in that he is essentially saying "and if you can't pick stocks like me - and you can't - invest your money in an index fund...because you're all thick and worth of contempt".

David S
April 24, 2015

Roger - out of interest, can you point to any actual evidence that active managers have persistently outperformed the index over any reasonable time frame? I've certainly seen a lot of evidence to the contrary! I didn't see any in your article above, but I assume if you are putting forward this view so forcefully you'll be able to provide Cuffelinks readers some hard evidence to back up your view?

April 24, 2015

Is that why Buffett’s advice to his executors is to put 10% of his assets in Government Bonds and the remaining 90% in the US S+P500 index ?

This is a man who has the best investment record on the planet and his “growing old” is not some sudden event or illness that has just happened, requiring an immediate response. Questions have been asked about succession planning for YEARS now, but it has been poo-pooed.

Essentially, he will just stick it in the index instead of teaching someone else within the company his IP as to ‘how to invest’.

Seems pretty lazy and uncaring to me, if indeed, index funds really are SO bad.

(Roger, the index never goes broke, but companies can and do).

Graham Hand
April 24, 2015

Here's a curiosity. Race 3 at the Gold Coast on Saturday, horse number 1 is Index Linked. Also running is Perplexity. The race is called The Chairman's Handicap. I know how he feels. I'll report back on whether Index Linked wins (currently second favourite at $3.80).

April 24, 2015

Ahhh, the power of hindsight.

Gary M
April 24, 2015

That most active managers under perform index benchmark is not pithy marketing, it's a fact supported by data over many decades. In Australia, US and every other developed market. 75% of Australian active managers under-perform. What's pithy marketing is the elusive promise of beating the benchmark due to skill which is so badly lacking. And charging investors high fees in the meanwhile.

Rob Prugue
April 25, 2015

All poodles are dogs but not all dogs are poodles.

From 1960 through to 1980, the total real return on US equities was 0%. Total return. So given this is 4 business cycles, would you suggest that equity is a bad asset class?

If so, have a look at Lipper Data. U.S. Actively managed equity mutual funds, which Lipper publishes on net basis, delivered an avg annual return of just under 2%. Meaning the index was fourth quartile product.

David M
April 24, 2015

Roger puts together a compelling and logical argument, but I am yet to see the passive index approach to be creating the influence talked about in this article. We have all attended many a presentation and "stock story" rolled out by active managers. Yes - index investing does invest in bad companies, but it also invests in out of favour good companies, the company analysts got wrong. And active managers also invest in bad companies - or good companies at the wrong price. Sometimes they act with conviction too early, sometimes the pressure of research ratings or underperformance to benchmark aware portfolios create stress and influence decision making. Or plainly, the value they add once fees, performance fees and portfolio turnover are considered - fail to deliver real benefits to clients. For my clients, we do incorporate active investment managers for a portion of the funds - typically with concentrated and clear objectives which are not benchmark related. However, the Rafi style index approach offers a bit of both worlds which in my view - are worthy.


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