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The numbers tell the story for index investing

With the strong growth in index funds and exchange traded funds (ETFs) in the Australian marketplace in recent years, debate is again swirling on the benefits of active versus passive investment management. Some commentators have suggested that index-oriented investments are merely for ‘dumb’ investors, who have no real skills in picking mispriced securities likely to outperform the market. If this were true, it would follow that these investors are leaving money on the table. By either investing in the development of these skills – or hiring talented active managers – they could produce better returns. It has been suggested that over the very long run, ‘sensible investing’ in ‘quality’ stocks will beat an index. How true is this?

DBa Figue1 150515

DBa Figue1 150515

The evidence suggests most active managers don’t outperform the index

Fortunately for participants in the ongoing active v passive debate, whether active managers outperform a market-cap weighted index is ultimately an empirical question. The evidence seems overwhelmingly in favour of passive investment, both in Australia and overseas. According to the latest SPIVA Australia Scorecard by S&P Dow Jones Indices, charted above, about 78% of active Australian general equity managers underperformed the S&P/ASX 200 Index over the five years ending December 2014. The performance of local international equity managers, Australian fixed-income managers, and listed property managers was somewhat worse. Over the latest three year period, the scorecard was slightly better for Australian equities active managers, although 6 in 10 managers still underperformed.

Even if active managers were able to consistently outperform the market, moreover, their degree of outperformance would need to exceed their management fees to beat some of the low cost ETFs and index funds available. As an example, a fund that charged a 1% p.a. management fee plus a 10% outperformance fee (charged before deduction of fees) would need to generate a return of 10.95% p.a. to offer the same return to an investor in an index product that rose by 10% in the year and charged a management fee of 0.15% p.a.

Active outperformance is unlikely to persist

Of course, the above evidence suggests that some active managers can outperform the market. The challenge investors face, therefore, is in identifying these superior managers. Picking active managers that consistently outperform is not easy. As the old truism goes, past performance is not a great indicator of future performance.

The chart below, for example, is based on research on Australian active equity managers from Mercer Consulting which tracked the performance of investment managers across two three-year investment periods. How many of the funds that performed well in the first period also performed well in the second period? In other words, how persistent was outperformance?

Only 24% of the 29 funds identified by Mercer as enjoying top quartile investment performance in the three years to September 2010 were also able to produce top quartile performance in the three years to September 2013. In fact, statistically speaking, the most likely scenario (31%) is for a top quartile performer in the first period to end up becoming a fourth quartile performer in the second period. Meanwhile, almost one in five of these top performing funds ceased operation (or were merged/taken over) in the second three-year investment period.

DBa Figue2 150515Indeed, according to the Mercer Survey, of the 32 funds with top quartile performance in the three years to September 2013 (among 126 funds covered), 16 – or 50% – of these funds were new to the market.

DBa Figue3 150515Active managers dominate the market so it’s hard to outperform

Due to the fact that institutional money – which is still predominantly active in nature – tends to dominate ownership and therefore trading in the Australian equity market, not all managers can outperform the market all of the time. This is because for every ‘winning’ trade, there will equally be a ‘loser’ on the other side. As seen in the chart below, of the $1.6 trillion worth of ‘listed and other’ equities in Australia as at end December 2014, a whopping $1.4 trillion – or 83% – was owned either by domestic institutional investors, or foreign owners (which are also largely institutional). Households directly owned only around $200 billion, or 13%. The collective attempt of active managers to beat the market is akin to a zero-sum game.

DBa Figue4 150515There is more to indexes than tracking cap weights

Due to the development and continued innovation in indexation, there are now a number of indices which recognise the limitations of traditional cap weighted indices, including some offered in Australia by BetaShares. These ‘smart beta’ indices, such as fundamental weighted indices, combine the benefits of index funds (i.e. low cost, transparent, diversified, rules based) along with the potential to outperform the market cap benchmark.

We’re a long way from passive investment distorting the market

There has been some conjecture that the continued growth of index investing and ETFs may contribute to potential market distortions. We are a long way away from that. According to Morningstar Research estimates, passive investment strategies account for around 8% of Australian managed funds. At these levels it’s unlikely rebalances in such products will be a major influence on market pricing. With only about $18 billion funds under management, Exchange Traded Products account for only about 0.7% of the $2.4 trillion managed funds industry as at March 2015.

Even in the United States – where passive investment is estimated to account for a much larger 24% of funds under management in 2013 – it still seems evident that active managers have a hard time beating the market. According to S&P’s latest survey, for example, 88% of large-cap US managers failed to beat the S&P 500 index in the five years to the end of 2014.

There is no doubt that there do exist a select number of active managers who have a strong track record of persistent outperformance. We firmly believe that active management has a role to play in investors’ portfolios, and often find ourselves discussing how ETFs can be used in combination with high quality active managers. However, when considering the active versus passive debate, we believe it’s important to be armed with the empirical facts.


David Bassanese is Chief Economist at BetaShares, a leading provider of Exchange Traded Products on the ASX. This article is general information and does not address the personal needs of any individual. This article was originally published on the BetaShares blog. 

SMSF Trustee
May 17, 2015

Yes, it all assumes there is such a thing as 'alpha' and 'beta' and that either matter to the ordinary investor. All I really care about is achieving the investment objectives I've set for my portfolio. Given that I invest in about 20 different funds plus some direct holdings across several asset classes, there's a place for both 'active' and 'passive' in my portfolio. It's not one or the other, but the appropriate combination that matters.

And my combination is going to be very different to yours, or the guy next door's. As the crowd in Life of Brian said, 'yes, we're all individuals'.

Jonathan Hoyle
May 17, 2015


Great article. The S&P data makes the case for active management look pretty dismal. However, the data set only goes back five years, during which we have experienced a roaring bull market in all the above asset classes.

To Jerome's third point, is there any data that proves managers fare better in more turbulent times? Or is this more wishful thinking?

Gavin Rogers
May 15, 2015

While David is correct that the impact from index investing on the overall market is insignificant at present, what is not acknowledged by proponents of indexing investing is that the only reason an index approach (or at least a pure index approach) generates any returns for the investor - positive or negative (ignoring dividends) - is due to the activities of active investors.

By this I mean that if 100% of investors who choose to invest into say the ASX200 used a passive investment vehicle (whether for example an ETF or an index fund), then the return of the ASX200 index would be 0% for any time period. Given the index is based on market capitalisation, and capitalisation is essentially number of issued shares x the share price, then there is no reason for the share price for any individual company to change from day to day because no investor can bid or offer a price in that company's shares that is different from the "last" price, otherwise they are making an active investment decision.

Further, it doesn't matter what information about a particular company becomes available (eg, record profit result, or massive asset write-downs), a passive investor cannot do anything about this information. He/she has to passively stand by!

May 15, 2015

This debate on active versus passive seems so pointless. You can argue there is no such thing as passive as the index is an active construct. So called smart beta is simply quant active. Of course there is good reason to use the index at times - when style bias is weak, when dispersion is low, for tactical measures or to fill a gap.

Assuming one does not want to support index hugging managers, one should expect relatively significant variation against the index in the short to medium term but then expect longer term outperformance. If the manager can make a convincing case for their approach and sticks to it, most investors are comfortable with that active approach and prepared to pay a reasonable fee. Many don't offer value or have fee structures that are heavily skewed in the manager's interest; it is up to the investor to avoid those.

Jerome Lander
May 15, 2015

As always the devil is in the detail. Three basic points readers should understand:
(1) Is the manager genuinely active? Most managers who are called active are in fact just expensive passive like strategies. It is these managers which dominate the data-sets used for empirical analysis. Empirical analysis of this adds little to an understanding of what is being studied in the first place.
(2) Who on earth would want to invest in the "average" active manager? (or have the prospects of an "average" graduate in an oversupplied market for that matter?) The whole point of investing actively is to invest with the best (requiring qualitative analysis) and to understand the conditions under which they will succeed. Sure, not everyone can do it or be bothered using help so they can.
(3) Index investing is in fact a suboptimal momentum strategy and tends to work well in a raging bull market and then get dusted. Naively owning a significant portfolio of your portfolio in Australian banks (let us just overly simplify this and say it is simply leveraged residential mortgages) plus an Australian house is hardly a diversified portfolio. Index investing in Australia would have you do this. If houses go up the portfolio will do well (isn't that what HAS happened?). if house prices get smoked, the opposite occurs. There are better ways of building portfolios, either with active managers or simply in a more diversified and sensible way.

May 15, 2015

If the majority of active managers perform worse than the market and passive managers by definition match the market, who is beating the market?

Is it a small number of active managers outperforming the market by a large margin, half of which are, according to the graph are ‘new’. Or is it private investors acting on their own behalf?

Either way suggests there are a lot of ‘old’ active managers with limited talent making a nice living at the expense of their clients.

May 15, 2015

The majority of active managers perform worse than the market AFTER fees. It is likely the majority of active mangers outperform their index BEFORE their fees. After all taxes (realised CGT due to high turnover), fees, buy/sell spreads and other costs it is likely even more active managers underperform than demonstrated by the results in the article.

May 15, 2015

One legitimate concern for a retail investor considering an index investing strategy in the ASX 200 is the level of exposure it provides to the mining and financial services sectors.

However I don't know if this concern is supported in terms of the historical data. If you took time periods of say 10, 20,30, 40 and 50 years which are reasonable for an index investing strategy to pull ahead and looked at an investment in only the mining and financial services sectors what the historical returns would look like.

I am curious whether these sectors in the long term are actually the drivers of the ASX returns or whether it pays to be cautious in terms of timing (timing is supposedly an anthema to index investors but I am not sold on completely blind investing).

Unfortunately index investing in Australia, at least for the retail investor, is currently in its infancy and the data to make informed decisions is not easy to get hold of.


May 16, 2015

I note that as usual the analysis compares sector specific Index Funds v sector specific Active Funds. However, as an adviser, I am really interested in "whole portfolio" returns. As such an analysis of diversified Index Funds (eg Vanguard Growth Index Fund) versus similar diversified Active Funds is more important.

For example, the Vanguard Growth Index Fund (30% Defensive / 70% Growth) returned 18.83%, 15.93%, 10.95% and 8.32% compounded over 1, 3, 5 and 10 years respectively. The best Balanced Stable Fund (55% - 75% Growth) as measured by Selecting Super returned 16.4%, 15.0%, 9.7% and 8.2%.

Of course, this is only a point in time and recent strong performance by the diversified Index Funds would be impacting longer term results. However, it is interesting and food for thought.


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