There has been debate over whether an active approach to managing assets, where fund managers try to purchase investments that perform better than the average or a passive approach to managing assets, where fund managers purchase all of the assets in an index is superior. I say that there has been debate because more and more evidence is piling up on the side of index investing being the superior approach.
A big difference between the two approaches is cost. An active fund is likely to be 2 to 4 times more expensive than an index fund. This is because an active fund has research costs, trades more often and incurs trading costs and generally needs more staff to support their approach. As an investor, if you are paying more than 2 to 4 times as much for an actively managed fund you want to know that the active fund manager adds value. But do they?
There has been a tremendous amount of research done that compares the investment returns from managed funds with the returns from index funds. The overwhelming reality is that, on average, managed funds do not outperform index funds. Lets look at some evidence.
Dr Rich Fortin and Dr Stuart Michelson, both finance professors, authored a paper in the September 2002 Journal of Financial Planning entitled 'Indexing Versus Active Mutual Fund Management'. (A mutual fund is another term for a managed fund). They found that, in both before tax and after tax terms:
Index funds outperformed managed funds for most share based categories and all fixed interest categories.
The share based categories where managed funds outperformed were small company funds and international funds.
In the summer 2000 edition of the Journal of Portfolio management, Arnott, Berkin and Ye wrote a paper entitled 'How Well Have Taxable Investors Been Served in the 1980's and 1990's?' Within the paper they state that 'There can be no question that indexing, for most categories of taxable investor and most market conditions will outperform conventional active (managed funds)'.
David Gallagher and Elvis Jarnecic, from the University of New South Wales, have authored two papers that look at the performance of Australian managed funds that invest in international assets and fixed interest assets. In the article 'The Performance of Active Australian Bond (fixed interest) Funds', published in the December 2002 Australian Journal of Management, they found that there was 'significant underperformance for retail bond funds after fees'. In the article 'International Equity Funds, Performance and Investor Flows: Australian Evidence', published in 2003 in the Journal of Multinational Financial Management it was found that 'active management (ie in managed funds) does not provide investors with superior returns to passive indices'. In reviewing the literature concerning managed funds Gallagher and Jarnecic found that 'the empirical evidence widely documents the inability of active fund managers to outperform market indices', with 'Australian research also supporting this international evidence'.
As well as drawing these conclusions, both of these papers provide an insight into one of the problems that active fund managers have. For both international funds and fixed interest funds it was found that the inflow of money into managed funds from new investments actually negatively impacted on performance. This makes sense, as investors are more likely to invest new money with a managed fund after it has performed well. However, this period of strong performance may well correlate with a peak in the value of a market. This means that the investment manager has to make more investments when markets have peaked, or has to retain the new money in cash investments until it can be invested in the market. Either approach is likely to drag on the overall performance of the fund.
Two economics professors from the University of Queensland, Michael Drew and Jon Stanford, examined the returns from superannuation investments. In a paper published in the September 2003 edition of the Service Industry Journal, entitled 'Returns from Investing in Australian Equity Superannuation Funds, 1991 - 1999', they found that 'the average superannuation fund, specialising in the management of domestic share portfolios, underperforms passive market indices by about 2.8 to 4% per annum. Their overall conclusion was 'Australian superannuation investors would achieve their retirement income objectives more rapidly by engaging a low cost fund manager employing a passive technique (ie indexing)..'. It is interesting to note that most of our superannuation assets are managed in active managed funds.
An advantage of index funds that is often not even considered in the literature is that they are generally more tax effective than actively managed funds. This is because buying and holding the assets that make up an index requires little trading, whereas active managers looking to acheive outperformance are often trading stock and having to pass on capital gains tax liabilities to investors.
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