• Tax Efficiency
• Reduced Market Impact
• Research Costs
• Portfolio Asset Allocation Control
• Diversification
• Fees

As we saw in the early chapters of this book passive and index funds also have the important attribute of providing above average investment returns.  For this section of the book let's focus on the six points listed above, and consider these one at a time.

Tax Efficiency

Active management, regardless of whether it is done by a managed fund, stockbroker or an individual assumes that you are going to actively make investment decisions over time that will result in a higher than average portfolio performance.  These decisions mean that you will have to buy and sell investments. 

Each time you buy or sell an investment you have to pay capital gains tax, assuming that the investment has increased in value.  This applies even if you are an investor in a managed fund.  If the fund manager sells an investment at a profit you become liable to pay capital gains tax on this profit at the end of the financial year.

An interesting way to think about an unrealised capital gain that you have in an investment is that it is 'an interest free loan from the tax department'.  (An unrealised gain is where an investment has made a gain, however you have not yet sold the investment.  So the gain is described as 'unrealised'.)  As soon as you sell the investment you will have a tax obligation that will need to be paid.  However, if you never sell the investment then you will never have to pay that capital gain.

Therein lay the tax efficiency of passive investing.  If all the underlying investment manager is doing is tracking an index or subsection of the index, then there is little need for any trading.  Less trading means less realised capital gains, and more 'interest free loans from the tax department' in your underlying investment portfolio.

Using market figures from the Australian Stock Exchange website (www.asx.com.au), we calculated the total turnover for the Australian Stock Exchange in the 12 months to November 2005 as being 89.4% - great for the shareholders of the ASX who generate revenue every trade, but perhaps not so great for investors who have to pay tax on every profitable trade.   We actually find this level of share trading quite staggering.  A nearly 90% sharemarket turnover implies that every 13 or 14 months every single investment on the Australian stock exchange is traded.  Clearly index funds are not trading much at all, so the remaining market participants must have very high levels of trading in their portfolios.

Reduced Market Impact

A key problem with managing large sums of money in structures such as managed funds is that when a large fund manager wants to buy or sell an investment they end up moving the price of that investment against themselves.  For example, if a fund manager wanted to take a $40 million position in a listed company such as Leightons, their demand for shares would be pushing the price of the shares up as they bought in.  Similarly, when they decided to sell their stake in Leightons, their $40 million of shares would mean an oversupply of sellers and therefore push the price of the shares down.  This market impact effect sees the price of the shares increase as the fund manager buys and decrease as the fund manager sells, reducing the expected return from the investment.

Index funds have less of a problem in this regard.  Firstly, they are trading less than active market participants, so have fewer trades that can be affected by market impact.  Secondly they own all of the companies in an index, so they have their capital more evenly spread over all the investments in a market, rather than just the 30 or 40 that might be targeted by an active manager. 

Market impact costs, exacerbated by the high level of trading by fund managers, are largely avoided with index funds.

Research Costs

There are many levels of research services that offer advice to investors on which managed funds to invest in or which individual shares to buy.  These include services such as:

• Portfolio management services that manage direct share portfolios for investors
• Investment newsletters and stock picking sheets
• Services that help select managed funds
• Financial planners that help select managed funds for a commission payment

With index funds these services are no longer important.  An index fund is a simple 'commodity' that investors should feel confident choosing themselves based on the price of the fund.  All Australian share funds based on the ASX200 will be almost exactly the same, and investors should be confident simply choosing the cheapest fund.

Portfolio Asset Allocation Control

This book has presented significant evidence that asset allocation is the primary driver of portfolio performance.  Using index funds that mirror each asset class, and in the case of small companies and value companies passive funds that provide exposure to sub-asset classes, the focus can be taken away from the investment selection process and onto building a portfolio with an asset allocation that best suites each investor.

The adoption of index investment and passive investment is something that should empower individuals to be more closely involved in their own investment process.  The simplicity and effectiveness of indexing and passive investment means that investors are no longer compelled to pay high fees to the financial services industry for mediocre results.

Diversification

That indexing and passive investment allows a great deal of diversification is not hard to understand.  For example, an index fund based around the 200 largest stocks in the Australian share market will have 200 investments in its portfolio.  This minimises the impact that a fall in value of any one investment can have on your portfolio, the key advantage of diversification. 

Once you start to get into the world of active management it is almost a given that the portfolios formed will be less diversified than the underlying index.  However, active investment managers often choose to have well diversified portfolios.

Here is a fundamental problem for active management.  Let's call it the third paradox of active management.  The more diversified an investment portfolio becomes the more it will look like the underlying investment index, and the less it becomes able or likely to outperform the index.  The paradox is this: most active fund managers and investment managers exist because of their belief that they have 'skill' that can beat the relevant investment index; however they also believe in diversification as a risk management tool.  If active fund managers really believed in their skill at picking outperforming investments, surely they would only choose the best 10 - 15 investment ideas to hold in their portfolio!  If they have the ability to pick better performing investments, then why not just hold the very best of their ideas?  Why water these best ideas down with diversification?

Consider a large company fund invested from the top 200 companies in the Australian Stock Exchange.  Large investment managers are always touting the idea of 'diversification' as a way of managing risk and often hold portfolios that consist of the majority of the investments in an index.  Suddenly active management starts to look very much like very expensive index management, an issue addressed in a recent academic study.

Ross Miller, in his paper 'Measuring the True Cost of Active Management by Mutual Funds', sets out to identify how much the returns from mutual funds (US term for a managed funds), are a result of closet indexing and how much they are a result of active management unrelated to the index.  He then proportions a reasonable fee for the index fund management based on the Vanguard S&P 500 Index Fund (0.18%) to find out the true cost of the actively managed portion of the fund.  That is, he assumes that the indexing investment management cost 0.18% for the portion of the fund managed this way, with the remaining management cost being attributed to the actively managed portion of the fund.  The results are very interesting.  For the 152 'large company' mutual funds that formed the sample, on average only 15.55% of the total funds were actively managed.  (ie the other 84.45% effectively mirrored the index return).  The average management expense ratio (MER) for the actively managed portion of the funds was 6.99%.  On average more than 96% of the variance in the returns of the fund was explained by movements in the index.  On average the 'value added' by the active management was negative 9%.  This is an investment loss of 2% on top of the fees of 6.99% apportioned to the actively managed component of the fund, clearly demonstrating that in this sample active management destroyed value.

On an overall basis the 152 mutual funds underperformed the index by an average of 1.5%.

Fees

Earlier in the chapter we looked at the research costs borne by investors and the market impact costs of investing through an actively managed fund.  It stands to reason that any active investment process will incur  higher level of fees as the underlying investment manager is really selling you their expertise. 

This expertise might be 'sold' to you in the form of the fees paid on a managed fund, the fees paid for a portfolio management service or the fees paid to a financial planner.

These fees add up, and it is not uncommon to find people paying in excess of 2% of the value of their portfolio in fees.  In fact, most active managed funds charge fees of around 1.8% to 2% per year.

Somehow a 2% fee doesn't sound too expensive.  However, a $4,000 annual fee on a portfolio valued at $200,000 starts to add up very quickly. 

Assessing fees in the world of active management is difficult, because of the assumption that the fund manager, portfolio manager or research company that you have chosen will outperform the market anyway.  If they can do better than average, then why worry about fees?  Once the reality that they cannot outperform sinks in, then the level of fees that have been paid becomes a very sad lesson.

Whereas the average fees for a managed fund are 1.8% to 2%, the fees on an index fund start at around 0.7%.  This level of fee is still higher than in the United States, where fees start at around 0.18%, and it is hoped that over time as the Australian index fund market matures and becomes less expensive the level of fees charged will fall.

Lower fees in index and passive funds are a function of the lack of research needed to run index or passive funds.  Simply holding all the investments in a market, in the proportion that they exist in the market, requires little research, ongoing monitoring or advanced decision making.