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 Financial Happenings Blog 
Thursday, July 30 2009

Our firm's investment philosophy is based on an index appoach to investing.  We follow this approach because we believe you should get a better than average result from investing this way.

The theory goes like this, if you accumulate the returns for all investors before fees and costs, the average investor will receive the market or index return.  Some will do better and some will do worse.  Therefore if you implement a lower cost strategy than the average market you should expect to come out slightly above average.  For instance, if the average market return for a period was 10% and it cost you 1% to get that return your net result would be a 9% return.  If on the other hand the average market costs were 2% then the average investor should earn a net return of 8%.  By taking a lower cost approach, which using index funds would provide, you will be doing better than average.

Over time this effect compounds period over period so that over a number of years you should see a significant difference between the investor who has used a low cost index based approach compared to the avaerage investor who has utilised an active approach which has cost more to implement.

Theories are all well and good unless they are backed up by actual data.  Standard & Poors have recently published their latest scorecard comparing active funds to the index.  The latest report is for the period leading up to the 30th June 2009.  So what have they found?

  • Over a five year horizon, benchmarks have outperformed a majority of actively managed funds across equity and bond fund categories. Shorter horizon results are mixed.
  • The S&P/ASX 200 index has outperformed two-thirds of active Australian general equity funds over the last 5 years. Year-to-date, the S&P/ASX 200 has only outperformed about half of active funds.
  • The S&P/ASX Small Ordinaries index has out-performed just over half of the active Australian small-cap funds in the last five years. Year-to-date, the index has outperformed 60% of the actively managed small cap funds.
  • The UBS Composite 0+Y Bond Index has outperformed 97.22% of actively managed bond funds in the last five years. However, in first six months of 2009, the index has outperformed only 25.81% of actively managed bond funds.
  • Over a five year horizon, approximately 10% to 30% of funds have disappeared. This makes it important to consider survivorship in industry analysis.

This report is very interesting and provides some compelling evidence that an index based approach will outperform over the long run.  Some may comment that if an index only beats just over half active managers like it has in the past 12 months then this is not a great result.  The point is that an index approach should consistently do this year after year.  The active managers that beat the index each year will be different so that after a number of years you would expect the index approach to be ahead of well over 1/2 of the active managers.  S&P have found that over a 5 year period the index is ahead of more than 2 thirds of active managers.

I encourage you to take a look at the report.  It makes for interesting reading -

Scott Keefer

Posted by: Scott Keefer AT 06:35 pm   |  Permalink   |  Email
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