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 What price index funds? - Eureka Report article 

July 30, 2008
What price index funds?
By Scott Francis

PORTFOLIO POINT: In a volatile market that is really tough for a stock picker to beat, index funds are a relatively tax-effective, low-cost investment option.



Do index funds still make sense? With the ASX down 2000 points from its peak of 6800 last November, a generation of index fund investors are about to realise - possibly for the first time - that index funds can offer falling returns.

Moreover, with a very mixed outlook in the year ahead, investors are asking whether it makes sense to buy an index when the feeling is that some companies are likely to see a fall in profits.

Index fund managers use your money to simply reproduce an index return (capital return and dividends) as closely as possible. With "low" fees and a simple investment proposal, the products have been very successful in recent years as the market seemed to rise effortlessly. From a standing start in the mid-1990s, it is estimated that 10% of retail investor funds may now be held by index products.

What's more, as returns from listed markets soften, the comparatively high fees paid by Australian investors for index funds will surely start to bite. What to do?

Indexing in the Australian environment

Perhaps the most disappointing aspect of locally available index funds is their relatively high costs. An investor in the US can access a S&P 500 index fund for $20 a year plus an ongoing fee of 0.15% on a $3000 minimum.

In Australia, at the market leader Vanguard, the Vanguard ASX 300 index fund costs 0.75% for the first $50,000, 0.5% for the amount between $50,000 and $100,000 and 0.35% above that.

Ironically, I used the US website of Vanguard to look at their fees, and the current advertising slogan is 'Investment costs count - the lower the costs, the more you keep'. Of course, even a retail fee of 0.75% is much less than the fees from average wholesale of retail managed funds in Australia which can be 1.5-2% on average.

There are many other higher-fee index funds. Here's a snapshot:

nHow index fund fees compare
Fund
Fee
USA based Vanguard S & P 500  Index Fund ($20 account keeping fee +)
0.15%
Australian Vanguard ASX300 Index Fund (balances up to $50,000)
0.75%
ANZ Investment Vanguard Australian Shares Index Fund (Nil Entry Fee)
1.99%
BT Wrap Essentials - State Street Australian Share Index
1.40%
Colonial First State - FC Inv - Indexed Australian Shares
1.10%
ING Integra - Vanguard Australian Shares Index
1.54%
MLS Master Key - InvSer/UT - MLC Vanguard Shares Index
1.28%
Source: Morningstar and Eureka Report


Perhaps it is not fair to expect Australian index funds to be as cheap as those in the US. In defence of the higher costs offered by local index funds, managers such as Jeremy Duffield, chief executive of Vanguard Australia, argues that the US is a much larger market with much greater efficiencies of scale (see Leading the Indexing Vanguard).

That's true but does it justify Australians paying five times as much as their US counterparts for exactly the same service?

I guess we can only hope that as indexing becomes more popular as an investment strategy, fees will fall - or perhaps a new, low-cost provider will enter the market?

ETFs - which are index funds listed on the stock exchange - are a recent addition to the indexing environment. These are offering index exposure with lower costs and, if international evidence is anything to go by, they are likely to become an increasingly popular investment in the Australian landscape.

It's difficult to diversify

It might sound as though the almost 2000 stocks listed on the ASX provide a vast field to choose from, but there is a high concentration of mining and resource companies. Banks and miners can easily dominate the index; BHP controls roughly 16% of the ASX 200. The issue becomes ever more worrisome as you enter more specialised index funds such as, say, REITs.

The ASX 200 Property index is dominated by Westfield. At the end of June, Westfield made up about 40% of the listed property index. Investors in the ASX 200 Property index are probably very relieved it was Centro that collapsed, not Westfield property trust.

At the moment BHP Billiton, Rio Tinto and Woodside make up nearly one quarter of the Australian index. For investors, particularly those nearing retirement, a question might be: how well do these low income-paying stocks meet my retirement needs?

The average yield of the market is about 4.5% at the moment, but these resource stocks have an average yield of about 2%, well below the 5% average of the rest of the market.

Of course, there is a counter argument to this as well. These resource stocks have been among the best performers in the market over the past 12 months, and the reason that they have such a prominent position in the index is that the collective wisdom of market participants is that these companies are the most valuable and therefore the biggest in the market, wisdom that sees index investors have a good exposure to their strong performance over the past 12 months.

Is it a time for stock pickers?

In the paper Prophets During Boom and Gloom Downunder, published in the Global Finance Journal in 2005 and written by Sarah Azzi and Ron Bird, from the University of Technology, Sydney, looked at the performance of analysts during the last market downturn (2000-02) and found that analyst market recommendations significantly underperformed the average market return during this period of time.

The evidence of woeful stock-picking by market professionals continues to accumulate. Look no further than a recent Eureka Report article by Madeleine Heffernan, which showed the appalling record of local stockbroker analysts to forecast this year's bank stock prices (see Bank prices? Who tipped that?). Many leading analysts were as much as 40% out in their assumptions made only nine months ago!

Alternatively, take a look at Sydney's Daily Telegraph, where a panel of stock pickers are underperforming the market since their picks seven months ago in an article entitled The Hot Stocks of 2008 (the price movement of the ASX 200 index since publication of the table on December 14, 2007, to July 11, 2008, was -23.29%).


nStock pickers see red

Craig James
CommSec

Rick Klusman
AEQUS Securities

Merrill Lynch 

Peter Switzer
Switzer Financial Services

Fat Prophets

Credit Suisse

Code Change Code Change Code Change Code Change Code Change Code Change
RIO  -7.51% BXB  -30.43% NWS  -37.09% WBC  -32.03% COK 41.27% TWR  -20.42%
GNC  -24.35% SNV  -52.63% BSL  15.61% BHP  -3.28% MUN -34.18% ILU  -1.81%
LEI  -26.42% REX  -48.02% AWC  -24.64% BNB  -72.72% IMA -57.98% RRT  -92.75%
HVN  -55.76% CCP  -82.40% MQG  -34.32% OXR  -40.79% CXC -46.84% ZFX  -37.86%
CSL  -3.57% SRA  -25.00% BBP  -70.91% DES  -81.48%    PEM  -76.69%
Average  -23.52%    -47.70%    -30.27%    -46.06% -24.43%    -45.91%
Out-performance over the ASX200  -0.24%    -24.41%    -6.98%    -22.77% -1.14%    -22.62%


It is also interesting to look at the reasoning behind the picks. Record Realty Trust (RRT) was chosen because of its "stable long-term cash flows from tenants"; Record has fallen more than 90%. Destra was chosen because the chief executive was "savvy" and understood "new media"; it has fallen 81%. Credit Corp (CCP) was chosen after a bad 2007 year for "its big hopes for a strong 2008-09; it is down 82%. And Babcock & Brown (BNB down 72%) was chosen as "a company whose many offshoot listed companies have been given strong thumbs up from expert analysts who understand the complexities of the niche industries they operate in".

The point here is not to highlight the inability of a range of market experts to "pick" stocks over a short period of time, but rather to support the argument behind index funds that because you simply can't pick the market, the best thing to do is to sit back and let the index do its work.

Conclusion

Although they are expensive by international standards, and although our market indices might be heavily tilted to banks and resources (or heavily overweight Westfield for our listed property index), and although it feels like a time when stock picking will surely beat the index, there is significant evidence that beating the market is really tough to do.

Index funds in the Australian environment remain a relatively low-cost, tax-effective and well-diversified tool within an investment portfolio.

Equally, the early evidence on Australian managed share funds does not suggest that they provide a way of beating the average market return . and they are tax-ineffective as well.

Perhaps, after looking at some of the weaknesses of index funds, it comes back to a slightly mangled version of a Winston Churchill quote: "Index funds are the worst form of investment strategy, expect for all those other forms."
Scott Francis' articles in the Eureka Report 

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