Active versus Index-Based Investing: which is better?

For as long as investing has existed in its modern form, there’s been an ongoing debate about what is the best investment philosophy. While there’s passionate opinions on each side of the fence, we think the obvious way to decide is to look at the data. Thankfully, there are studies that have looked at the results of more than 2,000 funds and compared these to historical outcomes. In this post, we’ll look at the evidence of both Active and Index-Based Investing, and share why we’re confident in our approach.

Active and Index-based Approaches to Investing

Professional investors can be divided into two broad camps, “active” and “index-based” investing.

Active investors believe it is possible to consistently ‘beat the market’, generating investment returns greater than the market through some combination of superior insight, analytical skill or ability to forecast the future. These investors actively research, select and buy (or hold) investments they believe to be “undervalued” relative to their assessment of what the “fair” market price should be, and conversely sell investments believed to be “overvalued”. In so doing, they hope to outperform an index that most closely matches their portfolio.

Index-based investors believe that modern financial markets are too efficient at incorporating new information into the market price of investments for any investor to consistently outperform the most appropriately matching index, particularly after the costs of active management are taken into account. Investors who adhere to an index-based approach believe that by constructing portfolios that closely match an index, then buying and holding investments and thereafter minimising trading activity and portfolio turnover, they will out-perform those investors who adopt an active approach.

What Does the Evidence Say?

The active versus index-based investment approaches have been the subject of heated debate since investment performance started being compared to index performance almost fifty years ago. One of the earliest studies[i], published in 1968, looked at the performance of 115 professionally managed funds during a ten year period from 1955 to 1964, and calculated the likelihood that any outperformance relative to an index was due to manager skill (for which the term “alpha” was introduced) or merely to chance.

What did the study find? Far from observing manager skill (positive alpha) the researcher, Michael Jensen, found that the average alpha was negative, and that “on average the funds earned about 1.1% less per year…than they should have earned given their level of …. risk”.

Further studies over the decades have confirmed Jensen’s broad findings that active investment management, on average, does not generate returns matching an indexed-based buy-and-hold strategy. Somewhat more troubling, there is evidence that it is becoming progressively harder to consistently beat the market.

A 2009 study[ii] that analysed the performance of over 2,000 US active managed funds between 1975 and 2006 found that only 0.6% of funds exhibited some level of skill, a figure that the researchers noted was statistically indistinguishable from zero. Somewhat to their surprise they found that had the data been confined to funds operating only up to 1990 and no further, some 14% of the managers studied would have exhibited genuine skill.

Is the same true in Australia?

In Australia the most comprehensive source of data on active versus index-based investing is to be found in the SPIVA® (S&P Dow Jones Indices Versus Active) Australia Scorecard, developed and maintained by global index provider S&P Dow Jones Indices.

The SPIVA® Australia Scorecard currently tracks some 600 Australian share funds, as well as some 290 international share funds and 66 Australian bond funds, reporting on the after-fee performance of these funds against appropriate indices over one, three and five year investment horizons.

The results below are from the current SPIVA® Australia Scorecard, and show how many active funds managed to beat the most relevant index over the five years to 30 June 2016.

Source: SPIVA® Australia Mid-Year 2016 Scorecard

The SPIVA® data broadly confirm what’s been identified elsewhere; that the average Australian active managed fund has failed to outperform the index it aims to beat over the five years to 30 June 2016.

Fewer than a third of active share funds benchmarked against the S&P/ASX 200 index outperformed it. Thus investors in almost 70% of large active Australian share funds could have done better simply by adopting an index-based approach rather than investing in funds trying to beat the market.

The Impact of Fund Manager Fees on Investor Returns

One reason the majority of active funds struggle to “beat the market” is because the cost of active investing is a significant headwind to net-of-fee outperformance. And from an end investor’s perspective, it’s only after-fee returns that matter.

The 2009 study mentioned earlier provides a hint as to why active managers struggle to outperform index-based strategies. It found that on a pre-fee basis some 9.6% of the fund managers studied exhibited genuine skill. But once fees were taken into account the results plummeted to near zero. So in effect a small minority of fund managers were beating the market, but retaining all the outperformance for themselves, rather than delivering those gains to investors who bore the risks. That hardly seems fair, does it?

Why Does Clover Adopt an Indexed-based Investment Approach?

At Clover we’re all about improving investor outcomes, driven by an evidence-based approach to investment. And the evidence points pretty conclusively in one direction; if you’re an individual investor trying to beat the market, you’re likely to get beaten by the cost of doing so, and by the investor who’s using an index-based investment strategy.

When the active versus indexed-based investing debate gets raised, those who believe it is possible to consistently beat the market invariably raise billionaire investment guru Warren Buffett as living proof it can be done. The “Oracle of Omaha” does indeed have a track record that would be the envy of any active share manager, building a A$500 billion-plus empire through his company Berkshire Hathaway, with his own wealth now estimated at more than A$95 billion by Forbes magazine.

Warren Buffett is in many ways the exception that proves the rule; from the tens of thousands of equally talented, hard-working and diligent professional investors who have tried, and failed, to beat the market over the past half century, the fact that there is only one Buffett is testament to how truly unlikely it is to outguess the collective wisdom of the markets over an extended period of time.

Let’s face it, as much as we’d all like to think otherwise, we’re just not like Buffett, for a host of reasons that I wrote about some years ago.

And where does the world’s greatest investor stand on the active versus index-based investing debate? Well, according to Buffett:

“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”

Fair enough.

Our Approach to Investing

We at Clover think five decades of incontrovertible evidence that active investing isn’t able to produce consistent benchmark-beating performance suggests investors would generate more wealth over time by adopting an index-based investment strategy. This philosophy is at the core of how we create our investment portfolios, using Exchange Traded Funds (ETFs) to harvest index-based returns in an efficient, low-cost manner.

Of course, there’s more to creating a well-diversified portfolio than just throwing a few ETFs together and hoping for the best. Our expertise in selecting the right blend of ETFs across different investment types aims to provide you with an appropriately diversified investment portfolio based on your financial objectives, investment time horizon and ability to commit to the portfolio strategy.

So there you have it. Why do we favour index-based investments over active investing? Because our aim is to provide the best outcomes for our clients, not for the funds management industry. And the best way to make that happen is to ignore those professing an ability to beat the market when the weight of evidence suggests otherwise.

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Sources

[i] Jensen, Michael — ‘The Performance of Mutual Funds in the Period 1945–1964’ The Journal of Finance, Vol 23, Issue 2, May 1968

[ii] Barras, L; Scaillet, O; Wermers, R — ‘False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas’ Université de Genènve working paper, April 2009

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