This article has been written by expert contributor, Duncan Burns, Chief Investment Officer Asia Pacific, Vanguard Australia.
From a standing start in 1998, index funds now account for $700 billion of assets under management in Australia. That’s mainly to do with cost and performance.
It’s now 25 years since the first retail index investment fund was launched in Australia.
Indexing didn’t grab a whole lot of attention back then, which is kind of hard to fathom given its prominence today and the improvements indexing has made to the investment outcomes for millions of Australian investors.
These days there are more than $700 billion of indexed assets under management in Australia. Index-tracking exchange traded funds (ETFs) and managed funds are used by many and collectively account for around 20% of investable Australian assets, according to financial data and research group Rainmaker.
Index funds and index ETFs, also known as passive funds, are managed pools of investments that simply attempt to follow the general performance of a market, rather than trying to outperform it, as so-called active funds attempt to do.
There are index funds and ETFs that invest in shares, and others that invest in bonds, both locally and globally.
Share index funds typically invest in a mix of companies that are representative of a specific market index.
For example, an ETF tracking the S&P/ASX 300 Index typically replicates the benchmark by holding all 300 stocks at or close to target weight.
A big advantage is that investors can inexpensively diversify their investments in one go, rather than trying to individually buy a number of different companies operating in different sectors of the market.
The other big advantage of index funds is their long-term track record.
Global index provider Standard & Poor’s regularly measures the performance of active funds against passive benchmarks. The results paint a strong case for index funds, because a high percentage of active managers underperform passive index benchmarks most of the time.
For example, the latest S&P Indices versus Active scorecard, or SPIVA as it’s known, showed 57.6% of actively managed large-cap Australian equity funds – that is, funds that invest in a selection of the largest Australian companies chosen by an investment team – underperformed the S&P/ASX 200 Index in 2022.
The SPIVA report found that underperformance rates over the longer term were even higher, with 81.2%, 78.2% and 83.6% of actively managed large-cap Australian equity funds underperforming the S&P/ASX 200 Index over the 5-, 10- and 15-year horizons, respectively.
Interestingly, costs are a key headwind diminishing the chances of successful outperformance.
All investors, be they active or passive, are subject to the costs of participating in the market. These costs include management fees, bid-ask spreads, administrative costs, commissions, market impact, and, where applicable, taxes. These costs can be high and reduce investor returns over time.
Importantly, the aggregate result of these costs creates a hurdle which must be overcome to beat the market averages. The higher the investment costs, the higher the odds of market underperformance.
This is not to say that active fund managers cannot outperform the broader market. A number of exceptional active managers do, but beating the market is harder than most people think. When investors go active, they are much more likely to be in the long-term majority of the distribution that underperforms than the smaller percentage that outperforms.
On the other hand, index fund managers have a much easier task of delivering the market return to investors and this they can reliably do at very low cost compared to active fund managers.
With it being so hard to consistently outperform, one can see why many investors have turned to a low-cost core-satellite investment strategy consisting of an efficient index fund core and intelligent active satellites as a starting point.
Those investors include Warren Buffet, one of the richest and most successful investors in the world, who has instructed the trustee in charge of his estate to invest 90% of his money into an S&P 500 index fund after he dies.
Some naysayers have described index investing as accepting mediocrity. But looking at the data and the cold hard facts, the truth is that for most of us gunning for average with index funds is much easier than trying to outshoot the market.
An iteration of this article appeared in The Australian Financial Review.
Duncan Burns is the Head of Investments and Head of Equity Index Group for Asia-Pacific at Vanguard Australia. He is also a member of the Australian executive team.
In these roles, Duncan leads Vanguard’s experienced team of investment management and strategy professionals in Australia and Asia. He also oversees the management of Vanguard’s Australian and global equity index portfolios and the firm’s trading operations in the Asia-Pacific region.
Duncan brings to the team more than 20 years of equity trading and investment management expertise, focusing on quant active investing, electronic trading, algorithmic strategies, market microstructure and transaction cost analysis.
The above material has been republished with the permission of Vanguard Investments Australia Ltd.