I started thinking more about this question myself after several investors I follow online switched to index funds over the past few years, citing lower fees, less work, and very acceptable returns.
Indeed, there seems to be a general trend at the moment greatly in favour of index funds. The passive index strategy is purportedly advantageous due to its relatively low management fees, greater tax efficiency and higher diversification across the asset class. Investing in a managed fund, however one must believe the fund will beat the market (ie. the average investor) over the long run due to superior timing, stock selection, asset allocation or hedging, despite (usually) higher management fees and lower diversification.
The most common arguments in favour of index funds are that
i) most actively managed funds underperform the market over 5-10 year periods and
ii) index funds provide a market average return for lower fees (around 0.5% pa vs 1.5% pa) compared to active funds.
Indeed, in an interview during 1976, Benjamin Graham asserted “[Investors] should require approximately [at least market equalling] results over, say, a moving five-year average period as a condition for paying standard management fees to advisors” and in the Intelligent Investor states he can see “no reason why [investors] should be content with results inferior to those of an indexed fund or pay standard fees for such inferior results”.
While many authors argue for index over active investment funds, few provide identifiable statistical data to back up their assertions. This led me to do a bit of research, the best of which can be found online (for free) via Standard & Poor’s SPIVA Scorecards.
I downloaded the latest (June 2015) scorecards for U.S., Canadian, European and Australian actively managed funds vs their respective indices to examine the data for myself, a summary of which is below. The strength of the results were somewhat surprising!
Full results for US equity funds are in Table 1 below. The key figures, I believe are that over a 10 year time horizon, the majority of actively managed small (80%), mid (87%) and large (80%) cap funds underperformed their benchmarks. In general, 75% of domestic US equity funds underperformed their benchmark over a 10 year period. Results were similar for 5 year time horizons.
Table 1. Percentage of US Equity funds Outperformed by Benchmarks
The authors summarised
“It is commonly believed that active management works best in inefficient markets, such as small-cap or emerging markets. This argument is disputed by the findings of this SPIVA report. The majority of small-cap active managers consistently underperformed the benchmark in both the 10-year period and each rolling five-year period since 2002.”
Full results for Canadian funds appear in Table 2 below (note this includes US and international equities selected by Canadian funds and that the table illustrates outperformance of actively managed funds, not underperformance as in all other Tables provided by S&P). Over a 5 year time horizon, 77% of active Canadian equity funds underperformed their benchmark. Active funds seeking Global and US exposure faired even worse, underperforming their index in 90% of cases. The only class in which active funds came close to being competitive with the indices were the Small-Mid Caps, in which only 57% of active funds underperformed.
Table 2. Percentage of Canadian Equity funds Outperforming Benchmarks
These results were described by S&P as “unequivocal” evidence that domestic equity funds underperform over the long term.
Table 3 shows full results for European equity funds over one, three, five and 10 year periods. These indicate index funds were superior in well over 80% of cases for EUR denominated funds and between 69-89% of cases for GBP denominated funds.
Table 3. Percentage of European Equity funds Outperformed by Benchmarks
You’ll notice that over the shorter-term (one to three years) UK mid and large but not small cap funds tended to outperform the index however this effect diminished at five to 10 years (lower half of Table 3).
You’d be forgiven for asking why I bother putting in Australian funds into this post. The Australian publicly traded equity market is the 8th largest in the world yet represents only 3% of publicly traded equities by market capitalisation (being home turf, I have a soft spot for her!). Full results for Australian equity and bond funds are provided in Table 4.
Table 4. Percentage of Australian Equity funds Outperformed by Benchmarks
Similar to American, European and Canadian equity funds, over the longer term (five years) actively managed Australian funds underperformed the index investing domestically (in 71% of cases) and abroad (90% of cases). Australian small and mid cap funds however, were out-performed by the market index in just 29% of cases which is an interesting potential trend. That is, 71% of Aussie small and cap funds outperformed the index over 5 years. The associated S&P report provided no explanation, so your guess is as good as mine, but I suspect the number of analysts covering Australian small-mid cap companies is quite small, allowing for under-valued companies to be picked up somewhat more readily by an astute investment manager.
A note on Survivorship Bias.
S&P stated that “Many funds might be liquidated or merged during a period of study. However, for someone making an investment decision at the beginning of the period, these funds are part of the opportunity set. Unlike other commonly available comparison reports, SPIVA Scorecards account for the entire opportunity set—not just the survivors—thereby eliminating survivorship bias.”
Survivorship of funds can affect general industry perceptions; the best funds continue to exist and the under-performing funds are liquidated or merged. It’s interesting to examine these figures because they might point toward the success of active funds generally – the lower the survivorship rate, the poorer the overall performance. This is just my opinion, however it’s reflected in the Australian figures above, with small cap funds having a survivorship rate of almost 84% over five years compared to 75.11% survivorship rate for Australian general International Equity Funds over the same time frame. Similar results for Canadian Funds over 5 years were reported (58% for domestic Canadian equities). Remarkably, whilst approx. 75% of US Funds over a 5 year time horizon remained, only 55% remained after 10 years, indicating a high long term liquidation/merger rate (results are similar for European Funds). A summary of comparable survivorship rates over 5 years is shown in Table 5 below.
|Survivorship rate over 5 year period|
The evidence clearly points in favour of index funds over 5 to 10 year periods except in isolated cases (e.g. Australian domestic small to mid Cap funds or UK domestic mid and large cap funds) which exceptions may evaporate over time. This was surprising for me as to date, I’ve used managed funds fairly often, and currently invest in one (with a large dose of luck, it’s an Australian domestic small companies fund which has outperformed the index by 9.73% after fees over 10 years). This is not to say the DIY investor cannot achieve superior returns compared to the market over the long term (although the average DIY investor is by definition only expected to achieve a market return, since the average investor is the market!). Like many value investors, I believe that a portfolio of approx. 20-30 strong businesses with attractive ROE, ROIC, low debt and strong cash flow purchased at a significant margin of safety to a reasonable estimate of their intrinsic value will do suitably well over the long term. The issue is, finding the latter requires significant time, effort and discipline whilst index investing is a much simpler affair!
Are you in favour of passive index investing or actively managed investments? Or do you prefer to invest directly yourself?
Disclaimer: This post is for informational purposes only. Please seek personal and professional financial advice before buying or selling any financial product.