This article is an introduction to the concepts of index and active investing and how they differ. This will serve as a basis for future articles that explore these areas in greater detail and with more editorial leeway.
The debate between index investors and active investors has raged since the invention of the index fund itself. Why do different styles of investing create such impassioned criticism from both sides?
Let’s start with what they actually are, beginning with Active as this came first.
Active Investing
The word active in this context can also mean making decisions. An active investor or fund manager will constantly be making decisions when it comes to their investment.
At the extreme, this could be trading a set of stocks every single day. But for our purpose, we will be looking at the average active fund manager.
An active fund manager will undertake considerable research into their chosen area before making investment decisions. This could be something as broad as the entire Australian share market, from which they might select 30 individual stocks that will form the basis of their portfolio. A portfolio that is packaged up and distributed to clients via a managed fund or ETF structure.
These individual stocks are often chosen because the fund manager believes they are undervalued compared to the rest of the market or have strong growth potential for specific reasons. The idea is that these stocks should outperform others, generating higher returns for their clients, which in turn attracts more investors to their fund.
As the market evolves, the manager may adjust their portfolio based on their latest research to maintain performance and manage risks.
These investment decisions come at a cost. An active fund manager is primarily remunerated through an investment management fee, typically between 0.50% and 1.50% per annum. This fee is deducted from the portfolio before any returns are passed on to clients, making the fee structure a key consideration for anyone investing in an active fund.
There are many different styles of active management, each with its own approach to stock selection. Some of these styles include value, growth, contrarian, and growth at a reasonable price (GARP).
The underlying goal of most active managers is to outperform the benchmark index net of their fees. If an active manager consistently outperforms the benchmark after fees, it seems like a clear choice, right?
Index Investing
The word index in this context refers to a passive investment strategy that aims to mirror the performance of a specific market index. A passive investment strategy seeks to remove as much bias from the decision-making process as possible, relying on the market’s overall performance rather than attempting to predict individual stock movements.
An index investor or fund manager does not constantly make decisions about buying or selling investments. Instead, the goal is to replicate the holdings of the chosen index, which could mean buying and holding a wide array of stocks from that index.
For example, an index fund might track an Australian share market index, such as the ASX300. This would involve purchasing shares in the top 300 companies listed on the ASX in a market-cap-weighted manner. In a market-cap-weighted index, larger companies (with a higher total value of shares) make up a bigger portion of the index, while smaller companies represent a smaller portion.
This portfolio is then packaged and distributed to clients via a managed fund or ETF structure.
These stocks are included simply because they are part of the index, not because they are expected to outperform. The idea behind index investing is that, over time, the market as a whole will generate solid returns, and by tracking the index, the fund can deliver these returns to clients with minimal management costs.
Since the goal is to match the market, there is minimal need for ongoing adjustments, except when the index itself changes, such as when companies are added or removed.
Because there is little active management involved, index fund managers are remunerated through a much lower management fee compared to active funds, typically ranging between 0.05% and 0.30% per annum. This lower fee structure is a major advantage for index fund investors, as more of the portfolio’s returns are passed on to them.
The goal of index investing is to match the performance of the chosen index, minus the small management fee. While index funds won’t outperform the market, they provide a low-cost way to achieve market-average returns.
Which should I choose?
In most cases, investors choose an actively managed fund in hopes of achieving outperformance compared to an equivalent index fund. Other reasons can include greater control over investments, hedging risk, or aligning with specific investment philosophies. However, for now, we’ll focus on performance.
So, how many active funds consistently outperform? If they can’t generate better returns than an index fund, what’s their value for most investors?
Fortunately, comprehensive research already exists to help answer this question. SPIVA, a regularly updated report, compares actively managed funds against their benchmark index across many countries and markets.
The results speak for themselves:
The most important points are as follows:
Australian Shares
- 75% of active funds underperformed their benchmark in 2023.
- Over 15 years, this rose to 85% of funds underperforming.
International Shares
- 81% of active funds underperformed the benchmark in 2023.
- 94% underperformed over a 15-year time period.
So, I should just pick the ones that outperform?
It’s tempting to look at the historical outperformance of funds and use that as a basis for selecting an active fund. In fact, this approach is commonly used by financial advisers when constructing portfolios.
But does that mean you should just pick the few funds that outperformed? Fortunately, SPIVA has addressed this as well.
They state:
“196 out of a total 329 Australian Equity General funds outperformed the ASX 200 in calendar year 2021, and only 4 of those 196 winners—about 2%—managed to continue outperforming annually through December 2023.”
This means that, to pick a fund that consistently outperformed for just three years, you would have had to select 4 funds out of 329. As you can see, picking a consistent winner is extraordinarily difficult.
The challenge is that every one of these funds can present an equally compelling case for why their strategy will outperform. Many employ teams of PhD-qualified analysts to explain why their approach is the best. Yet, despite these resources, 98% of funds fail to outperform the index three years in a row.
This highlights the main issue with active investing: while outperformance can happen, it is incredibly rare for it to be consistent.
So just invest in index funds then?
Based on the data presented in this article, it might seem like index funds are the only obvious choice. After all, the majority of active funds seem to struggle to consistently outperform their benchmarks.
However, it’s important to note that this analysis focuses specifically on comparing general, large-cap broad active funds against benchmark index funds.
It doesn’t include other asset classes such as emerging markets, small-cap stocks, or bonds. In these areas, the dynamics can be different, and there may be more opportunities for active managers to add value. The potential utility for active managers in these areas will be covered in a future article.
That said, for many investors, index funds offer a low-cost, reliable way to achieve market-average returns without the uncertainty of trying to pick the small percentage of active funds that may outperform. As always, the right strategy depends on your personal financial goals, risk tolerance, and investment horizon.
