The case for indexing
A passive investment strategy seeks to track the performance of an index by mimicking its holdings. Primarily because of their low-cost structure, well-managed index investments, such as an index-based mutual funds and ETFs, have generally outperformed higher-cost investments over the long term. When investors index a solid portion of their portfolios, they often benefit from lower costs, broader diversification and minimal cash drag. These elements can translate to a long-term performance edge.
Understanding the zero-sum game
As a group, market participants are playing a zero-sum game. That is, half of investor assets outperform and the other half underperform the market average. The bell curve in Figure 1 illustrates this, with the market return shown as a dotted line. In reality, however, investors pay commissions, management fees, bid-ask spreads, administrative costs and, where applicable, taxes, all of which combine to reduce realised returns over time. These costs shift the curve to the left. A portion of the after-cost asset-weighted performance continues to lie to the right of the market return, represented by the tan region in Figure 1. But a much larger portion is now to the left of the dotted line, meaning that, after costs, most of the asset-weighted performance falls short of the aggregate market return. Given the difficulty of selecting an active manager who consistently outperforms the market, we believe many investors are better off using a passive approach, minimising costs so that, over time, they can achieve a return close to the market average.
The zero-sum principle holds regardless of a market’s efficiency. Even in areas traditionally considered inefficient, such as emerging or small-capitalisation markets, our research has shown that most active managers fail to outperform their corresponding benchmarks.
Figure 1: Investing is a zero-sum game
Half of all invested assets will outperform the market return before costs (blue curve). After costs (brown curve), a much smaller portion outperforms the market return (tan).
The indexing cost advantage
The role of costs is so critical to investment success that it merits a closer look. The return from a mutual fund or ETF reflects the returns of its underlying holdings less transaction costs and expenses charged by the fund.
Most investors best chance at maximising net returns over the long term lies in minimising costs. Compared with index funds and ETFs, active funds typically have higher expense ratios. In most markets, low-cost index funds have a significant cost advantage over actively managed funds. As a result, we believe that most investors are best served by investing in low-cost index funds over their higher-priced, actively managed counterparts.
In addition to the expense ratio, there are many other fees investors should be aware of. Turnover, or the trading within a fund, results in transaction costs including commissions, bid-ask spreads, market impact1 and opportunity cost. These costs are incurred by every fund and detract from net returns, but they are difficult to measure. Active funds often have higher transaction costs, due to the generally higher turnover associated with active management’s attempt to outperform the market.
1 In this context, market impact refers to the effect of a market participant’s actions – that is, buying or selling – on a stock’s price.
Active managers frequently underperform
Even before accounting for merged or closed funds, actively managed equity funds, on average, have fared poorly versus their benchmarks over the past decade.
Figure 2 compares the performance of actively managed funds in various fund styles to the performance of an appropriate style benchmark. For the ten-year period ending 31 December 2016, the relative underperformance of actively managed funds versus their style benchmarks has been consistent across and within asset classes. Comparisons over three- and five-year periods yield similar results.
Figure 2: Performance of active funds outperforming the average return of index funds
Notes: Data cover the ten years ended 31 December 2016. The actively managed funds are those listed in the respective Morningstar categories.
Sources: Vanguard calculations, using data and fund classifications from Morningstar, Inc.
Consistently picking winning managers is difficult
Even for managers who outperform the market in a given year, success can be fleeting. Figure 3 shows the relationship between the past and future performance of top-quintile actively managed funds, as measured over two discrete five-year periods. If managers were able to provide consistently high performance, we would expect to see the majority of first-quintile funds remaining in the first quintile. However, Figure 3 shows that a majority of managers fail to remain in the first quintile.
The essentially random nature of active returns over time helps to explain why investors who change managers in search of market outperformance are often disappointed.
Figure 3: The relationship between past and future performance is nearly random
Notes: Figures may not add up to 100% due to rounding. Actively managed funds were divided into quintiles based on their excess returns relative to their stated benchmarks during the five-year period ending 31 December 2012. These funds were then followed in the subsequent five-year period ending 31 December 2017 to determine their relative performance.
Source: Vanguard analysis, based on data from Morningstar, Inc.
Other benefits of indexing
In addition to the potential performance edge that indexing offers relative to higher cost investments, index funds and ETFs have other traits that make them appealing to investors.
Diversification. Index funds and ETFs typically are more diversified than actively managed funds. Except for index funds that track narrow market segments, most index funds must hold a broad range of securities to accurately track their target benchmarks. The broad range of securities lessens the risk associated with specific securities and removes a component of return volatility.
Style consistency. An investor who desires exposure to a particular market and selects an index fund that tracks that market is assured of a consistent allocation. An active manager may have a broader mandate, causing the fund to be a moving target from a style point of view. Even if a manager has a well-defined mandate, the decision to hold a larger or smaller proportion of a security than the index holds will lead to performance differences.
Transparency. Because they are designed to track and hold the same securities as an index (or a representative sample), index funds and ETFs are transparent and easy to understand.
Combining indexing with active management
Investors who seek market outperformance, but without the potentially higher costs and risks of an all-active portfolio, may benefit from a combination active-passive approach.
One such approach is a “core-satellite” strategy that employs indexing at the core of a portfolio and actively managed funds as satellites. The indexed core provides a risk-controlled, low-cost way to capture market returns (beta), while the actively managed satellites provide an opportunity for market outperformance (alpha).