Investment: Another word on index funds

I WAS beginning to think that there was soon going to be nothing more to be said on the subject of active versus passive investment funds. From all the millions of words written on the merits of index tracking funds, it is clear to me that the argument is effectively over. Index funds have earned their place at the investment table on the strength of clear and overwhelming evidence.

They are not the answer to every investor's prayer, nor are they the most appropriate solution in every market. The more inefficient a market, or market sector, the more scope for achieving outperformance with an actively managed fund (which is one reason why more Japanese and emerging market funds outperform the relevant indices than do UK or US equity funds).

But what is now beyond dispute is that for most people low-cost index funds are the most reliable and cost-effective way of building a core holding of equities in an investment portfolio. It is perfectly legitimate to add an element of actively managed money to add spice to this core holding, but anyone who puts all his faith in active management hoping to achieve sustained above-average performance is paying a high price for a proposition that is the equivalent of backing a rank outsider in the Grand National. In racing, bookies get rich at the expense of those who pursue impossible dreams at high odds: in investment, fund managers and those who sell their funds make money at your expense.

Of course, index funds cannot provide an answer to every issue you face as an investor. They won't address the central issue of how much you should be investing in the stock market in the first place. They are merely tools for delivering an objective that ultimately can be determined only by your own circum- stances and risk preferences. Most actively managed funds by definition do not provide bespoke solutions. They are off-the- peg merchants who should be judged accordingly, on fit, style and cost. To pay an active manager's fee for delivering a performance worse than that of a low-cost indexed alternative is simply throwing money away (just as by the same token anyone who pays a bid/offer spread, or an annual management fee of more than 1 per cent, for an index fund is doing the same).

Yet it is not entirely the case that everything worth saying has now been said on the subject of indexing versus active management. Reading a new book on investment by Dean LeBaron and Romesh Vaitlingem (The Ultimate Investor, Capstone Publishing), I was struck by an interesting comment from Bill Miller, a professional investor in the US. He advocates active management and thinks part of the reason why active managers have such a bad name is that they failed to cope with the intellectual challenge posed by the success of indexing, refusing to learn from the success of the index fund phenomenon.

He points out that investors who buy a mainstream equity index fund are not pursuing as dumb or mindless a strategy as might first appear. Being an American, he uses the example of the S&P 500 index, but the same arguments apply to anyone who buys a Footsie or FTSE All-Share index fund. Mr Miller's says the S&P 500 index is itself an actively managed fund - its constituents constantly changing on the basis of guidelines laid down by the index selection committee.

"The S&P 500 index" says Mr Miller "is a long-term-oriented, low- turnover, tax-efficient portfolio employing a buy-and-hold investment strategy. It lets its winners run and selectively eliminates losers. It never sells a successful investment no matter how far up the stock has run, and does not arbitrarily impose size or position limits on holdings, by company or industry. Size is fixed at 500 names. New names are added and others eliminated, replacing marginal companies with those whose position in the economy or an industry are deemed more important."

The overall portfolio, Mr Miller goes on, is positioned to represent the broad sweep of the US economy. Turnover of stocks in the index has recently risen to around 40 names a year, but this remains less than 10 per cent of the total, in stark contrast to the feverish activity normally associated with actively managed funds - many of them turn over their portfolios once every one to two years.

Mr Miller says: "The average mutual fund is short- term-oriented, has high turnover, is tax-inefficient and employs a trading-oriented investment style. Most funds systematically cut back winners or rotate out of stocks that have done well into those expected to do better. The overall portfolio is constructed in accordance with some style the manager erroneously believes is likely to outperform the long-term low-turnover approach of the S&P 500."

And what are the roots of this failure? Part of the answer, Mr Miller suggests, lies in the much abused academic notion of market efficiency - the idea that share prices accurately reflect the current state of knowledge about a company's current prospects. "Much of the activity that makes active portfolio management active is wasted; it adds no value since it is engendered by the mistaken belief that the manager possesses information the market is unaware of, or that the market has mispriced". Pursuing this belief impose hefty costs, in the shape of dealing costs, market impact costs and taxes. It is ultimately these costs which help to drag down the performance of even the best performing actively managed funds.

Investors who pick an index fund, Mr Miller concludes, are "rationally selecting an active money management style that is sensible, tax efficient, has a long history and works". His argument is that active managers should do more to model their behaviour on that of the index.

There is nothing in these comments, I venture to suggest, that does not apply in equal measure to the UK fund management industry. My feeling has long been that active fund managers could do a lot to make their offerings more attractive, starting with lower costs. But for so long the attitude of the industry has been, "If it ain't broke, don't mend it". The successful arrival of index funds in this country is shaking the active management community out of its complacency. The best companies have nothing to fear from competition - but it is up to investors to make sure the pressure to deliver good value for money is sustained.

davisbiz@aol.com

Start your day with The Independent, sign up for daily news emails
PROMOTED VIDEO
Arts and Entertainment
British musician Mark Ronson arrives for the UK premiere of the film 'Mortdecai'
music
Voices
Winston Churchill, then prime minister, outside No 10 in June 1943
voicesA C Benson called him 'a horrid little fellow', George Orwell would have shot him, but what a giant he seems now, says DJ Taylor
News
i100
Sport
footballBrighton vs Arsenal match report
Arts and Entertainment
Benedict Cumberbatch has spoken about the lack of opportunities for black British actors in the UK
film
News
ebooks
ebooksA year of political gossip, levity and intrigue from the sharpest pen in Westminster
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Tax Assistant

Negotiable: Recruitment Genius: A Tax Assistant is required to join a leading ...

Recruitment Genius: Outbound Sales Executive - OTE £25,000

£16000 - £25000 per annum: Recruitment Genius: This is an exciting opportunity...

Ashdown Group: Java Developer / J2EE Developer - Watford - £45,000 - £47,000

£45000 - £47000 per annum + bonus + benefits: Ashdown Group: Java Developer / ...

Ashdown Group: Marketing Product Manager - (Financial Services) - SW London

£35000 - £38000 per annum + Benefits: Ashdown Group: Marketing Manager - Marke...

Day In a Page

Iraq invasion 2003: The bloody warnings six wise men gave to Tony Blair as he prepared to launch poorly planned campaign

What the six wise men told Tony Blair

Months before the invasion of Iraq in 2003, experts sought to warn the PM about his plans. Here, four of them recall that day
25 years of The Independent on Sunday: The stories, the writers and the changes over the last quarter of a century

25 years of The Independent on Sunday

The stories, the writers and the changes over the last quarter of a century
Homeless Veterans appeal: 'Really caring is a dangerous emotion in this kind of work'

Homeless Veterans appeal

As head of The Soldiers' Charity, Martin Rutledge has to temper compassion with realism. He tells Chris Green how his Army career prepared him
Wu-Tang Clan and The Sexual Objects offer fans a chance to own the only copies of their latest albums

Smash hit go under the hammer

It's nice to pick up a new record once in a while, but the purchasers of two latest releases can go a step further - by buying the only copy
Geeks who rocked the world: Documentary looks back at origins of the computer-games industry

The geeks who rocked the world

A new documentary looks back at origins of the computer-games industry
Belle & Sebastian interview: Stuart Murdoch reveals how the band is taking a new direction

Belle & Sebastian is taking a new direction

Twenty years ago, Belle & Sebastian was a fey indie band from Glasgow. It still is – except today, as prime mover Stuart Murdoch admits, it has a global cult following, from Hollywood to South Korea
America: Land of the free, home of the political dynasty

America: Land of the free, home of the political dynasty

These days in the US things are pretty much stuck where they are, both in politics and society at large, says Rupert Cornwell
A graphic history of US civil rights – in comic book form

A graphic history of US civil rights – in comic book form

A veteran of the Fifties campaigns is inspiring a new generation of activists
Winston Churchill: the enigma of a British hero

Winston Churchill: the enigma of a British hero

A C Benson called him 'a horrid little fellow', George Orwell would have shot him, but what a giant he seems now, says DJ Taylor
Growing mussels: Precious freshwater shellfish are thriving in a unique green project

Growing mussels

Precious freshwater shellfish are thriving in a unique green project
Diana Krall: The jazz singer on being friends with Elton John, outer space and skiing in Dubai

Diana Krall interview

The jazz singer on being friends with Elton John, outer space and skiing in Dubai
Pinstriped for action: A glimpse of what the very rich man will be wearing this winter

Pinstriped for action

A glimpse of what the very rich man will be wearing this winter
Russell T Davies & Ben Cook: 'Our friendship flourished online. You can share some very revelatory moments at four in the morning…'

Russell T Davies & Ben Cook: How we met

'Our friendship flourished online. You can share some very revelatory moments at four in the morning…'
Bill Granger recipes: Our chef serves up his favourite Japanese dishes

Bill Granger's Japanese recipes

Stock up on mirin, soy and miso and you have the makings of everyday Japanese cuisine
Michael Calvin: How we need more Eric Cantonas to knock some sense into us

Michael Calvin's Last Word

How we need more Eric Cantonas to knock some sense into us