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
ebooks
ebooksAn introduction to the ground rules of British democracy
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
SPONSORED FEATURES
Independent Dating
and  

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

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Sales Adviser - OTE £24,500

£22500 - £24500 per annum: Recruitment Genius: Inbound and outbound calls with...

Recruitment Genius: Business Development Executive / Sales - OTE £40,000

£18000 - £40000 per annum: Recruitment Genius: This fast growing Insurance Bro...

Guru Careers: Research Associate / Asset Management Research Analyst

£40 - 45k (DOE) + Benefits: Guru Careers: A Research Associate / Research Anal...

The Green Recruitment Company: Graduate Energy Analyst

£20000 Per Annum: The Green Recruitment Company: Summary: The Green Recruitm...

Day In a Page

Turkey's conflict with Kurdish guerrillas in Iraq can benefit Isis in Syria

Turkey's conflict with Kurdish guerrillas in Iraq can benefit Isis in Syria

Turkish President Erdogan could benefit politically from the targeting of the PKK, says Patrick Cockburn
Yvette Cooper: Our choice is years of Tory rule under Jeremy Corbyn or a return to a Labour government

Our choice is years of Tory rule under Corbyn or a return to a Labour government

Yvette Cooper urged Labour members to 'get serious' about the next general election rather than become 'a protest movement'
Singapore's domestic workers routinely exploited and often abused in the service of rich nationals

Singapore's hidden secret of domestic worker abuse

David Cameron was shown the country's shiniest veneer on his tour. What he didn't see was the army of foreign women who are routinely exploited and often abused in the service of rich nationals
Showdown by Shirley Jackson: A previously unpublished short story from the queen of American Gothic

Showdown, by Shirley Jackson

A previously unpublished short story from the queen of American Gothic
10 best DSLRs

Be sharp! 10 best DSLRs

Up your photography game with a versatile, powerful machine
Solved after 200 years: the mysterious deaths of 3,000 soldiers from Napoleon's army

Solved after 200 years

The mysterious deaths of 3,000 soldiers from Napoleon's army
Every regional power has betrayed the Kurds so Turkish bombing is no surprise

Robert Fisk on the Turkey conflict

Every regional power has betrayed the Kurds so Turkish bombing is no surprise
Investigation into wreck of unidentified submarine found off the coast of Sweden

Sunken sub

Investigation underway into wreck of an unidentified submarine found off the coast of Sweden
Instagram and Facebook have 'totally changed' the way people buy clothes

Age of the selfie

Instagram and Facebook have 'totally changed' the way people buy clothes
Not so square: How BBC's Bloomsbury saga is sexing up the period drama

Not so square

How Virginia Woolf saga is sexing up the BBC period drama
Rio Olympics 2016: The seven teenagers still carrying a torch for our Games hopes

Still carrying the torch

The seven teenagers given our Olympic hopes
The West likes to think that 'civilisation' will defeat Isis, but history suggests otherwise

The West likes to think that 'civilisation' will defeat Isis...

...but history suggests otherwise
The bald truth: How one author's thinning hair made him a Wayne Rooney sympathiser

The bald truth

How thinning hair made me a Wayne Rooney sympathiser
Froome wins second Tour de France after triumphant ride into Paris with Team Sky

Tour de France 2015

Froome rides into Paris to win historic second Tour
Fifteen years ago, Concorde crashed, and a dream died. Today, the desire to travel faster than the speed of sound is growing once again

A new beginning for supersonic flight?

Concorde's successors are in the works 15 years on from the Paris crash