Index tracking gathers momentum as investors wake up to ‘the maths’. Best of BizNews

images-67Index tracking funds should be an easy sell. The charges are lower than you can expect to pay if you invest in an actively managed fund. And, as so few fund managers can beat the indices, your returns are likely to be higher. Yet, although the selling points are appealing, index funds are still not the preferred option. This is partly because intermediaries aren’t incentivised enough to sell them and partly because many of us believe we – or our fund manager – can beat the odds. The experts at 10X Investments take a look at the rise of index funds and offer some suggestions on how the South African investment landscape can be improved to the benefit of individual savers. – JC

By 10X Investments*

An interesting industry related article in The Economist, Will invest for food, has caught our attention. The author insightfully discusses the rise of index funds over the past 40 years and explains why many pension funds have moved partially or exclusively to passive investing, but also why many funds continue to invest in hope of market-beating returns – despite the low odds of success.

The author concludes with a strong admonishment to companies, governments and individuals:

Companies and governments can look after the best interest of their workers by ensuring their pension schemes have as low costs as possible. [And] the average investor will need to be better informed. At the very least, they need to read the personal-finance pages of newspapers, and understand the merits of tracker funds and the impact of low charges.”

Key insights

Below we have summarised key insights included in the Editorial discussing the article, aptly titled ‘Cheap is cheerful. The business of managing other people’s money is being commoditised. About time’.

•Despite their massive cost advantage, index funds still only represent 11% of the industry’s assets under management. Two things have held them back:

1.Distribution: the brokers who sell funds to investors have had little incentive to sell cheap ones. The higher a fund’s fees, the greater the incentive to sell it.

2.A belief that investors can do better than the index by picking a hot fund: money for old hope. Some funds will indeed beat the index, whether by luck or skill. It is easy to identify those funds with hindsight, but hard to do so in advance.

•The index represents the performance of the average investor before costs; the higher the costs, the greater the odds that a fund will do worse than the market.

•Thankfully the industry is changing. Employers that run DC (defined contribution) schemes tend to use trackers as an obvious way to show they are protecting their employees’ interests.

•Might a market dominated by trackers be more prone to bubbles, as investors pile into the biggest stocks regardless of their value? Not really. As the dotcom bubble showed, active managers themselves are prone to chase trends.

•Governments should ensure that financial advisers are paid, not by product providers, but by clients (much as you would not want doctors to be paid by pharmaceutical companies). More countries should follow the UK’s example and stop the use of commissions.

•In a world of slower growth, low inflation and Treasury-bond yields of 2.5-3%, future investment returns are likely to be low. All the more reason for them not to be eroded by the fees of an industry with such a lacklustre performance.

Key observations from the main article

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Index tracking should be an easy sell: it’s lower cost and the returns are more predictable. Plus, we now know that active managers can outperform the market.

•Even great investors think that low-cost tracker funds make sense. In his latest letter to Berkshire Hathaway shareholders, Warren Buffett describes what should happen to his personal portfolio after his death. “My advice to the trustee could not be more simple: put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund.”

•As investors wake up to the maths, active fund managers are starting to face the kind of pressure seen in other industries, which is costing them their role as gatekeepers.

•Earlier generations of investors were prepared to believe that the returns achieved by fund managers were down to skill. Now it has become clear that the returns were the result of factors that are easily replicated, and that it is a myth that active managers can outperform the market.

•Low-cost trackers did not have sufficient fees to reward the advisers, so tended not to be recommended.

•Most employers offer a default DC fund, which usually have big exposure to low-cost index-
trackers: no employer can be blamed for opting for a low-cost fund, as more than half of all schemes use trackers exclusively.

•Investors may also believe, despite legally-required caveats, that past fund performance is a guide to future riches. They want the best fund, not an average one (which an index tracker is likely to be). This gives active managers a great marketing advantage: hope.

•Inertia is a factor too. Investors who have placed their money with a big active manager often do not bother to move it. They may not even know whether their holding is outperforming or underperforming.

•A good proportion of managers will beat the index in a given period, whether through their own skill or simple luck. But it is hard to see how investors can identify managers like Mr Buffett in advance. Indeed, if such paragons could be easily identified upfront, they would attract all the available funds, driving the hopeless managers out of business.

•Institutional investors, too, have gradually become more sophisticated about identifying how fund managers generate returns. A hundred years ago they regarded all returns as evidence of a manager’s skill, then they began to compare returns with those of other managers or the market. Later, with the help of academics, they realised that fund managers might beat the index by taking more risk; so they started to use risk-adjusted measures.

•The index investor need never worry about the manager losing his mojo or quitting to join another firm.

•Good advice is certainly worth something: many American investors in pension plans have devoted a big portion of their portfolios to cash (a low long-term return) or to their employer’s shares (too risky). The ability to avoid such mistakes is worth a once-off fee, but an investor should not pay 1% – 1.5% per year to an adviser. Nobody has yet shown that they can correctly and consistently time markets.

* This blog is published here on BizNews.com with the kind permission of 10X Investments.

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