(Why) Does Index Investing Work? | BetaShares

(Why) Does Index Investing Work?

BY betashares | 8 July 2014
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Investors often choose to buy index tracking products like ETFs because of their lower cost (compared to the traditional actively managed fund) as well as a range of other potential benefits, like improved tax efficiency, better transparency and control. ETF users often also cite concerns about poor performance from traditional actively managed funds as another reason. But what does the evidence tell us about the real prospects for better performance by ETFs and index tracking funds, compared to actively managed funds?

The 2013 Nobel Prize in Economics was awarded to two scholars whose work is focused on this very point: how efficient are markets – and as a result, what is the best way to invest in them?

Professor Eugene Fama takes the view that its difficult (if not impossible) to consistently beat markets by picking stocks: his “efficient markets theory” holds that share prices incorporate all available information and there are no exploitable mispricings to consistently deliver outperformance. He concluded in his Nobel winning research paper that:

“Going forward, we expect that a portfolio of low cost index funds will perform about as well as a portfolio of the top three percentiles of past active winners, and better than the rest of the active fund universe.”

Ironically, the other joint winner of the 2013 Nobel Prize in Economics takes the opposite view. Professor Robert Shiller’s work is around investor behavior – specifically the “irrationality” that greed and fear can introduce into their decisions: Shiller’s view is investors seeking to beat the market can take advantage of this irrationality. The example of Warren Buffett and his success at Berkshire Hathaway (where investment returns have consistently been better than the market) is frequently cited as evidence of market inefficiency and in support of the concept of stock picking.

But what does the data tell us?

One way to test the “index vs active” debate is to refer to the “SPIVA scorecard”, produced bi-annually by S&P Dow Jones Indices. The SPIVA acronym simply refers to the performance difference between “Share Price Index vs Active” investment styles.

The SPIVA scorecard has been tabulated for several years and shows the majority of “large cap” Australian active fund managers have not beaten their index benchmark. The results depend very much on the asset class that the active manager invests in – for example, the less liquid “small cap” sector has produced more outperformance by active managers than the large cap sector.

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Interestingly, during the 12 month period ending December 31, 2013, the index only beat 32.21% of funds tracking the S&P/ASX 200 benchmark. That is significantly different compared to the norm, eg over the last three year period 62.83% of these managers under-performed and over the last five years a full 69.67% of these managers under-performed.

The conclusion? Scholars still disagree on how and why markets behave the way they do. In Australia, the evidence points to most large cap active fund managers underperforming the S&P/ASX 200 index. There is a case to be made for using the typically smaller number of active managers that outperform, but very few of these managers have outperformed consistently (so picking the winners is not easy). We believe the more compelling case is to use index tracking ETFs as an efficient way to invest in the broad sharemarket, and to use active managers/stock picking carefully as a way to try to add to those returns.

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