Are index funds still outperforming?

Index versus active

Share markets have been highly volatile over the past couple of years. Markets fell by circa 30% when Covid hit in March 2020 and then proceeded to boom until the end of 2021, fuelled by government stimulus and zero interest rates. However, markets fell by circa 20% in 2022 after central banks aggressively hiked rates. It’s been a wild ride.

Arguably, these large volatility events should have made it a lot easier for active fund managers to beat the index. Share market mispricing, overreactions and volatility should create profitable opportunities for active managers. I wanted to investigate whether this was the case.

What is an active manager?

An active manager picks a basket of stocks that they believe will generate high investment returns. Active managers can achieve that using two primary methodologies. They can try to identify undervalued stocks on the hope that their market value eventually rises to what they believe is fair value (that is called a value manager). Alternatively, they can identify companies that are likely to generate a lot of growth in the future, with less focus on whether they are fairly valued (that is called a growth manager). The truth is that there are lots of different strategies that active managers use, and it could be a combination of value and growth.

Because active fund managers need to employ a portfolio management team, they typically charge management fees of around 1% p.a.

What is an index fund?

Traditionally, an index fund invests in an index of the most valuable companies. For example, A200 is the lowest-cost Australian market index fund – it charges an investment fee of only 0.04% p.a. (e.g., fee on $100k invested is only $40 p.a.). It invests in the ASX 200 index which is the most valuable 200 companies listed on the ASX.

For example, the total value of the largest 200 companies is $2.1 trillion. BHP’s value (market capitalisation) is circa $240 billion, being approximately 11% of the total index – Australia’s most valuable company. Therefore, if you invest in A200, 11% of your money will be invested in BHP. 7.8% in CBA. 6.5% in CSL and so on.

An index fund is simply a managed fund that invests in a very broad basket of companies. The manager uses a rules-based approach for determining which stocks are included in that basket and how much to invest in each, such as the ASX 200. Because it uses a rules-based approach, it doesn’t need to employ costly portfolio managers and as such, the fees charged by index funds are very low.

What happened last year?

As I said in my opening paragraph, large movements in share markets caused by one or two major external factors often create obvious investment opportunities. Theoretically, active managers should be able to exploit these opportunities to generate higher returns. Therefore, I thought it would be interesting to investigate how active managed funds performed over the 2022 calendar year.

The table below shows that less than half of active managers beat the index in the 2022 calendar year. Only one quarter of active managers in the US and one-third of Australian managers have beaten the market over the past 3 years (i.e., the volatile covid period).

Index funds outperforming

Longer term results are even worse for active managers. Only 7% of active managers in the US and 16% in Australia have beaten the index over the past 15 years. But the key factor to note is that it’s not the same active managers over the 15 years. They change all the time. Outperformance by one manager rarely persists for more than a couple of years.

For example, in June 2018 there we 79 Australian active managers in the top quartile (by investment performance). Four years later (by June 2022), none of those 79 managers remained in the top quartile.

Only just over 40% of active managers can remain in the top quartile for two years running and 15% three years running (none four years running).

Therefore, for active management to work, you must pick which managers are likely to outperform over the next 12 months and then sack and replace those managers every 1 to 2 years with new outperforming managers. And you must do that with consistent accuracy. It’s impossible to do!

Sidebar: By the way, active managers perform a bit better in Australia than the US probably because Australia is a much smaller market (fewer participants) and therefore more inefficient.

Criticisms/weaknesses with traditional market cap indexing

I will start by saying that traditional market capitalisation (cap) indexing, like the ASX200 example discussed above, has beaten the vast majority of active managers over the long run. Therefore, it is a proven and valuable strategy.

However, one of the problems with market cap indexing is that it is linked to each company’s share price. For example, since the start of February 2023, CBA’s share price has fallen 10% and Telstra has risen 3.4%. Therefore, if an index fund was to rebalance now, it would have to sell (reduce its holding) in CBA and buy more Telstra. But selling CBA just because its fallen 10% doesn’t make sense as its value hasn’t fundamentally changed over the past 2 months (it’s been affected by negative global banking sentiment). 

Therefore, the main criticism with market cap indexing is that allocating your investment across a pool of companies solely based on their prices causes inefficacies (it’s been empirically proven).

Other index methodologies such as fundamental indexing, factor-based and equal weight compliment traditional market cap indexing because they mitigate some of its weaknesses.

If index funds dominate markets, will they lose their edge?  

It is estimated that over $16 trillion dollars is invested in index funds, up from only $3 trillion only 10 years ago. A client asked me a very good question last week. He asked if index funds continue to rise in popularity, will returns suffer because everyone has invested in them i.e., they become the whole market?

One of the most important parts of the market is price discovery i.e., traders buying and selling stocks to arrive at a consensus on what a company is worth. This transparent process is a foundation principle of the efficient market hypothesis. It is estimated that trading by index funds only accounts for between 5% to 7% of total trading volume. Index funds benefit from this price discovery process but hardly contribute to it. They are merely along for the ride.

Active managers are not worth the higher fees

2022 was yet another example of how active fund management is likely to produce lower investment returns, even in highly volatile markets. And they are a lot more expensive.

Longer-term data is very compelling. The longer the time horizon (e.g., 10+ years), the more likely it is that index funds will produce higher returns for a much lower cost. There are some sub-asset-classes where active management makes sense (based on the data), such as emerging markets. But when it comes to developed market equities (which should account for most of your portfolio), all the evidence demonstrates that indexing, using a variety of methodologies, is best.