Investment and super fees: Don't cut off your nose to spite your face! (Hostplus Indexed Balanced)

Each year, we write an update to this article – see here.

Super & invt fees

It is very important to minimise investment fees and I have written about this previously. However, it is equally (sometimes more) important to ensure you invest in such a way that positions you to enjoy superior returns. I believe that you can do both i.e. minimise fees whilst at the same time maximise returns.

Industry super fund, Hostplus has an Index Balanced investment option that has a total investment cost of only 0.04% p.a. which is insanely low! You would know by now that I’m a big fan of passive (index) investing i.e. it’s superior than the alternative, being active investment management. Therefore, the Hostplus option seems to tick all the boxes (i.e. its passive and low cost), right?

No. Not for everyone. If you have a relatively low super balance i.e. less than $100,000 to $150,000, then it’s an excellent option. However, if you have over $150,000 (or expect to relatively soon), then you need to ensure that your super is invested wisely.

If you have more than $150,000 in super

The problem with Hostplus’ option is that I am virtually certain[1] that it’s invested only using traditional market cap indexing.

Traditional market capitalisation (‘cap’ for short) indexing works by allocating investment dollars based on the value of each company included in an index compared to the value of the index overall. For example, CBA’s market capitalisation is approximately $139 billion. The value of the top 200 companies in Australia is circa $1.72 trillion. Therefore, CBA’s market cap represents 8.1% of the ASX 200 index. As such, if you invested in a traditional market cap ASX200 index fund, 8.1% of your monies would be invested in CBA. The fund will invest in all the top 200 companies proportionately based on each stocks market cap.

Criticisms of traditional market cap indexing

There are two main criticisms levied at traditional market cap indexing

1. Index arbitrage

Companies such as S&P, Dow Jones are responsible for managing certain indexes. These indexes are reweighted every so often – typically every six months. At this time, companies are either added or subtracted from a given index (and reweighted). This creates demand for these stocks.

Market participants know that index funds must either buy or sell said stocks on the day that they are added or subtracted from an index. As such, studies have shown that the price of the stock that is being added to an index typically appreciates between 5% and 10% when it is announced. However, it loses most of those gains within approximately two weeks after being added to the index. This means that traditional market cap index funds tend to buy stocks at inflated prices. The same is true when a stock is removed from the index in that the market price becomes temporarily depressed so the index fund must sell when the price is low. Studies estimate[2] that the trading cost of such events amounts to approximately 0.28% for traditional index funds.

2. Follows price bubbles

Another criticism of traditional market cap indexing is that as the price of a stock increases, an index fund needs to hold more of said stock. If there is a price bubble (i.e. stock becomes overvalued), this traditional market cap indexing increases your exposure to it. For example, between 1987 and 2000 the valuation of tech stocks was appreciating at an alarming rate. However, the NASDAQ index fell by nearly 80% between the year 2000 and 2002 due to the dot-com bubble. Some index funds (depending on the index they tracked) would have had to track this level of exposure. As such, many people believe price is not always a reliable indicator of long-term value.

Whilst traditional market cap indexing has its flaws, the undeniable truth is that its still beaten the clear majority of active funds over the long run.

Traditional indexing works best in a constantly rising market

Traditional index has performed well over the past few years because the US and Australian stock markets have been consistently rising – almost all shares have done well. However, this won’t continue for ever. Markets will correct, volatility will increase and that’s when ‘value-based’ methodologies will perform better than traditional market cap indexing.

Alternative strategies to traditional indexing

There are several evidenced-based passive strategies to use as an alternative to traditional indexing. I’m not suggesting that traditional indexing should be ignored altogether. Instead, I am suggesting that you should diversify across a few passive strategies – some of which I highlight below.

All these strategies are low-cost (typically cost 0.40% p.a. or less). They all use a rules-based approach – meaning there’s no speculative or subjective decision making. In addition, because they are rules-based, we can back-test performance over many decades. Furthermore, they are easily repeatable methodologies – as the rules can simply be repeated.

Here are a few alternatives and their performance compared to the traditional index over the long term:

  • Fundamental indexing – the fundamental index has beaten the Australian market (ASX200) by 2.47% p.a. over the past 10 years and the US market by 2.43% p.a. over the past 20 years.
  • Dimensional indexing – Dimensional has outperformed the index in the US by an average of 1.27% p.a. over the past 28 years and by 1.26% p.a. in Australian over the past 18 years.
  • Quality indexing – the S&P/ASX 200 Quality Index has outperformed the ASX200 by 2.94% over the past 10 years.

The above data suggests that non-market cap index strategies can generate excess performance of in the range of 1% and 2.5% p.a. – well in excess of their slightly higher costs.

Not all indexing strategies are safe to use

There are lots of indexing strategies and methodologies to choose from. It is critical that you seek advice from an independent financial advisor prior to investing. The funds management industry is very good at marketing products, historical returns (back tests) and methodologies. Sometimes there’s lots of smoke and mirrors. Just be very careful.

A 1% higher return is better than saving 0.40% in fees

Hostplus’ Index Balanced super option appears very attractive on first impressions. It is an excellent option for people that have lower super balances. However, if you are in your 40’s and 50’s then your goal must be to minimise fees whilst at the same time maximising returns. I have strong reservations about whether a simple traditional market cap index fund will allow you to do that – particularly in a market that is not constantly appreciating.

[1] It is impossible to identify for certain due to the Fund’s lack of discloser and non-user-friendly website.

[2] Cost and Capacity: Comparing Smart Beta Strategies. By Tzee Chow Feifei Li Alex Pickard Yadwinder Garg July 2017