Index v Active

I've posted periodically a comparison of the results of active fund managers versus indices (generally US or UK data), and argued that it consistently demonstrates that active management is a hard game to play.

This year's data is now in (I got this from CBS Marketwatch), and, true to form, most managers did not outperform their relevant index benchmarks. The stats are: 33% of large-cap managers outperformed the S&P500 Index, 44% of mid-cap managers outperformed the S&P MidCap 400 Index, and 60% of small-cap managers outperformed the S&P SmallCap 600 Index.

The longer the time period, the more the statistics swing in favour of indexation, as you might expect (because it's even more difficult for an active manager to outperform consistently). The latest 5-year stats show 47% of large-cap managers, 20% of mid-cap managers, and 30% of small-cap managers, beating their benchmarks.

This longer-term data gives the lie to two other commonly held beliefs about indexation - (1) that small-cap active management is easier because the stocks are less widely researched (though in fairness small-cap managers did outperform over 1 year), and (2) that active management is more likely to beat indexed management in a bear market.

There was a nice quote from a financial adviser in the report, which pretty much sums up my own views. "Indexing is shooting par, and that's pretty hard to beat." I get the sense that a lot of Irish advisers regard indexing as settling for something sub-optimal. But shooting par every time will stand you in good stead over the long-term as the active managers around you combine the odd birdie with lots of bogeys or worse.

Just some food for thought. Any comments welcome.

Hi Dynamo - Does your data show typical charges for Index Vs Active? It would be interesting to see the variation in charges.

Indexing versus Active

It seems to me that indexing will outperform most active managers as long as indexed funds are a relatively small proportion of the market. What the index fund is doing is piggybacking on the decisions and the pricing of the active managers, but not paying their fees. Obviously there will be some active managers who outperform the index, but only if they outperform their active management competitors. I have never heard any active manager make a convincing case of why they should outperform their competitors, which leads me to suspect that few of them do anything different to the competition.

If index funds become too large, then the investment returns are going to suffer, as the market is in effect driving blind. This does not mean that index funds will then underperform active managers, though it certainly will give the active managers more scope to spot gaps and mispricing. What it does mean is that the market becomes less efficient, as the prices are being set not as a result of conscious buying or selling decisions, but by the weight of money going into or out of the index funds.

I suspect that the U.S. market is at or close to this point, and it may have contributed to the bubble. The U.K. market has a smaller index fund ownership, but there is definitely an issue of many active managers being closet index managers.

Pat

Re: Indexing versus Active

If index funds become too large, then the investment returns are going to suffer, as the market is in effect driving blind. This does not mean that index funds will then underperform active managers, though it certainly will give the active managers more scope to spot gaps and mispricing. What it does mean is that the market becomes less efficient, as the prices are being set not as a result of conscious buying or selling decisions, but by the weight of money going into or out of the index funds.

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That's an interesting point which I presume applies to consensus funds as well to some degree? It's interesting to think that we could arrive at a situation in which most investment decisions are made with reference to the composition of the indices or one set of managers looking over their shoulder at the others. On the other hand I guess the EMH would have it that as soon as inefficiency crept in action would automatically be taken to correct this and level the playing field again?

Re: Indexing versus Active

How easy/difficult is it to invest in index funds from Ireland, apart from Quinn Life?

Slim 8)

Re: Indexing versus Active

A few others offer index trackers if I'm not mistaken - New Ireland's SmartFunds and Irish Life's Scope for example I think (albeit with 5% down to 1% early encashment charges in the first five years). This topic might also be of interest to you:

Above

I think you're spot on about index tracking the large stock market for Pan European and US sectors, but in less efficient markets Active managers shoot better. Taking an extreme example I'd much prefer Active for China, or for Life Sciences. There's tons of scope to mix both styles in a portfolio of funds, where the anchor is medium risk US and Pan European indices, but where there may also be focused funds, theme funds, emerging market funds etc.

Its difficult to argue the case for general equity funds that invest in the type of stocks that make up the S&P, FTSE 100 or Eurostoxx 50, when you can index track, but there is a case nonetheless for example for Dividend Funds, and Value Funds that may specialise in parts of these markets.