Index funds better bet despite flat run

By MARY HOLM

Q: I am a financial adviser with 16 years' experience at the "front line". I am an admirer of the sage, practical and well-researched advice you provide to readers through your column.

But for some time I have had concern about your advocacy of index funds, largely because it is impossible to make gains from an index fund in flat or declining markets, particularly if those market conditions persist for an extended period.

During the 1990s, investment in index funds made a lot of sense, given the inexorable rise of market indices and that they often (but not always) outperformed more expensive actively managed funds.

As the major indices have now begun a third successive year of decline, my concerns appear justified.

Over the past 2 1/2 years, the Dow Jones Index has declined almost a third from its peak; the S&P 500 is down almost 40 per cent, as is the FTSE-100. We won't even mention the Nasdaq.

All these indices are now below their 1997 level. Any investor who has committed most or all of their equity investments to passive funds linked to those indices has taken a real hiding and may take several years to recover.

Conversely, there are examples of actively managed funds or investment trusts whose performance has significantly outperformed passive funds.

If I interpret your past comments correctly, your advocacy of index funds revolves around two primary factors: fees and taxation.

There are, of course, plenty of opportunities for investors to enjoy tax-free capital gains from investment vehicles such as British investment trusts.

With respect to fees, I view fees as relative, not absolute. I would be more than happy to pay a fund manager who was providing me with, for example, 20 per cent per annum returns, a 5 per cent fee.

Conversely, I see a 0.8 per cent annual fee for a passive index fund that is run by a computer system as quite expensive.

A: I, too, would be happy to pay 5 per cent to a fund manager making 20 per cent. Who wouldn't?

The tricky part is knowing in advance which, if any, manager will perform such a feat. More on that in a minute.

First, for the uninitiated, index funds invest in all the shares in a market index, such as the NZSE40, America's S&P500 or the worldwide MSCI.

The fund managers change their investments only when the index changes.

By contrast, managers of active funds research which shares to buy and sell and change investments as they see fit.

An important point to remember about index funds is that their performance - before fees and taxes - will over time be about the average of all active share funds that invest in the sector of the market covered by that index.

An example: the NZSE-40 covers the biggest 40 shares on the New Zealand market. About half the active funds that invest in big New Zealand shares will perform better than an NZSE-40 index fund, and about half will perform worse.

So you simply invest in an above-average fund, right? The trouble is:

* The funds that do better than the index tend to change. Over five years or more - and you shouldn't invest in a share fund for a shorter period than that - most active funds will sometimes outperform the index, sometimes underperform it.

* We're talking about returns before fees and taxes. Because active fund managers do research, and tend to trade more often, their fees are higher than for index funds.

And New Zealand-based active funds pay tax on their capital gains, but index funds don't. This can make a pretty big hole in active returns.

As a result, after fees and taxes, most active funds in the long term will underperform index funds covering the same market sector.

This includes during bear markets, such as we are experiencing now.

You're right to say an index fund can't make gains if the market, and hence the index, is falling.

But there's no evidence to suggest that active fund managers are better at picking shares in a declining market than in a rising one. Most active funds have also lost value lately. As you say, some haven't done as badly as index funds. But will they continue to shine?

Let me quote a recent Economist article, titled "Actively Cheated".

"It is hard to predict [which funds] will succeed, especially for retail investors, which means you and me.

"Most fund-management firms bombard [investors] with past-performance numbers, manipulated over particular time periods so that their fund looks like a winner.

"Past-performance figures are meaningless unless an investor knows what produced the success - it could have been one freak investment in a high-flying technology stock, for instance, rather than a sustainably superior investment process."

More broadly, the article opens with the bald statement: "Retail investors should stay away from actively managed funds."

It quotes a report that found: "An investor in a typical actively managed retail fund would have to put in £1.55 to get a return equivalent to £1 invested directly in the market."

In a recent year-long review, Ron Sandler, former boss of Lloyds of London, found that the average British unit trust underperformed the equity market by 2.5 per cent a year, because of high charges and poor performance by active managers, says the Economist.

Sandler goes on to say that individual investors put considerably more of their share fund money into active funds than do better-informed institutional investors.

This all applies to Britain. But there have been similar findings in the United States. It's hard to imagine New Zealand fund managers are consistently superior to those in the world's financial capitals.

What it all boils down to is that, yes, index funds don't grow in bear markets. But, in any market conditions, the average index fund will tend to do better, after fees and taxes, than the average active fund.

True, we'd be better off out of all share funds if the bear market continues. But it might end on Monday.

I'm keeping my money in index funds.

Footnote: The above has been about New Zealand-based funds - including those that invest in international shares.

You mention British-based investment trusts which, as you say, enjoy tax-free capital gains. And their fees tend to be lower than for many other active funds.

So, if I were going into active funds, I would favour those ones.

For people who like a dollar each way - often a good idea in investment - a combination of index funds and British investment trusts should work well.


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