Active vs Index Funds

An active fund is a managed fund in which the fund manager’s goal is to outperform the market average by actively seeking out stocks that will provide superior total return. There are inherent costs associated with active management including research and brokerage costs.

Index funds have the objective of matching the asset class index by generally investing in companies in accordance with the constituents of the index. The key benefits of investing into Index Funds are low cost, potentially less capital gains tax due to less trading, diversification across that asset class index and reliable exposure to that particular asset class.

The chart below illustrates Retail Managed Funds performance after fees versus their comparable index over the 7 year period to 31 December 2004 in Australia.

Enhanced index funds, such as Dimensional, share very similar characteristics of Index Funds, however, utilising intensive academic research as their foundation, Dimensional Funds are constructed on an Asset Class basis rather than purely focusing upon indices such as the ASX300, etc. To highlight the effectiveness of their methodology, the Sydney Morning Herald on the 14th March 2005 noted Dimensional’s top performance over the last 5 years:

Because the sum of the parts must equal the whole, active sharemarket investors must then also earn the same gross return as do the passive sharemarket investors. However, on average, their costs are higher therefore they must earn lower net returns. The mathematical logic is so simple that it is amazing that active investors persists.

To expand on it further, if one active manager is bullish on BHP and wants to buy more BHP for his portfolio, he must buy it from someone else who is bearish on BHP and wants to reduce his holdings. In other words, a manager can deviate from holding securities in his market proportions only if someone else deviates in the opposite way. Across all of the active funds, these deviations cancel out and so the average performance of active funds cannot be greater than the performance of the market. Active managers are engaged in a zero sum game with the gains of the winners exactly offset by the losses of the losers. In fact, since active managers incur trading costs, the game is actually a negative sum game.

There will always be some active managers that outperform their appropriate benchmark, even for very long periods of time. This provides hope for believers in active management. Unfortunately, there is no evidence of any persistence in performance beyond the randomly expected. Nor is there any demonstrated ability to identify ahead of time the very few winners. What is even worse is that the evidence over long periods is that the very few winners outperform on an after tax basis by a very small amount, and the losers underperform by a much larger amount, about three times greater. So even if you manage to pick one of the few active funds that outperforms, the odds are great that you will outperform by only a small amount. On the other hand, the odds are great that you will choose an active fund that will underperform by a large amount. No wonder Charles Ellis called active management a loser's game - it's not that you cannot win, but instead the risk-adjusted odds of winning are so low that it does not pay to play a game you are not forced to play.

Disclaimer:

No investment advice provided to you.
This web site is not designed for the purpose of providing personal financial or investment advice. Information provided does not take into account your particular investment objectives, financial situation or investment needs.

You should assess whether the information on this web site is appropriate to your particular investment objectives, financial situation and investment needs. You should do this before making an investment decision on the basis of the information on this web site. You can either make this assessment yourself or seek the assistance of any adviser.