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What's in the secret sauce of index funds?

Glenn Freeman  |  03 Apr 2017Text size  Decrease  Increase  |  

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The active versus passive fund management debate rolls on, and the outperformance of index funds will also continue, says Vanguard's head of investment and equities, Asia Pacific.

 

Having recently been named Morningstar's Australian Fund Manager of the Year for the second time in three years, Vanguard knows plenty about what makes equity markets tick.

One of the most recognisable names in index investing--as distinct from active management--Vanguard's Asia Pacific head of investment and equities, Rodney Comegys, has a strong view on how it stacks up against active management.

"Index funds are here to stay. They're going to continue to perform well against the competition, if the active manager has high fees. Index funds work because of low fees, it gives them a fighting chance right from day one," Comegys says.

"We should remind ourselves that the biggest difference between us and other managers is in fees. The cheaper price guarantees us better performance just in that relative expense ratio. If the active funds keep costs down, they can insert alpha, but they have to get their fees in line and not destroy their alpha."

Though he doesn't write off active funds--indeed, in the last six weeks Vanguard has also added active management to its Australian dashboard, following suit with its active business in the US: "There will be active funds that outperform, but I don't think the days of index funds are in any way over."

"In the US, we have over $1 trillion of AUM (assets under management) in active management funds--we believe in each of those, but we're keeping our costs low so it doesn't destroy that alpha."

His comments contrast with those of a Grant Samuel Funds Management executive, Damien McIntyre, who suggests the salad days of index funds are almost over.

Vanguard's Comegys believes the fees argument is one thing that more or less guarantees indexers a headstart over active managers.

"Also, with active funds, you have to be prepared for periods of underperformance. We're not anti-active, we just think that passive has a good chance because of its cost and its consistency," he says.

"Every time there's a period of crisis or of constraints on growth, they say active is going to outperform--but Vanguard has survived all those periods since 1976."

How active is active?

Active share is another issue you need to be mindful of in deciding between active or passive funds. This refers to how correlated funds are to any given index--a fund with high active share performs considerably differently to an index, while one with low active share will often be quite closely index-aligned.

No one wants to be paying active fees for inactive management. A good way to assess if your manager really is taking differentiated calls from the index is through active share, which measures the active component of an investment portfolio in relation to an index.

This is a topic that Morningstar has researched extensively--its Equities Sector Wrap has been tracking "active share" since 2011.

Professor Martijn Cremers, from the University of Notre Dame, recently spoke with Morningstar UK about this topic.

"Those funds with low active share, below 60 per cent or so, substantially underperform. On the upside, there's much weaker evidence active managers have had a hard 10-15 years, but there's some evidence, that the high active managers, even as a group, have performed fine," Cremers says.

"If anything, most funds are not that high active share. So, unless you know that the fund is high active share, then I think passive is, for many investors, the right approach.

"At the same time, I like the core-satellite approach, where the core would be passive, but then for the satellites, you go wide and you diversify, and introduce high active share managers."

While fund manager skill is hard to measure, Cremers suggests that selecting a fund with high active share means that, at the very least, the manager has "the courage of its convictions and a lot of opportunity to actually be different".

"And so, in my view, having a high active share means at least having conviction and opportunity. In general, it takes a lot of skill to successfully run a high active share fund for a while.

"So, whenever you find that the patient high active share managers have done well, that's what I would suggest for the satellite."

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Glenn Freeman is Morningstar's senior editor.

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