[GRTV] The case for index funds

S&P Dr Tim Edwards details the case for index funds and why they are a better option than active funds.

Monday, July 9th 2018, 2:39PM

My final guest on this episode of Good Returns TV is Dr. Tim Edwards. He's the managing director of Index Strategies at S&P Dow Jones, based in London. Thank you for coming on the show. I think you've been in New Zealand doing some master class sessions with the ETFs?

My pleasure, thank you very much for inviting me. That's right, we've been doing a series of sessions around New Zealand, around ETFs, indexes, and the role of passive investing.

So there's been a massive flow of money into passive investing in recent years. Is that a good thing or a bad thing for the market?

It's a good question. The first and most important thing is that for the investor, the ability to offer market returns at a lower cost in aggregate has saved the investment community hundreds of billions of dollars in fees. So it is unequivocally a good thing for the end investor that they have the option to go passive.

But does at the end of the day, it's the net return at the end which matters. Has that been as good?

Well, obviously there are some active funds which have outperformed. We're not going to say that no one has. But what we have done over the years is that we produce a regular report. It goes under the name of SPIVA, which stands for S&P Indices Versus Active. The idea is we'll take all the mutual funds operating in a particular market. It could be US funds or Australian funds and so on. And we'll just report the percentage that actually managed to outperform the benchmark. In nearly every market, what you see is most of the time, most active managers under-perform. And that actually tracking an index is one of the most sure fire ways to offer above average returns within the fund industry.

I know you do SPIVA reports in Australia, and there's been some work on a New Zealand version of it. Where's that at?

Unfortunately we don't yet have a SPIVA report for the New Zealand market. There're two reasons for that. The first is just simply there's not an awful lot of active funds in New Zealand. We don't want to report a number that we say 60% and it really means three out of five. More importantly, because there are more than five funds, what you need in order to do this report properly is to ... If I want to show you a 10 year number: How many funds beat the market over 10 years, I need to include all those funds that were available 10 years ago that are not available today. And the reason is that roughly 30 or 40 percent of funds that were on sale 10 years ago, are not available today. If I go now and I look at all the funds that I can see today that have a 10 year track record, many of them would have outperformed. But it's because the ones that under-perform don't exist anymore. So it's just struggling to get good data going back in history.

It would be interesting to do because there's a theory in New Zealand that active managers generally can do very well in this market. But we'll wait for the report.

There are times and there are markets when active managers always have an advantage. The extent to which New Zealand has some of those characteristics are as follows: one, there's quite high a dispersion in New Zealand's equities. By dispersion, I mean the difference in winners and losers is quite wide. The second thing is that the New Zealand equities market is quite concentrated in the sense that there's a few very big stocks take a large proportion of the market. And when those large stocks don't perform well, you'll typically see active managers outperforming because they unlikely have quite as much allocated to the largest stocks.

What I would say just in the balance there, most of the passive funds that are operating in the New Zealand market actually account for that, and they'll follow an index that doesn't limit the exposure to the largest stocks. So I think even the index providers kind of taking that perspective that diversification can help or can be necessary.

So what are some of those common myths that we hear about index funds?

There are many. If I were to just pick my favorite is that you always hear that the advantage of active management is that in a bear market, we can go to cash. And it's always can go to cash, it's never did go to cash. Over the years with our SPIVA data, year on year on year, we can actually study this. What does the data tell us? Actually we found that active managers don't do any better in market downturns than they do in rising markets or in moderate markets. There isn't a real connection there in terms of active managers proven that they're able to time the market really well.

Do you find that there are some active managers that continually outperform the market, or is it more random than that?

No, and it's really interesting to ask why. Again, this is just what the data tells us. So we've looked at, either year on year, you know, do the good managed fund stay in the top half? And there we found that over four, five years, it's about as likely as getting heads on a coin, that a good manager will stay on the top half. We'll look over longer periods and say, over a five year period, and you pick the top quarter of funds. How do they do in the next five years? They're roughly as likely to be in the top quarter as they are to be in the bottom quarter.

I believe in skill. I believe that skill is out there. The question is: Why aren't we seeing it in the data? And I think that is a harder question to answer, so I'll speculate. We don't really have data on this. What I think is happening is, you have to remember that in an active and passive world, for someone to outperform the average, someone else has to under-perform.

So it's a zero sum game?

Well we can all get rich if the equity market goes up, but we can't all beat the market.

So what I think is happening is the skilled funds...Let's say there are some, and then some unskilled funds or less skilled, they don't perform as well. They are punished for this. Investors take their money from those badly performing funds and at the moment, typically, put it in an index fund. That means they're not going to be supplying that alpha to the out performers. What happens now is a manager who is moderately skilled, suddenly has found that among his peers, he's one of the worst performers. I don't think you need to take an index provider's word for this. I'm sure you've interviewed active managers who will tell you this. I've heard many who will tell you this. What they will tell you is that delivering out-performance is a ruthlessly competitive difficult task that requires huge investment to maintain an edge. So don't take my word for it. Take theirs.

Is there a risk that with this big flow of money into passive that you'll lose more of that performance in the market? That everything will just become vanilla?

It's an interesting paradox. So clearly we're in a stage where ... I would say we're in a stage where the availability of passive products is good for market, good for investors. If the world goes 100% passive, what will happen then? Who will help us set prices? It is clear that at some point we have to reach a balance. What I would argue is that we are nowhere near that kind of capacity for passive. We've estimated that roughly 20% in the equity market is invested passively today.

That's globally?

That's globally. And the point at which it gets interesting in terms of passive trading roughly equaling active trading is actually closer to along the like 70 or 80% passive. The reason passive can get so big is because passive point follows don't turn over very much.
You want to stay cap-weighted, you just stay cap-weighted. You don't need to...As the big stocks get bigger, your positions get bigger. Active managers tend to trade quite a lot, and that means that because they trade so much, the marginal trade would become a passive investor when passive is, quite frankly, unrealistic proportion of the market.

Do you have a number where that crossover is where?

What you can do and what we did in and if I may...Shameless advertisement. What we did in a paper called The Slings and Arrows of Passive Fortune, was showed how you could model this out. So you need to make assumptions: How much to passive turnover, how much is active turnover. And then it's quite easy to come up with the figures. If I speculate, we're probably good until the world is at least 70 or 80% passive.

So we're a long way away.

And frankly I don't think that will ever happen.

So there's always going to be a role for active managers?

There will always be a role for active managers. They are the policemen of our markets. There are enough investors as well who see the value in active management. And this is where the lines get a little blurry, in the discipline systematic investing like value investing, which you don't maybe necessarily need someone's gut feeling to enact.

So you'd be a supporter of the core satellite strategy then?

I think I would. Certainly to the extend that our data suggests that putting a passive core investment at a low cost at the core of your portfolio, is one of the most helpful things you can do, if your goal is to perform relatively well.

Excellent. Thank you very much for your time, Tim. That was really interesting.

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