Is our Index Fund obsession limiting investment returns?
Written January 2023
Many believe that Warren Buffett said it best. Investors seeking retirement savings should consistently buy an index fund - a passive investment fund that replicates an underlying stock market index. For those feeling bewildered about which stocks to buy, the cost-conscious, or not wanting to engage with an adviser, this message has become commonly accepted. So, as Monty Python might say, what have active fund managers ever done for us?
Since 2010, global Exchange Traded Fund (ETF) and Index Fund assets have grown by eight times. Significant inflows have caused investors and the financial advice community to rethink their traditionally active fund approach. Depending on their overall asset allocation, the many investors who made the shift from active funds probably found it worth it. Major stock market index ETFs have outperformed most of their active fund rivals whilst giving passive investors significant cost savings. Financial advisers have relied on the same to provide clients with better value, whilst some have benefitted from higher ongoing advice charges due to the lower effective costs.
The active/passive fund debate continues, with both sides relying on performance and charge data to structure their arguments, but it isn’t that simple. Investors and advisers must dive deeper into the details of both arguments and their relevance to global economic and market cycles to take advantage of the benefits both active and passive strategies offer, particularly as we shift into a new economic phase.
But how did Passive investing take the fight to Active?
Until recently global interest rates were maintained at historic lows because of a collapse in inflation following global economic stimulus in 2008. This created a surge of growth stocks- the larger companies with higher earnings and lower dividends but steadier long-term growth prospects who can typically borrow more and have done so at extremely low rates of interest. Think of tech companies today, like Apple or Meta. Most major stock index ETFs predominantly hold large growth stocks due to the capitalised construction of their underlying index driven by the relative size of each company.
The Credit Crisis put banks and financial firms under the microscope. Investors were justifiably upset about the collapse of the mortgage and real estate markets in 2008/9. US legislation in the form of Dodd-Frank (2010) created oversight, and despite its partial repeal in 2018 by the Trump administration, the anti-banker, anti-commission culture cultivated and spilled into the US advice industry, particularly those representing wire-houses (banks and brokerages) in the U.K. The Retail Distribution Review (2013) addressed the professional qualification and the commission focus of the advice market, which caused adviser numbers to decrease. Regulation created a cultural shift. Investors turned away from advisers towards lower cost and self-investing; Vanguard, one of the largest global ETF firms, flourished, and Nutmeg and Betterment were established. The terms independent and fiduciary became staples for new advisers in global advice markets, and the independent and RIA markets in the U.K. and U.S. began to take asset share from the private banking adviser community, staking a larger claim into the well-established High Net Worth territory.
Buffett’s tracker fund argument is reflected in behavioural finance and the Nobel Prize-winning Efficient Markets Hypothesis- it’s impossible for anyone to beat the market consistently because common information that might provide an advantage is already priced in. So, why would any investor question this logic? Firstly, Buffett addressed American investors and referred to an S&P 500 tracker fund. For global investors such as those in the UK, the situation is more challenging given the relative size of the UK stock market, currency constraints, and particularly as we enter a new market cycle reflected by higher inflation, interest rates, and market volatility.
As we are acutely aware, interest rates are rising, and whilst 4%+ rates may arrive but not stay, it’s probable by 2024, they won’t return to the levels we’ve enjoyed in the past 14 years. This scenario makes growth investing more challenging and, with a rise in market volatility, reverts focus to how strategic investing used to be: active, bottom-up, and value-based, a skill few investors can successfully pull off consistently, but we haven’t needed to consider since pre-2008 thanks to the growth stock wave. Warren Buffet, Peter Lynch, Ben Graham, and Sir John Templeton are/were famous value investors who became investing heroes of their time, seeking out intrinsic value within unloved companies and holding them until their time in the sun came, but their skills were much less relevant through the growth wave.
The ETF universe has moved on, too. There are index funds for just about anything investors can think of, including value stocks and actively managed passive funds, such as Cathie Wood’s Ark Fund. Despite getting burned in their global growth ETF during the first half of 2022, an investor can gradually re-adjust their weighting towards value stocks but stay passive by investing into a range of value index funds, blending styles to accommodate their strategy. Given their passive nature, using an ETF to deliver a value strategy is difficult to define as strategic, particularly during volatile times, as traditional value investing should be, but that said, you could do worse by including Vanguard’s Value Fund in your allocation.
What’s the answer as we aim to balance strategy, the costs of investing, and, if relevant, advice? Firstly, don’t be obsessed by ETFs simply because they are cost-effective. Getting caught in a style or a tracking error trap is more likely without proper research. Investment styles typically ebb and flow into relevance depending on the economic and market cycles; moving forward, it's, therefore, good to be agnostic, blend styles across your portfolio, and recognize the past 14 years have been unusual. A good adviser should be able to manage and adjust fund investment styles across their client’s portfolios as market conditions evolve. Secondly, as part of a good due diligence process, focus on assessing active fund manager talent, and, if necessary, be prepared to blend your or your client’s portfolios with ETFs and active funds, known as a Satellite Approach. You or your adviser should be capable of creating and maintaining this strategy, but if you don’t feel comfortable as a self-investor, the passive world may be more suitable.
When should you use an ETF over an active fund? Generally, and as directed by the Efficient Markets Hypothesis, ETFs should be used to reflect your allocation across the most efficient growth-orientated markets, such as US, UK, and EU equities where commonly known information is heavily priced in, and active managers are less likely to outperform (known as achieving alpha). Your active fund allocation should reflect less efficient markets such as Asia, Emerging Market equities, and high-yield bonds where inefficiencies are present and information is less priced-in. This provides opportunities for fund managers, particularly bottom-up value investors.