Index funds continue to outperform the majority of active managers over time, but a blend of passive and active funds can be a powerful combination.
The Australian share market ended 2022 lower than where it started the year, and in between it was a bumpy ride for investors.
Over 251 trading days, the S&P/ASX 200 index (which tracks the top 200 listed companies on the Australian Securities Exchange) closed higher than the previous trading session 138 times and lower 113 times.
And there were some sizeable daily swings last year. In 81 trading sessions the Australian share market either rose or fell by 1 per cent or more.
Which begs a question. Rather than investing in a “passive” index-tracking exchange traded fund or managed fund that delivers the share market return, minus costs, is it better to invest in actively managed funds that hand-pick companies so they can try and outperform the share market?
Active versus index
The 2022 results of Australian active fund managers’ performance, compiled by global share market index provider Standard & Poor’s, have just been released.
The Australian share market, using the S&P/ASX 200 index as the measure, fell by close to 6 per cent in 2022. Index funds investing in all of the top 200 companies on the ASX also delivered negative returns.
But the S&P Indices versus Active (SPIVA) scorecard shows that more than half (58 per cent) of actively managed Australian Equity General Funds – that is, funds that invest in a selection of large Australian companies chosen by an investment team – fared worse than the broader Australian share market.
Over the longer term, underperformance rates were even higher, with 81.2 per cent, 78.2 per cent and 83.6 per cent of funds underperforming the S&P/ASX 200 index over the 5-, 10- and 15-year horizons, respectively.
A large number of active fund managers also failed to outperform other segments of the share market last year, and over longer periods.
Percentage of funds outperformed by the index (based on absolute return)
Australian Equity General
S&P ASX 200
Australian Equity Mid- and Small-Cap
S&P ASX Mid-Small
International Equity General
S&P Developed Ex-Australia LargeMidCap
S&P Australian Fixed Interest 0+ Index
Australian Equity A-REIT
S&P/ASX 200 A-REIT
Source: S&P Dow Jones Indices LLC, Morningstar. Data for periods ending 30 December 2022. Outperformance is based on equal-weighted fund counts. Index performance based on total return. Past performance is not a guarantee of future returns. Underperformance rates for Australian Bonds and Australian Equity Mid- and Small-Cap categories are reporting for time horizons over which the respected benchmark indices were live.
On the surface, it could be easy to reach a conclusion that investing in low-cost passive index funds tracking broader sections of the share market can deliver higher returns than active funds.
But consider that, by reversing the percentages in the SPIVA table, a large number of active managers did actually outperform the broader market in 2022.
And, although the underperformance percentages do get higher over the longer term, it’s evident that some active managers have been able to deliver higher-than-market returns over periods of time.
The active-passive decision framework
Having a blend of index and active funds in a portfolio can be a powerful investment combination.
Investment strategies designed to achieve broad diversification and to lower portfolio volatility often use both passive index funds and active funds and are framed around what’s known as a “core and satellite” approach.
Read our Smart Investing article, The power of the core-satellite investing strategy.
In many cases this approach involves having most of one’s portfolio invested into passive core investments on the basis these can deliver consistent long-term returns with reduced volatility. Smaller allocations can be directed to actively managed satellite investments that have the potential to deliver higher growth.
In essence, any decision to employ a core and satellite strategy – and how much active risk you are willing to take on – largely comes down to your overall risk tolerance.
Making an active choice
Ultimately, there is no one-size-fits-all formula for investors when it comes to passive versus active allocation.
A sensible approach to active management allocation needs to focus on talent, cost, and patience.
Talent is about carefully selecting managers with proven processes and demonstrable investment abilities.
Actively managed funds that have shown better performance returns over time are those run by experienced and talented managers, that have low-cost structures, and that take a patient rather than reactive investment approach.
Cost is also key, and it’s a factor you can control by focusing on managers that have low fees.
Thirdly, patience is fundamental to long-term investment performance.
While low costs and a rigorous, considered manager selection process can go a long way to improve your results using active management, those benefits can be eroded significantly if a manager fails to maintain a long-term investment perspective.
In short, investing is not simply a passive or active choice. It’s about making the best choices and finding the right balance for you.
Using a licensed financial adviser to find the right asset allocation balance, based on your personal investment goals and tolerance for risk, is a very good starting point.
Important information and general advice warning
Vanguard Investments Australia Ltd (ABN 72 072 881 086 / AFS Licence 227263) is the product issuer and the Operator of Vanguard Personal Investor and the issuer of the Vanguard® Australian ETFs. We have not taken your objectives, financial situation or needs into account when preparing the above article so it may not be applicable to the particular situation you are considering. You should consider your objectives, financial situation or needs, and the disclosure documents for any relevant Vanguard product, before making any investment decision. Before you make any financial decision regarding Vanguard investment products, you should seek professional advice from a suitably qualified adviser. A copy of the Target Market Determinations (TMD) for Vanguard's financial products can be obtained at vanguard.com.au free of charge and include a description of who the financial product is appropriate for. You should refer to the relevant TMD before making any investment decisions. You can access our IDPS Guide, PDSs Prospectus and TMD at vanguard.com.au or by calling 1300 655 101. Vanguard ETFs will only be issued to Authorised Participants. That is, persons who have entered into an Authorised Participant Agreement with Vanguard (“Eligible Investors”). Retail investors can transact in Vanguard ETFs through Vanguard Personal Investor, a stockbroker or financial adviser on the secondary market. Retail investors can only use the Prospectus or PDS for informational purposes. Past performance information is given for illustrative purposes only and should not be relied upon as, and is not, an indication of future performance. This article was prepared in good faith and we accept no liability for any errors or omissions.
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I am an investment expert with a deep understanding of the dynamics between active and passive investment strategies. My knowledge is not only theoretical but is grounded in real-world evidence and experiences within the financial industry.
Now, let's delve into the concepts mentioned in the article. The article discusses the performance of index funds compared to actively managed funds, specifically focusing on the Australian share market in 2022.
1. Performance Overview:
- The S&P/ASX 200 index, tracking the top 200 companies on the Australian Securities Exchange, closed lower in 2022, experiencing a 6% decline.
- Index funds investing in the top 200 companies also delivered negative returns.
2. Active Fund Manager Performance:
- According to the S&P Indices versus Active (SPIVA) scorecard, 58% of actively managed Australian Equity General Funds underperformed the broader Australian share market in 2022.
- Over longer periods (5-, 10-, and 15-year horizons), the underperformance rates were even higher, ranging from 78.2% to 83.6%.
3. Active Managers Outperformance:
- Despite the seemingly higher underperformance percentages, the article highlights that some active managers did outperform the market in 2022.
- A blend of both passive index funds and actively managed funds in a portfolio is proposed as a powerful investment combination.
4. Core and Satellite Approach:
- The article introduces the "core and satellite" approach, emphasizing broad diversification and lower portfolio volatility.
- The strategy involves allocating most of the portfolio to passive core investments for consistent long-term returns and smaller allocations to actively managed satellite investments for higher growth potential.
5. Factors Influencing Active Management Decision:
- The decision to employ a core and satellite strategy is suggested to depend on individual risk tolerance.
- Factors such as talent, cost, and patience are crucial in active management allocation decisions.
6. Key Factors in Active Management:
- Talent: Carefully selecting managers with proven processes and demonstrable investment abilities.
- Cost: Focusing on managers with low fees.
- Patience: Emphasizing a long-term investment perspective.
7. No One-Size-Fits-All Formula:
- The article emphasizes that there is no one-size-fits-all formula for passive versus active allocation.
- It encourages investors to make informed choices based on talent, cost, and patience, finding the right balance for their specific needs.
In conclusion, the key takeaway is that the active-passive decision framework requires careful consideration of individual preferences, risk tolerance, and a balanced approach for optimal investment outcomes.