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Index Funds Can be Costly

Published: August 17, 2017 by Rory Maguire, Fundhouse

The use of index funds inside portfolios is substantial and growing. But is it sensible? Clearly there is no simple answer, but our view is that a lot of caution is needed at this time.

Before we explain why, we should first acknowledge that the selective use of cheap passives makes sense. Markets are a zero sum game and over 50% of active managers do underperform the market average, after fees. There is also a lot of cost pressure out there and this is only increasing and leading more investors towards passives. And, so, we regularly advise our clients to use index funds selectively. So, why the word of caution?

We are concerned that the use of passives has gone from being selective to almost obsessive in some cases. And their indiscriminate use can be counterproductive, even when large cost savings are made. That is because seeking cheap return averages – what index funds are very good at delivering – can be a costly idea too. This is particularly relevant when markets are above historic averages and buying index strategies could be a way of averaging down, not up.

All else being equal, there are two distinct market environments that strongly favour active management, in our view:

  • When returns expectations are low
  • When market risk is high

We address each next.

Why a low return world favours (selective) active management: We are deeply suspicious of clichés, but one we agree with is that we are in a low return environment. The evidence seems overwhelming. Stock markets – powered along by an ever more expensive US equity market (particularly in Sterling) – are clearly top heavy in valuation terms. And bond markets, which tell you precisely what to expect in return terms – suggest a very low return even for those with a 10-year view.

This points to a world where prospective returns look limited. For example, a commonly used portfolio like a moderate risk strategy (say 50% equity, 50% bond), may struggle to deliver 3% or so from here. If you owned a passively managed strategy within this risk band, these prospects appear very modest. Yet, if you select a proven active manager, their added value (alpha) can be disproportionately high when returns are low. If they add say 1.3% a year (after fees) to the 3% market average, the alpha becomes 30% of the total return. Alpha can be very powerful and important in a low return world.

Higher risk markets favour active: Index funds are very good at managing returns but are poor (and even indifferent) at managing risk. And our sense is that markets look particularly risky today. It is quite rare to find many equity and bond markets looking this expensive relative to history, suggesting market corrections could be around the corner. Losses may be even more acute for UK investors buying expensive foreign assets with Sterling, if these assets and Sterling mean revert at the same time. It is precisely at extremes like these – which fall outside the averages that power index funds – that employing active funds can help mitigate downside risk. Active managers have tools at their disposal – whether it is reducing bond duration, credit exposure, equity exposure or even hedging currency risk. Index funds, by contrast, are takers of the risk employed by the market and this can really hurt when markets start to get fearful.

Clearly the choice between active and passive funds is a very complex choice and we do not aim to simplify it here. And we back both when building portfolios. But, our sense is that the use of passives has become such a focus – even an obsession – that clients could be exposing themselves to undue risks in the current market environment. Market averages are worth pursuing when markets are behaving in an average fashion – which is most of the time. But, now, it seems we are outside these averages and this is probably time to question how much pure market risk you take.

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