Vanguard Research recently produced a report on indexing. Indexing versus active portfolio management is an age-old debate. Vanguard quote Morningstar that index funds and exchange traded funds now account for almost 35% of US equity investment. The report refers to the “Zero-sum game” theory for active managers, for a winner there has to be a loser. Some active managers are now accused of being closet trackers, an investor pays the fees of an active manager, but the manager invests on a basis that will ensure his performance is close to the index. By ensuring he or she does not deviate far from the index, hopefully increasing the chances of remaining employed.
Do you invest in a fund manager that picks and chooses the stocks he invests in (active) or buy into a fund that purely tracks the index (passive) you want to benchmark to? The argument against active fund managers is simple, the best active fund managers outperform an index by about 2%, and if you are paying a management fee approaching 2% per year, the best you can expect is to match the index. The flip side is if the active manager has a bad year, you are paying him and he is losing out to the index, the double whammy. The other argument often cited against active fund managers is the potential for increased volatility in an actively managed fund.
Vanguard stresses how important costs are to the performance of the investment, something we agree with at Frank investments. Costs can be incurred several ways to impact performance. Commissions paid by the manager to brokers, activity of trading can be important; every time an active fund manager trades he gives away the bid-offer spread, market impact can also affect performance. A fund manager that can address those costs efficiently will improve his or her performance.
Vanguard point out indexing is not a simple as it seems and that the trackers can come in different forms. Costs will also impact performance of a tracker fund, and some trackers try to match the benchmark via sampling and not full replication. Our view is that those costs or tracking errors that an index fund has to incur, ensure that a tracker will always underperform its index. The tracker can never by definition outperform an index it is designed to track.
Investors have a lot to think about when deciding where to invest their hard earned capital. Vanguard point out the qualities they believe make a good active manager are a proven philosophy, are disciplined, are conscious of costs and can articulate, execute and adhere to prudent, rational strategies, consistently. Principles at Frank Investments we strongly agree with.
In one of the opening paragraphs Vanguard states it believes it has found support for the use of trackers, and we would agree, they do have their place. But as with all things when investors decide where to invest their money they should think carefully at what they expect from their investments, and invest accordingly as both active and passive have a part to play.