Index investing didn’t exist when Benjamin Graham wrote The Intelligent Investor back in 1949. I am guessing, based on the quote above, that he would have been a fan.
It is a simple and irrefutable fact that, once you subtract their often hefty fees, the average of all actively managed funds’ returns must be less than the market return. Keep your fees low, then, and you will inevitably do better than average.
It is compelling logic and explains the rapid growth of index funds, which promise to track a stock market index, like the All Ordinaries Index or the S&P 500, for fees that can be as low as 0.1% per annum. They do have their shortcomings, though, especially for Australian investors.
The Forager Australian Shares Fund is up 23.5% this calendar year. If you’re invested in the Vanguard Australian Shares Index ETF (Exchange Traded Fund – a listed index fund), your return is -0.1%, including distributions.
Before we get too carried away with our own brilliant investing skills, a quick look at my cohorts suggests we aren’t the only ones dramatically outperforming the market. I can’t get calendar year returns for our group in Morningstar, but the one year returns tell the same story; our “category” of 23 Mid/Small Value funds has returned an average of 10.3%, a long way ahead of the 0.5% return for the All Ordinaries Accumulation Index.
Perhaps we are all geniuses. Or perhaps not.
My beef with index investing in Australia is that the index is a joke. The big four banks, BHP Billiton and Telstra make up an absurd 42% of the S&P/ASX 200 index. Think about how correlated the risks are among the big four and its easy to see that, rather than reducing your risk by buying the index, you are exposing yourself to a highly concentrated portfolio of stocks. Hence the dramatic underperformance of the index in 2015. According to this morning’s AFR, “falls in ANZ, BHP Billiton, Commonwealth Bank, National Australia Bank, Woolworths and Telstra can account for the 317 point drop in the major S&P/ASX 200 index so far this year.” That’s a 6% fall thanks to 6 stocks.
The index providers are aware of these shortcomings, and are starting to provide products that address some of them. You can, for example, now buy an equal weighted index fund that holds a much broader cross section of stocks. I have suggested consideration of this option to a number of investors thinking of combining us with an index fund. But these will only work while they are small. If they attract a significant amount of money, they will start causing significant distortions in some of the smaller stocks that make up the bottom end of the index.
Which brings me to the other main issue with index funds – their success will be their downfall. The latest quarterly newsletter from US hedge fund Horizon Kinetics puts the blame for much of recent market volatility at the feet of ETFs. In the US, ETFs account for 7.5% of total market capitalisation and apparently 27% of trading volume (does that sound ‘passive’ to you?):
One of the challenges here is that far more money is in these index instruments than the securities in which they are invested can really bear. The mismatch between the seemingly substantial liquidity of the ETFs — to judge by their trading volume — and the real liquidity of their underlying holdings might become obvious only when the funds stop flowing in.
We have seen some examples of that happening recently, particularly in the biotech sphere, and the results aren’t pretty.
I’m a huge fan of keeping your costs low and index funds can be a useful tool for achieving that. But don’t be blind to their shortcomings. Horizon puts it nicely:
[A] marketplace cannot escape the reality of supply versus demand, that too much demand for even the very best idea will invalidate it.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.