To date, discussions over index funds have been somewhat limited to the believers and the non-believers. However, the unique role index funds can play in portfolio construction, coupled with research that repeatedly highlights the wild card factor manager skill can and does actually play in achieving outperformance, are now taking the index fund debate to the next level. Further, this year one of the largest world players in index funds, Vanguard Investments Australia, is celebrating 10 years in the Australian market, sending a strong signal that index fund providers can be a competitive force down under.
Index funds have two central platforms - they are cheaper than actively-managed funds and do not involve timing the market or the attempt to try and pick stocks. "So it's a cost thing, but it's also a philosophical thing," Colonial First State head of investment markets research Hans Kunnen says. Kunnen says although the main reason investors and planners use index funds is because they're cheap, it also comes down to whether they believe fund managers can outperform the market. "It depends on your active versus passive view and that's not based on the share market view," he says.
With current market conditions throwing up stellar performance figures, many are now questioning how long this situation can continue, and if indeed now is the time to consider options such as index funds to smooth the ride. "A lot of people are concerned with the health of the market. The market is getting jittery, but you have to come back to the fact that many companies are making record profits," Kunnen says. There are still strong indicators of good performance, such as earnings and the outlook for interest rates, that really should not send investors looking for the next big thing, he says.
In fact, to suggest investing in index funds has a timing element associated with it would contradict the principles of index investing. Vanguard Investments Australia head of retail Robin Bowerman says: "There is no timing issue. The best time to invest in index funds is today, so it's about dollar cost averaging rather than one big timing thing." Morningstar head of research Anthony Serhan agrees. "You buy an index as part of a long-term approach to investing. You do need to be comfortable that the index you are tracking stacks up from an investment perspective," Serhan says.
However, if you're stuck with underperforming funds, certainly the issue of timing has some immediacy. Kunnen says while it is true there is no timing issue with index funds, if clients are invested in an underperforming fund, you may as well get them a market rate of return for a lower cost. He bases his view on whether a fund is underperforming or not on a five-year track record. Whatever your view on the market outlook, incorporating index funds successfully into a client's portfolio not only requires a belief in the valid role index funds can play in how a portfolio is constructed, but also in the overall benefits to that portfolio. Bowerman says while it is true three to four years ago the investor market was divided into the believers and non-believers in index funds, today the key issue is how to best use them in portfolio construction. "The biggest shift for advisers has been how to use index funds in portfolio construction," he says. "But they're now understanding, particularly with fee pressure being applied as well as dollar disclosure and a general awareness of fees. There is a desire to lower the fees to the end client. Serhan agrees. "People are more conscious of the benefits of low turnover, low fee approaches. This is a positive for index managers," he says. In the Australian market, historically the early adopters of index funds have typically been the boutique financial planners; those planners who realise their value proposition is in the structure of their clients' portfolios and less about the selection of funds.
"A lot was around the next hot thing. But the tough markets of 2002/2003 taught a lot of financial planners about tax and that structure delivers value," Bowerman says. "With the after-tax story, advisers cop that. They recommend a fund and don't have the data around whether it is going to deliver the tax outcomes." Serhan says planners that have an increased focus on returns from the market and are more sensitive to building low-cost portfolios for their clients are most attracted to index funds. Kunnen agrees. He says those planners who deal with cost-conscious investors or slightly less risk-averse investors are more likely to support index funds. Further, these investors typically have slightly lower funds under management.
However, Kunnen says index funds can also be used in another way. "The more aggressive advisers will use index funds as central and then the boutique funds around the edges. Not every adviser has got the time to keep an eye on what is happening in boutiques," he says. It is the value in trying to select fund managers that might achieve outperformance that is at the heart of index investing. According to a study released by Morningstar early last year, finding managed funds that add value over and above an index over a five and seven-year period to June 30, 2005, is a difficult task.
Commissioned by Vanguard Investments Australia, the study aimed to not only identify Australian equity, international equity, Australian listed property and Australian fixed interest funds that beat chosen indexes, but did so with a degree of skill. Skill was defined as "a managed fund which had a positive excess return and monthly excess return (over the five or seven years to June 30, 2005) greater than zero at the 95 per cent confidence level". Fund returns were also calculated net of ongoing expenses. What the study revealed was not only consistent with results from a similar study conducted in 2003, but found that of the 369 funds included in the study, only 39 per cent produced positive excess returns over five years.
"While any number of funds can beat a benchmark over a period of time, few can demonstrate that they have done this with any degree of skill," the survey concluded. "At best, only 43 per cent of funds that beat the benchmark in a particular category also demonstrated skill. In some instances, none passed the test." Naturally, introducing index funds to a client's portfolio for the first time requires substitution - one fund has to come out to be replaced by another. And according to the experts, property securities and fixed interest funds are two of the most common areas to be replaced first by index funds. This is because in the property securities space there is a limited universe of securities so the opportunities to outperform are lower. In the case of fixed interest, managers ask what is the opportunity to add alpha. "Fixed interest and listed property are typically starting points. But they can also work in the equity space. It does not have to be all or nothing. An indexed balanced fund could be a good core to build around with some active managers," Serhan says. Vanguard launched its International Property Securities Fund in September 2005 - the first international property index fund in the world. Bowerman says in the case of such a fund, which is in a new asset class, a strategy might be to use an index fund as a default option to give investors the chance to see what active fund managers are doing. So it involves the core/satellite approach, which is particularly prevalent in the United States.
Currently, the Vanguard fund has $297.8 million in funds under management with management costs at 0.40 per cent a year. While this fund is a wholesale fund, Bowerman says institutional investing in index funds over the past 10 years has significantly increased. He says currently of the top 10 superannuation funds by size, seven use indexing in their portfolios. Another important consideration when selecting index funds is the different geographical areas in which they operate, as this affects their ability to perform.
Kunnen says in the deeper, more efficient markets, such as Japan, Europe and the US, it is harder for index funds to outperform. Meanwhile, in the smaller markets where there is less research, fund managers are more likely to be more successful stock pickers. According to Bowerman, this is how it should be. "In the small caps space, it should be about adding value. There are two reasons for this. Markets are reasonably efficient and it's about fees," he says.
But on the large cap side, the story can be somewhat different. "Large cap liquid indexes typically do better up against active managers. This obviously favours developed markets," Serhan says. Currently the US has the highest penetration of index funds followed by Europe. Bowerman says in the 10 years Vanguard has been active in the Australian market, it has attracted over $50 billion in funds under management.
While he concedes much of this inflow has been fuelled by Australia's compulsory superannuation regime, he says index funds do have capacity benefits over their boutique fund manager counterparts. "One of the great values of index funds is that a lot of money each month has to find a home. Boutiques have a fund capacity issue whereas index funds become more efficient as more money is invested into there," he says. Capital gains still issue under new super rules
The best way for investors to maximise their superannuation and make the most of the opportunity to receive tax-free superannuation when they turn 60 is to not realise any capital gains made in the accumulation years until they are 60, so they effectively disappear. However, according to Vanguard Investments Australia head of retail Robin Bowerman, by allowing unrealised capital gains to effectively "compound up", investors could then restrict their ability to move between superannuation funds. This is for two reasons.
Not only will it become financially unattractive for investors to switch funds and realise their losses, but it will be difficult for financial planners to make recommendations to do so if it means their clients have to realise a sizable capital gain. Bowerman says for this reason, the after-tax story for managed funds is still relevant despite the change in superannuation rules.
