The everlasting debate

Want to start an argument? Try asking if now is the right time for indexing. This seemingly innocent question is likely to generate a strong response, with active managers proclaiming volatile markets are a stock picker’s paradise and indexers arguing few active managers have outperformed their benchmarks.

It’s a question that has generated millions of words, but the short answer is there is no definitive answer.

According to Lonsec’s research manager – investments, Michael Elsworth, his firm believes both active and passive strategies have a role in volatile markets. “It needs a more nuanced decision than just active versus passive and which asset class to choose.”

He points out sector-specific issues also come into play at various times. “An example now is in the small cap equity space. Due to the inefficiencies in that market it appears that it is worth paying for active managers.” 

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The latest S&P Indices Versus Active Funds Scorecard (SPIVA) Australia for the year-end 2011, endorses the view that the investment decision is far more complex than merely whether to choose active versus passive in a volatile market.

The SPIVA scorecard found the majority of funds across all categories failed to beat their respective indices over all time periods in the report (see Table 1). 

This underperformance has particularly been the case in the continuing ‘risk on/risk off’ environment currently being experienced in investment markets. Underlying stock values have not been a significant factor when risk averse investors are selling off the entire market, which makes life very difficult for active managers.

When it comes to Australian equities, the SPIVA scorecard found the S&P/ASX 200 Accumulation Index had outperformed over 60 per cent of active Australian Equity General funds over one year. However, active Australian Equity Small Cap funds have significantly outperformed the benchmark. 

According to Elsworth, the findings are unsurprising. “We see there are benefits in active management from time to time in different sectors,” he says. 

“For a number of years it was difficult to add value in Australian fixed income, but now there is more scope to add value, so it appears there is some benefit to active management. Market dislocations in fixed income have led to greater scope to add value,” Elsworth says.

Having it both ways?

According to indexers, it is hard for most active managers to argue they are suited to volatile market conditions. 

Vanguard Investments Australia head of corporate affairs and market development, Robin Bowerman, is dismissive of this argument, claiming active managers are trying to have it both ways. “Pre-GFC [global financial crisis] when the market was high, active managers said it was not a time for indexing and they are now saying the same thing,” he notes.

“Through market run-ups and drops, the average active manager underperforms the market.”

Bowerman argues the key is not selecting active or passive investing, but focussing on portfolio selection. 

“Core plus satellites allows you to lock in the market return, and if you are confident an active manager can outperform, then you can lock in the return by using an active manager as a satellite,” he says.

“It is about getting the balance right between the core and getting the market return at a low price, which over time will be beneficial for the client.”

Despite the current enthusiasm for indexed investments, many experts believe this is a reaction to the GFC and ongoing market volatility, rather than a permanent shift in the market. 

“This is still cyclical, and past experience has shown that after a big sell-off there is a move into index funds,” Elsworth says.

“Some of it may be structural, but it is hard to tell yet – it will take more time.”

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Indexing for ease

While the argument about the suitability of index funds to current market conditions continues to rage, the SMSF investors who seem to dominate the listed sector of the index fund market are continuing to vote with their feet – and dollars. 

Indexed ETFs are rapidly being launched to cater to popular investment themes such as income and cash, with BetaShares’ new High Interest Cash ETF the fastest growing ETF in June, recording $7 million in inflows. 

“One of the key themes this year is high yield or income. This area is where the FUM flows are and this is the area where products are being launched,” Elsworth notes.

As the launch of an ETF to match a particular index is often a more straightforward task than releasing a new managed fund, the number of index products looks likely to continue expanding. Rather than cannibalising managed index funds, new ETFs are likely to complement them.

“Among ETFs, the new ones are very niche and they are often in areas where managed funds are not offered as the FUM would be too low, such as oil, commodities or high yield,” Elsworth explains.

However, managed index funds are not going to miss out entirely on all this investor attention. Vanguard has followed the launch of its Australian Government Bond Index ETF in April with a new Australian Inflation-Linked Bond Index managed fund catering to the surge in demand for indexed fixed income products.

Counting the cost of indexing

One market participant who believes all this focus on indexing is not the answer to market volatility is Russel Pillemer, CEO of active Australian equities manager, Pengana Capital. 

Although the cheaper pricing available from index products is very attractive, he believes investors will have regrets when they see the true cost of index funds – particularly in relation to their superannuation accounts.

“The Cooper Review and industry fund information has led to an increased focus on costs, but without any focus on return. There is no discussion about returns,” Pillemer says.

“Cooper and the cost focus can be very damaging to the products that will be created. They will be very volatile – or have a very small proportion in equities – and so will be lower performing products.”

He argues it will only be apparent to investors when they retire the true price they have paid by being in low MER index funds. 

“Index funds are exposing investors to 100 per cent of the volatility of the equity market. With such a volatile outlook, investors would be much better served by having a portion of their equity investments in strategies that have the potential to soften the blow in a falling market,” Pillemer argues.

“Financial planners need to consider what that means for the long-term for their clients.”

Rather than taking the index route, Pillemer urges advisers to consider investing clients into equity strategies designed to generate positive returns – irrespective of market movements. He believes they should consider options such as equity market neutral long short and special event strategies rather than index funds.

Pillemer also believes the idea of using index funds as the portfolio core surrounded by actively managed satellites is now rather ‘old school’.

“After core plus satellites, the next level is to say we do not want the core to be beta, the core should be alpha with a 5 per cent to 15 per cent return and the satellites should be the beta. The time where beta was the core has gone,” he argues.

“More sophisticated investors are now focused on achieving a low volatility 8 per cent to 10 per cent return, as everyone is terrified of equity markets.”

Pillemer believes savvy investors and advisers are interested in active managers who can demonstrate good performance in recent conditions. “There is a very strong shift to active management with no emphasis on benchmark – to achieve either an absolute return or to be benchmark unaware.”