Index investing not as sound as it seems
Some of the major arguments supporting the use of index fund managers over active managers are not as robust as they would seem on the surface, according to an investment analyst with a major financial services corporation.
One argument in favour of investing in index funds is that they are cheaper in regard to management fees. While MLC investment analyst John Owen agrees that index funds are cheaper, he feels the difference in cost compared to an actively managed fund is not as great as some people are led to believe.
“We actually think, just in looking at some of the platforms and how you would access an index manager say in Australian shares versus an active strategy, that it might only be around 47 to 50 basis points difference,” he said.
A second pro-index fund argument often raised is that index funds have a lower portfolio turnover, often around 5 per cent, and so are more tax effective as they trigger fewer capital gain events.
Again, Owen does not deny this fact but pointed out that active managers do not necessarily trade as actively as some people perceive.
“A lot of people think that active managers are very active. With lots of active turnover it is very attractive for the brokers they deal with but not necessarily [for] the after tax outcome for their clients. But the managers we’re using, some of them have only a 10 or 15 per cent turnover per annum. One of our global equity managers had turnover of 6 per cent last year,” Owen explained.
A third positive argument for using index funds is that they will deliver index like returns to the investor. Owen believes this argument is not accurate when looking at investors’ returns once fess and taxes have been taken out.
“On an after fees and tax basis, index funds will underperform the index that they are designed to replicate. Aside from that, we think there are some compromises in terms of the portfolio outcomes that clients will get by using index managers,” he said.
“If we let the index composition drive the sorts of securities that we will include in our portfolios, or that we allow our managers to invest in for our clients, we would actually be missing out on a lot of securities that could and should play a role in our clients’ portfolios,” Owen concluded.
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