Keeping it simple: the rise and rise of the index fund

Australian Financial Review, June 2008

Sometimes it’s the simplest things that really catch on. More and more investors are increasing their use of index investment techniques – whether through mutual funds, exchange traded funds (ETFs) or other vehicles – rather than giving their money to active managers.

According to a new report released worldwide by Morgan Stanley last month, global average daily trading volumes of ETFs – funds that trade like a share on stock exchanges, but which often represent the performance of a whole market like the ASX/S&P 200 or the USA’s S&P 500 – was up 53.3% in the March quarter. There are 1300 ETFs available worldwide now, up more than 100 since December. In Australia, the family of index-tracking ETFs sold by State Street Global Advisors here topped A$1 billion under management for the first time in May – a 33% increase in a year – while Barclays Global Investors has launched 14 of the structures over various international markets in the last year under its iShares brand.

At the same time, fund managers who specialise in index funds, such as Vanguard, are in rude health. Vanguard now manages A$1.5 trillion globally and A$69 billion in Australia alone. To give one example, its annual report shows that on June 30 2006 the net assets in its Index Australian Shares Fund were $230.9 million. One year later, the figure was $348 million – a 50% increase.

Why this increasing appetite for keeping it simple? There are a few reasons. One is an increasing trend in the way institutions invest: more and more they decide to use cheap index fund approaches to get the performance of the broader market (sometimes called beta), and then use a few active managers around the edges to get outperformance (sometimes called alpha). This is known as the core-satellite approach and explains why index funds are getting more and more mandates from big institutions – with the Future Fund being a classic example. So far its Australian and international equity mandates have only been given to passive fund managers like Vanguard and State Street.

For individuals, one of the main reasons they like index funds is because they are cheap. The management fee on State Street’s so-called Spider product which replicates the performance of the S&P/ASX 200 is just 0.286%. The iShares range goes from just 0.09% (for its S&P 500 product, tracking the US benchmark) to 0.74% for a China product. Index mutual funds aren’t quite so cheap, but even so they’re much less than active funds: the Australian shares fund from Vanguard charges 0.75% on the first A$50,000 of an investment.

There are other reasons too. An index investment gives you exposure to a whole market, with all its stocks, through a single purchase. It’s an easy way of making sure you don’t miss out, and of adding diversification to a portfolio without a big outlay. They are generally transparent; with an ETF you can buy in or sell out just as easily as any stock; and even with a mutual fund there is generally no problem with liquidity, with perhaps a delay of a few days in getting your money out when you want to.

Groups like iShares report that ETFs are proving particularly popular among people who run their own super funds. “Almost half the number of Australians who invest in iShares are doing so on behalf of their self managed super funds,” says co-head of iShares Australia, Tim Bradbury, in a recent statement. Since iShares only cover international markets, this is perhaps more a comment on how individuals like to get their global equity exposure. “Investors are becoming increasingly aware of the importance of diversification, and with SMSFs currently only allocating an average of 1 per cent of their entire portfolio to overseas assets, iShares offer an easy and cost-effective solution,” Bradbury says.

So how do index funds and products fit into this choppy market environment? It is often said that a falling market is a bad time to be in an index product, because you can’t steer clear of the duds along the way. An active manager, it is suggested, can do a better job of keeping the portfolio away from potential problems, and in many cases is permitted to switch money into cash if they think it appropriate to do so.

Index managers challenge this assumption. “People are saying that active managers can make wise choices to outperform, but you’ll see that especially after fees and costs, active managers haven’t performed that well in the current environment,” says Susan Darroch, head of the global structured products group at State Street.

Is that true? According to Mercer Investment Consulting, the median long-only Australian equity fund returned -4.4% in the year to April 30, and 17.6% in the three years to that date. The median Australian equities index fund returned -5.6% and 16.8% respectively. So in both cases the median active manager beat the index manager. But these numbers are before fees and taxes. Considering that Australian equity mutual funds typically come with a management expense ratio of between 1 and 2%, the net performance is pretty similar between active and index funds. Also, the turnover tends to be higher in active funds than index funds (though it does vary), and that can have a big impact on the fund’s tax position.

And how about ETFs? Well, the S&P/ASX 200 itself returned -5.6% and 16.7% over those two time periods, so to get your return from an ETF, just take off the 0.286% fee. Looked at like that, an ETF will have performed better, net, than many active managers over both the last one and three years.

The corollary to this argument is that it depends very much on the manager. Investors in SGH20 – an Australian equities fund managed by SG Hiscock & Co, up 24.1% in the year to April 30 – probably have a rather different view on the benefits of active management at the moment than investors in the Challenger Select Australian Share Fund, which is down 17.7% over the same period. Index managers tend to argue that this is another reason for taking the passive approach, since it takes the lottery of manager selection out of the picture.

If you invest using an index product you are not making a call on any particular sector or stock. On one hand, that’s inflexible; it would have been handy to avoid banking stocks in the recent downturn, for example. But did active managers do so? “Where’s the evidence that active managers have ever, as a group, managed to time the market and go more defensive just before a major crash or correction?” asks Robin Bowerman, head of retail at Vanguard.

But what if this is no longer a falling market, but one that has pretty much bottomed out and is ready for a new period of gradual rising? Index funds offer a cheaper and easy way of getting exposure to that broader momentum without taking a view on whether it’s resource stocks, or banks, or whatever else that will lead the charge. Again, though, the theory is that active managers ought to have a better sense of what stocks are primed for outperformance and which are not. For example, fund managers might feel financials have been oversold, and so position themselves accordingly; or that resource stocks have had a good enough run and are due a peg back. It’s really all about your confidence in their being right.

BOX: HOW TO DO IT

Index strategies come down to a simple choice: listed or unlisted?

In the listed camp are exchange traded funds and listed investment companies. Each has the same basic principle – that buying one share exposes you to lots of other underlying investments – but there is a key difference: ETFs tend to track very closely the index or investments that underpin them, but LICs can trade at big premiums or discounts to their underlying assets.

The most common index tracker in Australia is the SPDR series from State Street Global Advisors, nicknamed ‘spider’. This series arrived in Australia following the huge success of State Street’s ETFs in the USA, including the biggest, the SPDR over the S&P 500, which is believed to be the single most traded stock on the New York Stock Exchange. The SPDR series in Australia recently passed $1 billion under management, split between three funds, mirroring the S&P/ASX 200, the S&P/ASX 50, and an index of listed property trusts.

More recently, a series of international ETFs, called iShares, was launched by Barclays Global Investors – see the international article for more on these.

It used to be the case that ETFs, with their very low management fee, had trouble reaching retail investors because planners were unwilling to recommend them since they did not offer a trail fee to remunerate them. Susan Darroch at SSGA believes this is changing. “Certainly we’ve come a long way,” she says. “A lot of planners are moving towards fee for service rather than having trails, and that’s a positive thing for ETFs.”

Then there’s the unlisted approach. This involves mutual funds, which either hold all the stocks in a particular index or a representative selection that closely mirrors the performance of that index. Examples in Australia include products from BGI, Commonwealth Bank of Australia, Macquarie Bank, State Street and Vanguard. As discussed in the main feature, these tend to have higher fees than ETFs, but are still much cheaper than active funds.

Why choose this option? “I think both approaches are reasonable to consider,” says Jeremy Duffield, managing director of Vanguard. “What we’re trying to do is provide mainstream indices people need for sensible asset allocation. Lots of ETFs focus on quite narrow areas.” Other advantages of mutual funds is that they don’t have variations in buy-sell spreads, which can occur on listed products if liquidity is tight; there is certainty of buying at the right net asset value, which isn’t the case with LICs; and for people doing regular savings plans, mutual funds make sense, because with an ETF there is brokerage on every new trade. ETFs, in turn, have intra-day liquidity – you can buy and sell as quickly as buying a share, which isn’t the case with a mutual fund – and in some cases can be more transparent in terms of knowing exactly what they hold.

“It’s not that one approach is better than the other,” says Bowerman. “It’s what suits you and your time horizon.”

BOX: Going global

The iShares range offered by Barclays Global Investors launched a whole new method of reaching an asset class in Australia: using an ETF to get international equity exposure.

It has been an interesting approach. Between October and November last year, 14 of these products were launched. There is a global product (the iShares S&P Global 100), funds for the USA (large cap, mid cap and small cap), funds for emerging markets, for Europe and for EAFE (stocks outside America), and then a series of country-specific funds, for Japan, China, Hong Kong, South Korea, Singapore and Taiwan.

Globally, Barclays has had great success with these approaches. There are over 300 iShares trading on various stock exchanges worldwide; between them they account for US$397.41 billion in assets under management. It’s not clear at this stage how much money has gone into iShares from Australia – although assets under management are disclosed for the ETFs, they appear to be global aggregates, with figures varying from $1.4 billion to $49.3 billion in Australian dollar terms depending on the contract.

They certainly represent a cheap way of getting international exposure, with even the most expensive funds coming in it well under 1% in management fees. But, as with domestic funds, it is important to remember that an index funds exposes you to everything in that index – the dross as well as the shining lights. There is no active management of portfolios, nobody trying to pull you out of the way if it looks like a major company is heading for a fall.

For some people, this is a useful way of diversifying portfolio without having to develop any expertise on the merits of individual active managers. For some it’s a starting point, and for others it might be used in combination with active managers – the core/satellite approach again.

It’s important to realise that the risk profiles of these products varies significantly. There is a big difference between a well diversified index of American or global blue chips, and a fund that tracks the FTSE/Xinhua China 25, which, as the names suggests, is made up of only 25 Chinese companies. The country-specific funds bring with them significant concentration risk, as well as emerging market exposure, which isn’t necessarily a bad thing provided you’ve thought through how it fits into your broader portfolio. For example, there is no other Singapore-specific fund, or Taiwanese, or South Korean, available to Australian investors besides these new ETFs. Interestingly, iShares reports that the China and emerging markets funds are the most popular with self-managed super funds.

It’s not as if these new products are the only way of getting international index exposure, though. Managers offering international index funds to Australian investors including AMP Capital, Alliance, BGI, Blackrock, Colonial First State, Dimensional, Macquarie, State Street and Vanguard. Vanguard, for example, offers an international shares fund that invests in 1700 shares listed on the exchanges of 22 world economies. Vanguard, and some other providers, offer hedged and unhedged versions of their international funds so that if you want to you can neutralise the impact of currency movements. Currency exchange changes are something you would need to think about in an ETF investment too.

Some of these managers offer index funds over other international asset classes too, like bonds.