S&P Dow Jones Indices, the world’s leading provider of financial market indices, recently released its SPIVA Australia Scorecard, a review of active fund manager performance for the period ending December 2016. On the surface at least, it provides yet another damning indictment of the industry. The media was quick to jump on the results and the apparent superiority of passive index tracking funds as an alternative to active fund managers. A closer examination of the data, however, indicates that investors would be wise not to jump to such simplistic conclusions.
S&P: Indices Outperform a Majority of Actively Managed Funds
In their report, S&P state that they "have consistently observed that the majority of Australian active funds in most categories fail to beat the comparable benchmark indices over long-term horizons.”
The data they provide to support this conclusion seems compelling, as illustrated below.
Media Reaction
The media response suggested that the S&P SPIVA report supported “what most industry observers already knew”, with headlines such as:
- “Aussie active funds underperforming: S&P” (The Australian, 20 February 2017)
- “Active managers deliver worst results since 2009” (AFR, 21 February 2017)
- “S&P study finds active fund managers cost investors billions” (The Australian, 22 February 2017)
- “Failure of fund managers to match benchmarks builds case for passive funds” (AFR, 21 Feb 2017)
Methodology Problem
There are several limitations with S&P’s reporting that investors need to consider.
Firstly, S&P base their conclusions on the equal-weighted average fund performance rather than the asset-weighted performance which in their own words “is a better indicator of fund category performance because they more accurately reflect the returns of the total money invested”. When we look at the asset-weighted performance as reported by S&P, we find that the average active fund managers in general Australian equities outperformed the S&P/ASX200 index over five and ten year horizons.
The underperformance in 2016, which appears to have also dragged down the three-year result, was most likely due to many active fund managers being underweight the banking and resource stocks early in the year and missing out on the subsequent rally in these sectors. Nevertheless, we do not consider one year returns to be a meaningful indicator of active manager performance as short-term deviations from the index are to be expected.
The second limitation is that S&P compares the performance of fund managers to indices but investors can’t invest directly in those indices. They instead must invest in index funds that attempt to track on index but will usually underperform over time primarily because of costs. Taking an example of the largest Australian equities index fund, offered by State Street Global Advisors (ASX:STW), the index fund performance is 0.3% below the index, as illustrated below.
A Re-examination of Fund Performance
Given the methodology limitations described, we have re-analysed the performance of active and index funds in three categories: general Australian equities, mid-small cap Australian equities and international equities.
General Australian equity funds
When compared against the index fund alternative, the 300+ general Australian equity funds on average outperformed the passive alternative on all time horizons other than one year (after fees, asset-weighted). The outperformance was greatest on the five and ten year horizons at 0.6% p.a..
Mid-SMall Cap Australian equity funds
The asset-weighted return for the 80-100 managed funds investing in mid-small companies was significantly higher than the index fund alternatives over the five and ten year horizons. Their performance over the one year horizon, however, was well below the market as many missed out on the cyclical shift from growth stocks to resources.
It is interesting to note that the mid-small cap index underperformed the S&P/ASX 200 index over the five and ten year horizons even though active managers were able to outperform both. This supports the view that greater returns can be generated in the small/medium cap sector but only through a selective approach.
International Equities
Over a five and ten year horizon, the asset-weighted return for 200+ international equities funds was significantly below the index return. At the same time, only 7-11% of funds outperformed the index.
Risk Reduction during Severe Corrections
Looking at short term performance of active and index funds ignores one potential benefit of using an active fund; the ability to reduce the impact of a severe market correction.
During the Global Financial Crisis (June 2007- November 2008), the Australian market index (and index funds) fell by 54%. According to the first SPIVA Scorecard published for Australia (Year-End 2009), the three year return for the asset-weighted average fund was higher for general Australian equities, small-mid cap Australian equities and international equities, as illustrated below.
Key Conclusions
The S&P results support our view that index funds should only be used for diversifying portfolio holdings across asset classes and sectors where suitable active alternatives cannot be found.
Index funds should be avoided for general Australian equities
We believe that there are high quality Australian active managers capable of generating superior returns over the long-term. In addition, the structure of the Australian market, with its high concentration in banking and resource stocks, increases the potential risk exposure for investors using index funds (refer to our white paper on The Perils of Indexing). Non-index aware active managers are able to reduce exposure to these sectors when prices become elevated.
Investors, however, should avoid general equity fund managers that tend to ‘hug the index’ as their higher cost structure will result in serial underperformance relative to the index and passive index funds.
Small to medium size companies offer the best long-term return potential
Market inefficiencies in asset pricing are more prevalent in the small to medium cap sector, creating more opportunity for the active manager to generate above market returns over the longer-term. Market inefficiencies, however, can lead to over and under pricing which makes this sector unsuitable to an index based investment approach.
High quality specialist active managers are the preferred means by which to gain exposure to this sector.
Index funds are a suitable option for international diversification
International equity managers, particularly those based in Australia, are less likely to generate outperformance due to the efficiency and competitiveness of the markets in which they invest. For investors looking to diversify their assets beyond the Australian market, index funds present a suitable low-cost option.
As with Australian equities, however, we have identified internationally based equity managers that have generated superior long-term returns and that provide greater protection against market falls.
In conclusion, we find that the S&P report supports our view that index funds have a role to play in portfolio diversification but that active investment strategies are critical to maximising long-term wealth creation.
References & Notes
SPIVA Australia Scorecard Year-End 2016, S&P Dow Jones Indices (20 Feb 2017)
This article is issued by JJT Advisory Pty Ltd (ABN 83 613 456 063) and is intended to be general information only without taking into account the investment needs, objectives and financial circumstances of any particular investor.
Past performance is not a reliable indicator of future results.