There are three main reasons why low-cost index funds can be a staple in many investment portfolios.
The use of index funds has been questioned time and time again, but the evidence and rationale supporting the use of low-cost index trackers to provide diversified access to global equity and bond markets still stands. To rise to the challenge.
This does not mean that there is no case for active. Although Vanguard is synonymous with index investing, our roots are in active management – our fund lineup when we launched in 1975 included 11 active funds – and it’s probably our best kept secret that we’re one of the largest active investment managers in the world.
We believe this gives us a good perspective on the asset-liability conversation and we believe low-cost active funds have a place for investors comfortable with the risk of underperformance looking for alpha.
At the same time, we see three main reasons why low-cost index funds can be a core holding in many investment portfolios: zero-sum game theory, the cost effect, and the difficulty of persistent outperformance.
Zero-sum game theory
At the heart of index fund investing is the zero-sum game theory, which states that, in short, for every position that outperforms the market, there must be a position that underperforms the market by the same amount. , i.e. the excess return of the aggregate of all active positions is equal to zero.
In other words, before fees, a total market index fund provides market performance while the probability of active funds beating the average market return is “only” 50%.
Cost effect
The zero-sum game describes a theoretical market with no fees, which does not reflect reality. Thus, after costs, the probability of beating the market by mere chance is, by definition, less than 50%.
This point is illustrated in the chart below, which shows the distribution of returns above their benchmarks for all equity mutual funds and ETFs available for sale in the UK, net of fees, over a 15-year period until the end of 2021.
Breakdown of excess returns from UK equity funds and ETFs
Source: Vanguard
The data captured in the chart includes assets invested in mutual funds and ETFs, so it does not cover the entire market, but the overall message remains true: the majority of funds analyzed have not provided excess returns after taking into account costs in the form of expenses. ratios over the period. The results were similar for UK bond funds and ETFs. In short, costs eat away at investors’ returns and make it harder to outperform after cost. The higher the cost, the harder it becomes to outperform.
Persistent outperformance is rare
We’ve established that outperformance is difficult with net excess returns often subzero, but what about active funds that outperform? How consistent are their performances?
We analyzed the performance persistence of all active equity funds available in the UK over a 10-year period ending 31 December 2021 and found that only 26% were able to maintain a rank in the top quintile from the first five years to the second five-year period. .
Therefore, although not impossible, consistent outperformance is very difficult to achieve. Additionally, our research reveals that the majority of funds that outperform their benchmark over the long term underperform for a number of years until they eventually beat their benchmark, meaning that Investors need to be patient to allow alpha to materialize over the long term.
Active or indexed? The answer is low cost
At Vanguard, we know there are talented active managers who can deliver persistent net outperformance relative to their benchmark or the market in general. This is why our considerations are not based on absolute values but on probabilities – and the likelihood of persistent net outperformance depends on the skills of the manager, the costs of the fund and the patience of the investor.
The zero-sum game combined with the cost pressure on performance creates a significant hurdle for active managers in their attempts at net outperformance. This obstacle grows over time and can become insurmountable for the vast majority of active managers.
Therefore, for most investors, a low-cost, broad-market index fund is an ideal base holding. However, if an investor wants to invest in the pursuit of above-market returns and is comfortable with the risk of underperformance, we believe a well-diversified, low-cost active fund could add value to their portfolio. over time.
Jan-Carl Plagge is Head of Active-Passive Research at Vanguard Europe. The opinions expressed above should not be considered investment advice.
