Active managers and Index funds: How to avoid the pitfalls and get the best of both worlds

From James Kirby at The Australian:

Australia’s big fund managers are now openly bagging index funds and exchange traded funds (ETFs)….Keep away from index funds and ETFs, they cry, the market is too tough for investors to blindly follow an index-style fund when returns are as modest as we have seen in recent times….

But rather than flinging mud back at the active managers…. the passive brigade has instead made two killer moves.

The first move is to reveal quite plainly how the active managers are performing — and they are performing dismally.

The second move is to continually cut prices — or fees — to the point that active managers look very expensive indeed.

Dow Jones’ Indices versus Active Australia Scorecard:

Australian General Equity (Large-Cap) Funds

59.7% underperformed the S&P/ASX 200 Index over one year

69.2% underperformed the benchmark in a five-year period

International Equity General

80.7% underperformed the S&P Developed ex-Australia Large Cap Index in a one-year period

91.9% underperformed the benchmark in a five-year period

I have two major concerns with index funds:

First, index funds reward size, not performance. The bigger a corporation grows, and the bigger its weighting in the index, the more stock an index fund will buy. Over time the index is likely to grow increasingly dominated by a herd of dinosaurs — earning low returns on a large asset pool and unable/unlikely to adapt to change — headed for extinction.

Second, active fund managers perform a valuable role for the entire market, conducting in-depth research of industries, visiting companies and evaluating prospects and performance. Their resulting purchases and sales inform the entire market as to prospective value and under-pin long-term market value. Increasing dominance of passive index funds erodes this capability and will hasten the growth of my first concern.

An easy way to counter the first concern is to invest in equal-weighted index funds. These do not reward size, instead investing an equal amount in each stock in the index instead of weighting by market capitalization.

Apart from eliminating the size bias, the equal-weighted index has another major advantage. It out-performs cap-weighted indices by a sizable margin. The graph below shows the S&P 500 Equal-Weighted Index achieved an annual performance of 8.53% compared to 7.03% for the regular S&P 500 Index, over the last 10 years.

Performance Comparison: S&P 500 (TR) Index v. S&P 500 EWI (TR) Index

The only way to address the second concern is to keep a sizable part of your portfolio with active managers. Don’t blindly follow performance — last year’s winners are often this year’s losers — but follow managers with reasonable fees and proven long-term ability to outperform the index.