Active vs Passive Investing: Are You Settling For Average?

It is 48 years since the launch of the first index fund - arguably one of the most significant developments in capital markets in the past century.

Originally ridiculed by Wall Street, who argued “what investor would want to settle for ‘average’?", index investing has gone on to fundamentally reshape the way many investors think about investing and building long-term wealth.

Decades later, repeated research shows that index investors in fact aren't settling for average; rather, the average index investor achieves above-average results – as the majority of actively managed funds underperform their respective market indices, especially over consecutive periods.

Naturally, with any disruptive change, debate ensues. Add in the fact that in the US it is estimated that over half a trillion dollars has been saved in fees and underperformance by investors who have moved from active funds to index funds over the past 25 years, the debate is likely to get heated.

At its peak, the active vs. passive debate took on the form of highly emotive religious opponents battling for supremacy as a single winner. The index fans touted decades of performance metrics, while active managers often conceded the challenges in rising markets and flagged that for various reasons the future would be different.

But throughout these debates, the key points are often missed. Why is it that index funds seem to so consistently outperform? What makes equities so hard to predict? And with that knowledge, how should investors actually think about allocating their hard-earned dollars?

First, let's be clear that there are now millions of indices in operation – be it tracking the performance of a basket of commodities through to the well-known benchmarks like the S&P 500.

The vast majority of equity index funds track broad, market-capitalisation-weighted indices. However, with advancements in technology, the ability to create different versions of index strategies has grown.

What used to be only available in the domain of large sophisticated investors can often now be turned into a simple rule set and run in the form of an index.

• Seeking a low volatility, high dividend strategy? Great, it's available in an index.

• Want exposure just to a particular sector? Great, it's available in an index.

• Seeking to invest in an emerging technology theme? Great, it's available in an index.

Indices are available in all shapes and sizes, often doing opposing trades.

For now, let's remain focused on these core market-cap building blocks, the promoted benchmarks of “the market”, which make up the vast majority of indexed assets globally and can often act as the core in most investor portfolios.

Market-cap-weighted indices simply weight the securities in the basket based on their market capitalisation. The bigger the company, the bigger the weight.

There are plenty of nuances, such as liquidity filters, free float factoring, and so forth, but for the most part, these indices represent the core of a particular market exposure, such as the S&P/NZX 50 index in New Zealand or the S&P 500 index in the US.

An index itself is hypothetical; it doesn't suffer from the constraints of the real world – such as brokerage fees, liquidity, and spreads. The job of the index manager is to give investors the return of the index usually through replicating its composition.

Now let's be very clear: this sounds easy in practice, but there is a lot of nuances behind the scenes, including how an index fund can give investors the return of the index, even after fees. But we will leave that for another day.

So, how often is an index fund trading? This is regularly misunderstood. With a market-cap-weighted index – hardly ever. If there was no new money into the fund, then for most core indices, the trading would occur quarterly when there is an index rebalance.

This is when companies may be added or dropped from the index, or there are adjustments to the weights for some other factor. In between these dates, you will have trading events triggered by various corporate actions, such as a merger or rights issue.

With Kernel, we are seeing a lot of growth in demand for our products, which means that when there are daily positive net applications, we may need to trade to buy more underlying securities to create new units.

The frequency of trading depends on the percentage of cash in the fund (usually below 1%) and the net applications in proportion to the fund's size.

So how does an index fund buying assets in the market, proportional to the market capitalisation, impact single securities?

At first glance, the net buying or selling of an index fund could be assumed to exacerbate the rise or fall of the higher-weighted securities over time.

What investors need to realise is that a market-cap-weighted index is in fact buying in equal weight proportionality.

The below example breaks down the flow of money in a hypothetical index and index fund.

Working through each step, the "Value bought as % of company value" column is the net result.

As the fund buys shares in each respective company to make up a basket that reflects the weight of the index, the amount and value of shares bought in each company is equally weighted across each, in proportion to the respective company's market cap.

In this example, the fund is placing an order to buy effectively 10% of the market cap of each company.

The equal weight of the order across all companies results in no positive or negative distortion to any individual security, all other factors being equal.

When thought about through this lens, it makes sense. A market-cap index is just buying everything in the market proportionally.

If using the above example Company C doubles in value(and no other changes occur) the proportion weights change.

However new money still buys an additional 8.3% of all companies.

But does more ownership by index funds distort company value? Not often. First, let's consider money flowing into index funds that need to keep buying up more shares over time.

Is this of concern? Well, I'd argue that this isn't actually an active vs. passive concern; it is simply a flow of capital concern. If that money is net new money into the share market (i.e., it has moved from another asset class), that is new capital buying up shares which will create upward pressure on the market.

However, the same would be true if buying direct stocks or via an active fund. The upward pressure on prices is reflective of the collective flow of capital – as interest rates fell, more money moved out of savings accounts and into the share market, which overall drove values higher.

Bonus note: We should call out one of the benefits of an Exchange Traded Fund (ETF) is that it reduces the buying/selling pressure on the underlying securities in a market.

Rather than trading the underlying assets, investors can exchange existing units in an ETF on the market in real-time – with no impact on the underlying assets. It is akin to warehousing of finished goods.

In fact, the concept of the ETF emerged from thinking post the '87 crash in the US and how to create a separate mechanism for liquidity without impacting the market.

This is a popular topic of academics, especially in the US where there are decades of high-quality data that can be analysed. One of the most interesting papers on this topic is "Do Stocks Outperform Treasury Bills?" by Hendrik Bessembinder, published in the Journal of Financial Economics.

Key findings from this seminal paper include:

1. The majority (58%) of common stocks that have appeared in the CRSP database since 1926 have lifetime buy-and-hold returns less than one-month Treasury bills.

2. Only the best-performing 4% of listed companies explain the net gain for the entire U.S. stock market since 1926. The other 96% of stocks collectively matched Treasury bills.

In a follow-up global study looking at 64,000 global stocks from 1990 to 2020:

• 55.2% of U.S. stocks underperformed Treasury bills

• 57.4% of non-U.S. stocks underperformed Treasury bills

• Meanwhile, the top 2.4% of firms accounted for all of the $75.7 trillion in net global stock market wealth creation

Of course, there is a fine balance between academic theory and then applying these to the real-world practical experience of an investor – as many investors who have been Value style advocates have experienced over the past couple of decades.

Looking at this concept in another lens, we can model out the skewness of equity returns. By placing into bars, the returns of NZX listed companies within the S&P/NZX 50 index from December 2004 to December 2024 (total 111 stocks formed part of this index over that period) and bucket their return from when the stock was in the index.

Some have gone bankrupt, or have been acquired/privatised, or added/deleted from the index, so many returns are from a period shorter than 20 years.

What we see is that there is a large percentage,~40%, that gave investors a negative return to -100% complete failure (i.e. a very bad outcome).

But tellingly, the median return is 19.2%, yet the average is 206.7%. In fact, 77%of stocks appearing within the S&P/NZX 50 Index underperformed the average stock.

During this period, there were 12 stocks that went up over 500% and 5 stocks with 1000%+ returns, driving up the average / index returns.

In short, you have an approximately 3 in 4 chance of picking a stock at random that it performs below average.

Why? Because the average is pulled up by those handfuls of companies that perform phenomenally well.

This tells investors that diversification is important. You want to ensure you have some exposure to those companies that do go on to 10x. Picking those in advance is very hard, and those companies often go on a roller-coaster ride to ultimately end up in their position. The benefit of a market cap index, it ensures you get some of that exposure.

Simple math highlights the challenges of single security selection. It is the nature of equities, and this graph is repeatable across the globe.

Interestingly, the dynamics of fixed income market is the reverse!

New Zealand is a small and highly concentrated market.

Our liquidity is also low. With a decline in the number of listings on the NZX, the top 20 companies in the S&P NZX 50 have accounted for an increasing percentage of the daily value traded - almost 80% from April 2012 -Jan 2023.

In theory, this could create opportunities for active managers to take advantage. However, increased opportunity also creates increased chance of embarrassment.

The challenge of a market with lower levels of liquidity is that it may mean as actively managed funds grow, they are forced to increasingly hold positions in the same way and proportion as the index, as it becomes increasingly hard to manage flows against the available liquidity in the market.

SPIVA (S&P Dow Jones Indices vs. Active report card) is now available to cover New Zealand. This report has been a long-running global reference set on the long-term challenges of actively managed funds vs. index funds.

The report officially benchmarks active NZ equity-only funds against the S&P/NZX 50 index. The most recent results as of June 2024 show some positive results for NZ active managers. On the face of it, maybe there is value to be made, after fees, from an active manager of NZ equities with only 50% underperforming the index over 10 years

However, when we analysed the composition of active NZ equity funds, we found that 8 out of 10 had between 16-31 holdings (average of 25). Similarly, we see that the top 20 holdings typically make up ~90% of the weight of the fund. We’ve previously made the argument that active NZ equity funds should also be benchmarked against the S&P/NZX 20 index.

In 2023, when Kernel benchmarked active NZ equity only funds with 10 years of history, we found that results of note – approximately 9 in 10 of the funds underperformed the S&P/NZX 20 index after fees over 10 years. Typically, there was one or two outlier years where an active fund performed well, only to fail to persist. If investors missed this year, the results would be worse.

Further, increased scale, liquidity requirements or performance risk concerns can force active funds to end up holding weights closer to the index. When we look at the absolute active share of these funds, most had a median security weight difference to the S&P/NZX 50 index of ~1.2%.

However, there were a couple of funds that had quite material weight differences to the index, so called “high conviction”. As above, that could equally result in greater underperformance and embarrassment. Yet, from an investor's perspective, they are at least getting what they are paying for – active management.

When it comes to building an investment portfolio, this is actually what I would want: an active manager that is being active, recognising where they can add value, to what extent and what they can control. And there are some fantastic examples of this in NZ, with very talented individuals running smaller (and capped) funds that have delivered outsized returns.

Of particular note from the official SPIVA report is the 100% underperformance over 10 years of active management of Global equities via a NZ fund compared to the benchmark!

There is no shortage of related matters that can be debate or discussed, so I thought I would share a quickfire summary of some thoughts on these:

Yes, this is an issue! There a couple of NZ companies who are included in a global benchmark and where the size of those offshore funds can result in significant trading on a rebalance date, or when there is an add or a drop. Insufficient liquidity in our market are seeing the number of these decline as ineligible. It is an issue, and an opportunity for active managers to take advantage of.

Touted as an opportunity for active managers to game, the impact is declining as index funds and index providers adjust their approaches to avoid being captive to the closing auction. Equally, the changes in major benchmarks is often a lot less frequent than people assume.

Index funds have now overtaken active funds in terms of flows. Estimates vary that between 30-40% of the US market is held via index funds. But remember, it isn’t ownership that matters, it is the share of trading that matters. Trading determines price and value.

Most estimates are that trades by index linked products currently represent ~15% of trading volume in the US. i.e. price discovery is not impacted. Thought of another way, the fact Walmart has the Walton family as a large shareholder that rarely trades; does this ownership block distort the price discovery – no it doesn’t, as it is the share of trading which matters.

An interesting observation in the NZ market is the large amount of trading which occurs in the NZX daily closing auction. This is a long-running matter, where often 30, 40, 50% of the entire 6 hour day’s volume can be traded in the closing auction.

This isn’t just index money, it occurs every day from all investor segments. The low intraday liquidity on the market means many buyers simply allocate to the close, a reinforcing cycle.

This is handy for us as an index manager, as it means there is a core volume of liquidity trading at the close – the price we want to match in order to match the index value.

Firstly, while it is interesting and important to understand the nuances of investing, the active vs passive debate has matured.

Now, we are seeing a much greater awareness of core-satellite investing, whereby investors, advisers, institutions and more are realising that index funds are simply another tool in the box to help them achieve their objectives.

Thanks to the rise of index funds, investors can build an entire portfolio out of low-fee index funds and achieve their unique goals.

Equally, they may use index funds for some core holdings, complemented with active funds, alternative funds, single stocks or any other investment that they desire.

The benefits of core-satellite investing are multiple:

1. It ensures you have a core that gives you efficient diversification and can get you towards your goals,

2. A core of low-fee index funds can lower your total investment costs, and we all know how fees compound over time, and

3. Active satellites can enhance your overall returns, but you aren't betting your entire portfolio on it.

As covered earlier, I'd argue that investors should be conscious of what they're getting when they add in an actively managed fund.

You don't want to be paying active fees for a fund that closely resembles an index fund that you may already hold, at a much lower fee.

Kernel very much takes this lens. We are not an index manager; we are a data business. We look at the facts, where we add value, and optimise to deliver the best outcome for our customers.

We deliver investors core equity options via low-fee index funds, yet where the facts tell us otherwise (case in point the reverse skewness in fixed income), we may actively manage, such as our Cash Plus fund and NZ Bond fund.

Ultimately, the biggest factors that determine an investor's long-term wealth outcome are actually getting the very basics right – creating good habits, regularly investing, being diversified, getting the risk profile right for your objectives, and not reacting to short-term noise.

Do this, and you have 90% of the puzzle solved.