The shift to index funds by millions of investors around the world has been one of the most significant developments in modern financial history. This hasn’t been by chance. It is a self-inflicted wound caused by active managers consistently overpromising and underdelivering, while charging significant fees for the pleasure.
This shift has hurt the active management community where it matters most, in the pocket. S&P Dow Jones Indices has estimated that customers of US index funds alone have saved over USD$287b in fees over the 23 years to December 2018. When you add in the growth in indexing around the world, investors are estimated to be saving over USD$50b every year in fees.
Naturally, a disruption of this scale results in attempts to create misinformation. In fact, Googling ‘the dangers of passive investing’ results in 12x the number of hits as ‘the dangers of passive smoking’.
Not all index funds lag their index
The challenge and responsibility of an index manager is perfectly replicating the performance of a hypothetical construct that isn’t burdened with the constraints of the real world. An index holds no cash, it can trade without cost and it always uses the closing market price.
A fund manager’s success at this is measured by tracking difference. Simply calculated as the funds net return less the gross index return. Tracking difference is an important metric as it is a direct measure of total costs an investor faces.
Importantly, with the right controls and operating model it is possible for an index manager to deliver consistent positive tracking difference while maintaining perfect index weights.
Kernel has put a lot of energy into our efficiency, designing and building an operating model specifically suited to the nuances of the New Zealand market. Through this process, and attention to every fraction of a basis point, we’ve implemented an operating model that enables us to leverage the 16 factors we have identified to create positive tracking difference.
Some of the factors that impact tracking difference are:
|Manufacturing error||Not buying all the time at exactly the close price used by index.|
|Transaction cost||Indices don’t pay brokerage, funds do.|
|FX timing and rate||Index FX rate may not be the rate traded by the fund manager.|
|Cash drag||Any cash in a fund drags the performance of the fund. However this is positive if the index performance is negative!|
|Dividend drag||Dividends are reinvested by index on ex-date, but fund does not have the cash to reinvest until payment date and may not be allowed to reinvest dividends.|
|Primary issuances||Companies raise capital as a discount to the market price taken by the index.|
Accordingly in 2020, Kernel funds were able to generate tracking differences of between +0.22% to +0.40% on our NZ funds. So yes – the performance of some of our funds was better than the index.
We can achieve this while perfectly replicating the index holdings and minimising cash, dividend and tax drag by investing all available cash immediately.
Our fund weightings match the index to the 6th decimal place and we hold cash balances of 0.9bps to 2.1bps. A positive tracking difference can be achieved while simultaneously maintaining tracking error (the degree of deviation to index performance) to mere basis points.
Liquidity – show me the index fund that’s been frozen?
The scenario of what if all of a sudden masses of index investors rushed to the door and wanted to exit, the result would be market carnage with index funds unable to find enough buyers to fill the flood of forced index selling.
Given index investing has been around since the 1970’s, you would think this argument would have been put to bed as it ignores several key points.
Firstly, the investor base in index funds is exceptionally diverse, ranging from retail investors through to global pension schemes. This significantly reduces the risk of collective selling during any form of market correction.
Index investors are also very long term focused, they’ve made a strategic decision to invest in index funds based on the persistent data that shows index funds are hard to beat over the medium to long term. They tend to be less responsive to short term market noise.
Secondly, the hypothetical scenario isn’t actually an issue of active vs index. If the majority of investors in actively managers funds decided to sell, the potential need for active managers to realise cash would cause equally distorting impacts on the market.
Finally, let’s not forget listed index funds – ETFs. A structure that was actually created on the back of a report into the 1987 crash and developed in an attempt to reduce market volatility during a correction.
With ETFs, investors can sell their position in an index fund on market, without the need to sell the underlying assets. If no buyer can be found, natural supply and demand would take over with the ETF units selling at a discount until opportunistic investors jumped in, all the while avoiding the need to sell underlying assets.
“We will add value in a correction”, says the active manager. We say maybe not.
Warren Buffett famously said “when the tide goes out, you’ll see who’s been swimming naked”.
Active fund managers have long defended their high fees and underperformance during bull runs by stating their value will be proven in the event of a correction or crash, claiming their research and close scrutiny of the market equips them with the foresight to shift portfolios appropriately.
Looking at NZ equities, the year ended December 2020 quarter-end data in the MJW Investment Survey showed:
- 13 out of 17 New Zealand equity funds did outperform the S&P/NZX 20 index, before fees and taxes for the year-ended December 2020.
- However, in the 10-year comparison, 11 out of 14 actively managed NZ equity funds underperformed the S&P/NZX 20 index. That’s almost 80% of fund managers underperforming in the long term, before fees.
We acknowledge that in any one year, some active managers can outperform their benchmark, it’s just highly unlikely that this can be repeated year on year with assured consistency.
Therein lies the challenge with relying solely on annualised performance figures – which can skew the truth of an investors returns.
The decade that was
Annualised returns figures for active managers can be deceptive; it’s the results of their cumulative alpha that is key. Last year Kernel undertook a review of active managers over the past decade to year-end 2019 to assess whether there was any persistent outperformance.
We use the S&P/NZX 20 index as the benchmark, which we argue is a more appropriate benchmark for NZ equities given its sectoral alignment to the S&P/NZX 50, it’s 80% coverage of the market weight, and the number of constituents closely aligning to a number of actively managed NZ equity funds.
The average annualised alpha of all funds was -2.52%. Only two funds had positive annualised annual alpha, both of less than 0.69%. The range of annualised alpha per fund was between 0.69% to -9.26%.
The fund with annualised alpha over 10 years of 0.69% had in fact achieved this through one good year early in it’s life, subsequently delivering a cumulative alpha of negative 26.22% over the entire period. The average cumulative alpha for all funds was -18.86%.
The majority of the positive contribution to a fund’s cumulative alpha tended to have been delivered early in the fund’s lifecycle and is concentrated in just one or two years of exceptional performance. Hence lies an investors’ challenge with taking headline performance numbers at face value.
Index funds come in many styles.
Today, there are thousands of index funds available for investors to choose from. These range from the common market cap weighted indices through to thematic index funds powered by artificial intelligence.
Market cap weighted indices still hold the majority of assets globally. This doesn’t mean a disproportionate amount of buying power is put into larger companies and it doesn’t mean price discovery is impacted.
The assets flowing into a market cap weighted index are buying shares in a company proportionate to their capacity to accept the investment flow, as per this example of a hypothetical two stock market cap weighted index, with an index fund investing $5m of new capital.
|Company A||Company B|
|Company market cap||$50m||$25m|
|$ amount index fund needs to buy||$3.33m||$1.67m|
|Purchase as % of companies market cap||6.67% ($3.33m/$50m)||6.67%|
With a market cap weighted index, there is no greater weighting placed on the investment flow that would result in larger cap stocks increasing in value proportionally more than smaller cap stocks within the index.
And let’s not forget that in the US, where index funds have over a 30% market share, trading volumes associated with index funds are less than 10%, meaning 90% of all trading activity is still undertaken by institutions and individuals making an active decision. It is this trading that sets prices, not the share of ownership.
New Zealand is no different
Active management has become more difficult, it is no coincidence and it isn’t market specific. There are several structural and statistical factors of equity markets that explain why active management underperforms:
Portfolio management is a zero-sum game; the only source of alpha for the winners is the negative alpha of the losers. When most of the assets in a market are professionally managed, the average professional can’t beat the market because the average professional is the market.
When professionals become the dominant force in a market, the average professional cannot expect to outperform. It is relative skill, not absolute skill that matters.
It’s not a coincidence that the first index funds were launched in the 1970s. By that point the U.S. equity market had been largely professionalized and there have been an ever decreasing percentage of unskilled amateur investors to take advantage of with informational asymmetry.
With the professionalisation of the industry, increased global coverage, depth of our regulatory oversight and the growth in financial professionals, New Zealand is now structurally the same as all other development markets. The result is persistent underperformance of active management, a trend which will only continue in one direction.
The distribution of stock returns is positively skewed—i.e., most stocks underperform the market average. Skewness handicaps stock picking; relatively few stocks outperform the average return.
Over the last 25 years, big winners within the S&P 500 have been few and far between, and the punishment for missing out on their returns has been commensurately severe. This is the nature of equity markets, and it is this very statistical challenge that makes stock picking so hard.
Of the stocks that were listed on the NZX between 2003 and 2019, few returned more than average. The probability that a randomly chosen stock would deliver above average performance was not 50%, but over 75%!
When fewer stocks outperform, active management is harder.
In addition to these structural constraints there are manager level constraints that contribute to persistent underperformance.
With the average actively managed US equity fund in 2019 being 0.67% more expensive than the average index fund there’s a performance hurdle that needs to be overcome just to reach parity with an index equivalent.
A further challenge for New Zealand active managers is capacity constraints. With the vast majority of managers operating open-ended funds, as contributions and their funds have grown, it has become increasingly difficult to implement active decisions that can result in a material deviation to the benchmark index.
This issue is compounded by the size of the New Zealand market relative to economy, liquidity constraints, the few number of active managers, and the increasing size of KiwiSaver assets.
While active managers would love to declare index funds as being equally as dangerous as passive smoking, the rise of transparent, equitable index funds is democratising investing and creating greater investor outcomes on a scale not seen before in financial markets.