Opinion: Making the case for indexing

As appetite for low-cost passive funds continues to grow in the UK, there is a perception that their price tag is the sole reason for their success. This was an opinion raised by Money Management editor Jon Cudby in his most recent opinion column.

Like a credit-crunched shopper switching from organic to own-brand, or a holidaymaker switching from two weeks in the Med to a staycation, a number of investors and advisers seem to be shopping in the investment bargain basement and accepting a cheaper product.

It may be the case that some of the drift toward lower cost funds is purely price-driven, and some of the customers are nervy investors or advisers fleeing the too-interesting world which some active funds have experienced over the past few years.

But as well as short-term caution there are more fundamental strategic reasons for the growth of interest in low cost funds, which will outlast any current appetite for austerity.

One reason is that the inherent difficulty in picking tomorrow’s provider of Alpha, based on yesterday’s data, is increasingly understood.

On average, active managers in UK equities and bonds have failed to beat a broad market benchmark over the long term, e.g. five, 10 and 15 years, Vanguard research shows in its Case for Indexing report.

Of those funds that do outperform, leadership is quick to change. A top-ranked fund over the five years to 31 December 2004 was more likely to be bottom ranked/closed over the next five years to 31 December 2009 as stay top ranked. In this world you do not get what you pay for.

A big part of the reason for this failure is cost. Active funds tend be more expensive because they cost more to run and sometimes because they have more cachet. But the brutal negative compound effect of costs over time means that more than two-thirds of funds have not beaten their benchmark, Vanguard’s research shows.

There will always be some investment supercars ahead of the passive funds, but even more lagging behind. And no one knows which will be which.

As a result, advisers are realising that building their business proposition on picking the best investment vehicles is a strategy that sooner or later, is doomed to failure.

Even if they succeed once or twice that is no guarantee of future success. Instead, many are recognising that it is wiser to build a business of the solid foundations of controllable factors such as sound wealth management and financial planning strategies, guidance and controlling costs, rather than by attempting to outperform the market.

Otherwise advisers are staking their livelihoods on guessing something over which they have no control.

That is not to say that we are seeing the demise of the active manager. Vanguard uses talented external, low-cost managers in the US for example. And we should all be worried if large numbers of investors were simply trading in performance for cost. In fact, the idea of a trade-off between low-cost and performance is simply a false opposition.