The Three Benefits Behind Indexing’s Success

By Robin Bowerman | More Articles by Robin Bowerman

Success attracts supporters, detractors and imitators – just ask any premiership-winning sports team.

The one thing every member of a winning team knows is that when the next season starts they will have a target on their back – the hunter quickly becomes the hunted, as the Western Bulldogs in the AFL and the Cronulla Sharks in the NRL understood all too well as their respective 2017 seasons unfolded.

In the investing world, index investing and more specifically exchange traded funds (ETFs) have been kicking goals in recent years and the growth in assets and a growing global investor base has drawn both attention and criticism.

The phenomenon of the growth in indexing is real enough and Vanguard has been at the forefront of it both in the US where it launched the first public retail index trust more than 40 years ago, and in Australia where we have been offering index investment management to local investors for more than 20 years.

Critics of indexing suggest the growth is a cause for concern, potentially sowing the seeds of future financial instability and/or market volatility.

Much of the public debate seems to be based on the fear of the unknown – can indexing get ‘too big’? Will ETFs destabilise markets in a sell-off?

So perhaps it is timely to step back and look at the fundamental reasons why indexing has been increasingly used by both institutional and retail investors around the globe, and importantly, the benefits that have flowed to investors as a result.

There are three key drivers of why indexing has enjoyed sustained growth at a time active management has seen net outflows – the zero sum game theory, the impact of costs and the difficulty of picking active managers who outperform the market over the long term.

The intellectual underpinning of indexing is based on the notion of a ‘zero-sum game’, which simply means that as a broad universe all investors make up the market. At any given time the cumulative holdings of all investors constitutes the market and therefore the aggregate market return is equal to the aggregate return of all investors in the market.

So for every position that outperforms the market there will be someone that underperforms the market by the same amount, which means the average aggregate return for all invested assets is zero. Note that this is not an argument for market efficiency and the logic applies whether markets are rising or falling.

The zero sum game is a theoretical construct where 50 per cent of investors outperform and 50 per cent underperform in a standard bell curve distribution. But of course in the real world there are real costs to be counted such as transaction costs, fund manager costs and taxes to be paid. So in the real world more people will underperform the average market return after costs are properly accounted for.

The impact of costs – both on the long-term outcomes for investors and as a driver for the growth of indexing – is hard to overstate.

Investing in a low-return environment, which we expect will continue for the foreseeable future, brings costs into sharp focus. If your portfolio is earning double digit returns yet underperforming the market slightly then cost is easily overlooked, particularly when the hope of outsized returns in the future is being promoted.

Combine the low-return environment with a regulatory landscape that has tightened up both on fee disclosure and the way commission payments or rebates could distort product recommendations by advisers and it becomes clear that many advisers have – to the benefit of their clients – shifted their business approach to be more focused on costs and the importance of asset allocation.

The third driver of the growth of indexing is the challenge of finding managers who can persistently outperform over time. There is a considerable amount of academic research that shows that over the long run, the majority of active managers will underperform the market return.

That does not mean there is not an important role for active management going forward. Indeed amongst all the criticism of the growth of indexing the simple fact that is often overlooked or lost in claim and counterclaim is that despite the strong growth in indexing, it remains a relatively small part of global investment markets.

Indexing represents around 15 per cent of global market capitalisation of sharemarkets and 5 per cent of fixed income markets. In Australia indexing represents less than 20 per cent of the local managed investment market, so concerns that the growth of indexing is compromising price discovery is misguided.

Active management has a fundamentally important role to play in both price discovery and in giving investors choices about how they want to implement their investment portfolio and manage their risk.

There is also a misconception that indexing is a monolithic form of investing – as if all index funds are taking the same approach. The growth in indexing has meant the development of a wide spectrum of product offers increasingly focused on market factors or specific sectors. In many ways, this new generation of indexing tools are active bets away from the broad, market capitalisation-weighted indices that laid the foundations for index management.

Whether some of these new products pass the test of time remains to be seen but what it is certainly doing is giving investors and advisers more tools in the portfolio construction to choose from.

In the meantime what is not in dispute is that millions of investors globally have adopted index investing to some degree within their portfolio and have benefited from the lower costs as a result.

Robin Bowerman

About Robin Bowerman

Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia. As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment.

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