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This article appeared in the March 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Why core-satellite investing using index and active products makes sense.

Photo of Robin Bowerman By Robin Bowerman, Vanguard

An age-old debate ebbs and flows in the Australian funds management industry, with index and active management coming in and out of favour during different investment cycles. There are strong followers of both approaches and much effort spent in "proving" the advantages of each over the other.

(Editor's note: index investing involves trying to gain the same return as a market, while active investing aims to outperform a particular market. An ASX-listed exchange-traded fund is an example of index investing. An unlisted active managed fund is an example of active investing).

In Australia, Vanguard is well known for its index funds and exchange-traded funds (ETFs) and is a strong advocate of index investing. However, in the US almost half the assets managed by Vanguard are invested using active management styles, so in many ways we are agnostic and can see both sides of the argument.

For indexing proponents, the arguments for indexing can be boiled down into two major categories - one academic, the other more practical.

The academic logic that drove the development of index funds is perhaps best captured by the seminal investment book, A Random Walk Down Wall Street by Professor Dr Burton Malkiel of Princeton University that took academic theory and research and presented it in a way a lay person could easily understand. Malkiel's work shone in the spotlight because most US mutual funds of the time did not outperform the market index. That really ignited the debate that continues to this day.

First published in 1973, Dr Malkiel's work took the theory of the "zero sum game" where investors as a universe constitute the entire market and therefore compete with each other. Game theory - a branch of mathematics - says there are three types of games: a positive sum game where everyone wins, a negative sum game where everyone loses, and a zero sum game where some win and some lose.

Zero sum game

The Australian sharemarket, and all other investment markets for that matter, is a zero sum game where players (investors) must fall into one of two camps - those that outperform (winners) and those that underperform (losers).

Active managers argue that they are not concerned with aggregate returns but rather with individual investment performance. In other words, they aim to always be in the outperformer camp by demonstrating particular skill in choosing which shares to buy and sell.

Of course, a theoretical market return does not take into account real-world costs such as the transaction costs that come with buying and selling investments, and then you need to subtract the affect of taxes.

So if you accept the starting point that within an entire market half the investors will do better and half will underperform the market return and you add transaction costs and taxes, you quickly paint the picture of a market universe where the proportion of investors who outperform the market return is in the minority.

But the more practical and possibly more powerful arguments centre on costs and risk. Index funds, like active managers, have to deal with transaction costs and taxes. By their very design - no teams of expensive stock analysts, for example, and low portfolio turnover that keeps tax bills to a minimum - index funds have a considerable cost advantage over most forms of active management.

So the challenge facing any active investor, be they an individual or a professional fund manager, to cover the higher cost drag is high.

There's always a winner somewhere

But still the lure of active management is powerful. Having odds stacked against you has never stopped people going to the racetrack or casino, because the chance that you may be the lucky or skilful one who beats the odds and makes an extraordinary gain is a powerful incentive.

And there may be areas where perhaps you have professional expertise or knowledge and a higher confidence or expectation about a particular company or investment strategy.

In that case it may make sense to put that confidence to the test while understanding the level of difficulty inherent in consistently picking the right securities to hold in a portfolio, particularly over the longer term. In any one year some fund manager somewhere will have got a bet right and will outperform - often strongly. The problem for investors is identifying those fund managers before they outperform.

Unlike performance, costs are a more predictable and controllable element of investing and in investing, unlike other purchasing decisions, you get back what you don't pay for. Simply put, lower fees reduce the headwinds that a fund has to overcome to outperform the market return, regardless of whether it is actively managed or indexed.

The following chart brings that concept to life, showing the cost/return trade-off for two US actively managed funds, one in the lowest quartile of costs and one in the highest. You can see by this the 1.58 per cent performance haircut with the higher cost funds.

Actively managed mutual funds with low costs outperform funds with high
costs 31 December 1995 through 31 December 2010

Cost/return chart for two US actively managed funds
Source: Lipper data for all General Equity funds.

So costs matter, a lot. Research on US mutual funds has shown that a fund's expense ratio is a more reliable predictor of future performance than other factors, including research-house ratings.

Tax considerations are another significant cost affecting overall investment return. After all, the only return that really matters is the one you can put in your wallet or spend in retirement.

Typical active managers have much higher levels of portfolio turnover than an index manager and as a result the portfolio can be less tax efficient, as it can lead to higher realised tax gains.

Mitigate the risks

Investors should also be considering the amount of risk built into their investments. Risk comes in many forms and all investments carry some. However, some risks can be mitigated.

For example, when comparing investment funds you can look at how diversified they are: how many securities does the fund hold? Is there diversity in industry sectors represented? Diversification can mitigate specific security risk that comes with concentrated portfolios.

This is perhaps particularly relevant for individuals actively managing a share portfolio, possibly through a self-managed super fund. It is also where index and active management styles can combine using a "core and satellite" approach to give better outcomes on both risk and cost measures.

(Editor's note: A core-satellite approach typically involves using low-cost index products in the portfolio core, to gain the market return, and higher-cost active funds or shares as portfolio satellites, to gain a return higher than the market).

Sustained outperformance hard to achieve

Research house Standard and Poor's produces the SPIVA report every six months to allow investors globally to see the percentage of active managers who manage to outperform indices over various time periods and in all of the major asset classes in major markets.

Here is the most recent scorecard for the Australian market, at June 2011, showing the percentage of actively managed funds that were outperformed by the market index in each asset class - through Australian shares, Australian small caps, international shares, Australian bonds and Australian listed property.

Report on the percentage of actively managed funds outperformed by the index in each class.

Report on the percentage of actively managed funds outperformed by the index in each class.
Source: Standard & Poor's, Morningstar. Data as of June 3, 2011. Charts are provided for illustrative purposes. Past performance is not a guarantee of future results.

For someone who wanted to choose one approach over another, they might look at this and logically say there was certainly a good case for using an active approach to Australian small-cap funds, given more than 75 per cent of managers beat the Small Ordinaries index over five years.

Whereas for the other asset classes represented by the data, it can be seen how the zero sum game plus costs weighs the odds against outperformance.

Active management has an important role to play in helping investors achieve their retirement savings goals, but perhaps this debate is focusing on the wrong question. Rather than thinking if it is one or the other, perhaps the real question should be what is the right balance for your portfolio between index and active?

Many advisers and individual investors are increasingly using a core-satellite approach which incorporates both active and index funds or ETFs into a portfolio to provide balance and diversification, combined with the opportunity for outperformance.

This approach works to provide a low-cost, diversified core holding or holdings with active funds or individual share satellite investments where an investor has a strong conviction that the share or active fund in question will outperform.

Seek best of both worlds

To illustrate this concept, an investor could incorporate a core holding of 50/50 equities to bonds in two broad market index funds, and augment that core with allocations to active share funds or a selection of individual shares which they have a preference for and conviction in their opportunity to outperform. This approach means the investor has diversified the risk and lowered the cost of the portfolio, while maintaining the possibility of outperformance from the active funds and individual securities in which they have their satellite holdings.

In a fiercely competitive world we should not expect the active versus index debate to go away any time soon. For investors, the challenge is to look beyond that and consider how to get the best out of both worlds.

About the author

Robin Bowerman is Head of Corporate Affairs and Market Development at index fund manager Vanguard Investments Australia. To receive this column by email each week, visit Vanguard's website and register with Smart Investing.

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