Active vs Index Investing
Last year, when US basketball star LeBron James asked Warren Buffett for investment advice, Buffett advised him to buy an index fund. “Usually the simplest [idea] is the best,” said Buffett. His advice added to the debate about the merits of active fund management versus index investing.
This debate, has attracted renewed attention in the media of late, and it is a legitimate question to ask. However, the discussion tends to be framed in terms of “which one is better?”, which, to my mind, is the wrong way to think about it.
The maths of active investing are such that, on average, active managers won’t deliver market-beating returns. Outperformance is a zero-sum game, and for one investor to hold a portfolio that outperforms (i.e. returns more than the market average), another needs to hold a portfolio that underperforms (returns less than the market average). This is the nature of averages.
When fees are added to the mix, the average net performance offered by active fund managers to their investors will necessarily be below the market average.
It follows that if you had to offer the same piece of advice to all investors, you would advise them to invest in an index rather than with an active manager. As a group, they would be better off to the extent that they can still achieve the average market return without paying undue fees.
However, it is also true that some active managers can consistently beat the market, even after fees, and if you can identify these managers you are better off investing with them rather than an index.
Debating whether active management as a whole is better than index investing is missing the point. The question that matters is whether you can identify an exceptional manager. The answer to this question tells you which style of investing you should prefer.
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
peter
:
In 1984 Warren Buffett gave a speech to the Columbia University Business School on this very issue.
An article titled “The Superinvestors of Graham and Doddsville” which was based on this speech was published in Hermes, the Columbia Business School Magazine.
A reproduction of this article can be found in the following link.
http://gdsinvestments.com/wp-content/uploads/2015/07/The-Superinvestors-of-Graham-and-Doddsville-by-Warren-Buffett.pdf
Mark
:
I think with respect, to ordinary investors, “which one is better” is the right question to ask. All they mean by that is “which one / where can I maximise my returns”. I don’t think normal investors care for the merits of investment styles or strategies.. they just want to know where they can get good returns.
Your comment that some active managers consistently best the market may be true – but honestly it’s very hard to find active managers that beat the index consistently. I’ve had a look myself through the reported 3 and 5 year returns of about 40 funds on my super platform – 1 in 40 beat the asx200 on 3 year and 5 year basis. The other 39 failed. This is why I think warren buffet’s advice is generally sound – most active managers don’t beat the index in the long run.
Why pay fees for underperformance against the most basic strategy requiring no skill – just hub the index.
Actually the innovation I would like to see is “index guaranteed” returns. And I’d be happy to pay higher fees on the excess above index. Eg: if index return is 5%, then any net performance below 5% means nil fees to fund manager, anything above means higher fees than normal. I’m happy to pay higher because I’m beating the index. If active fund managers were any good, they would back their own skill and ability to beat the market, and offer a minimum return = index. The fact they won’t says to me they don’t have competence to beat the Asx 200.
Will Montgomery Fund offer a “minimum return = asx200” guarantee ?
Regards
Mark
Tim Kelley
:
That’s actually a very sensible proposal in terms of fee structures, mark.