Index Investing Outperforms the Majority of Actively Managed Investments
Much has been written about the benefits of index investing strategies relative to active fund management. Over longer time periods, most index investing strategies provide superior net performance. Research by Vanguard suggests that over 70 per cent of mutual funds are outperformed by their indices over a three year period, with this rising to just under 90 per cent after ten years (see chart below).
Percentage of actively managed funds outperformed by their index
Source: Lipper, MSCI, S&P, and The Vanguard Group.
The cost savings of index investing is one of the main reasons for this outperformance, and occurs across many fronts. With actively managed investments, not only do investors have to pay higher management fees but there are also significant ‘hidden’ costs resulting from being ‘active’. These hidden costs include greater trading commissions, bid-offer spreads, and market impact costs; and all of these are greater for active funds rather than index investments because of higher turnover and are not always reflected in the fund’s stated Total Expense Ratio (TER).
While there will always be some actively managed funds that outperform index investments on some years, past performance of actively managed funds does not provide a good prediction of future performance and, even with expert advice, many investors are unlikely to predict those actively managed funds that will outperform in a particular period. Furthermore, the cost of selecting the ‘wrong’ active fund is high in terms of possible underperformance relative to an index benchmark.
Frontier uses index investing to deliver the non-correlated beta returns of most asset classes at extremely low cost to investors. The inherent asset class return (beta) is the main driver of portfolio performance and the lowest cost route to access the beta performance is through index investing. Frontier thus provides investors with a significant cost advantage over average actively managed funds through the fee-efficiency of index investing. This outperformance compounds over time to have a significant effect on overall returns.
For further readings on index investing and the costs of active management compared to index investing, visit our Knowledge Bank.