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The future's bright, the future's low-cost index-fund investing

24 July 2018 | Markets and Economy

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Commentary by James Norton, senior investment planner for Vanguard UK.

When it comes to investing, there are two management styles to consider — passive and active. For investors who simply want exposure to a particular market or asset class, passive funds, also known as tracker or index funds are ideal. They aim to produce a return (before costs) as close as possible to a given market or index. Active funds, on the other hand, deliberately deviate from the index with the aim of producing higher returns. They tend to take on more risk in this pursuit of higher returns.

Should investors pass on passive?

When investors choose an active fund, there is a very significant chance, before costs are taken into account, that it will do what it sets out to do and deliver returns stronger than the market. But research has shown that, once costs are factored in, the chances of active fund outperformance are much lower.

However, over some time periods active funds have performed quite well, whereas index funds don't even attempt to outperform the market. So if active funds offer a chance of beating the market, surely that's where investors should be putting their money, right? Well, in 2017 that argument might have seemed sound.

A look at 12-month returns over that year show that across most equity markets, the majority of active funds outperformed. As Figure 1 shows, this was the case in global equities in general and in UK and European equities. Only in the United States and emerging markets did active funds underperform. For bond markets, the picture was a little more mixed, with active managers across global, UK government and European diversified bonds all underperforming.

Figure 1: Percentage of active funds that underperformed relative to their benchmarks over 12 months

Figure 1: Percentage of active funds that underperformed relative to their benchmarks over 12 months

Data as at 31 December 2017. Past performance is not a reliable indicator of future results. Fund classifications provided by Morningstar. Prospectus benchmarks reflect those identified in each fund's prospectus. Fund universe includes funds available for sale in the UK. Fund performance is shown in GBP terms, net of fees, gross of withholding tax, with income reinvested, based on closing NAV prices. Sources: Vanguard calculations, using data from Morningstar, MSCI, CRSP, Standard & Poor's, Barclays.

However, while 2017 suggested that active management was the approach to follow, especially for equities, investors need to consider the longer-term picture. As soon as we start looking at returns over longer time periods, the story starts changing dramatically and the majority of actively managed funds start underperforming. This is the case across both equity and bond markets.

In fact, the longer the time period being analysed, the greater this underperformance becomes. As Figure 2 shows, over a ten-year period, more than 85% of actively managed global equity funds underperformed their benchmarks. This means that investors had a less than one in five chance of picking a winning fund. For UK investors in US equity funds, the odds of picking a winner were even worse, with more than 90% of actively managed US equity funds missing out on market-beating returns.

Figure 2: Percentage of active funds that underperformed relative to their benchmarks over ten years

Figure 2: Percentage of active funds that underperformed relative to their benchmarks over ten years

Data as at 31 December 2017. Past performance is not a reliable indicator of future results. Fund classifications provided by Morningstar. Prospectus benchmarks reflect those identified in each fund's prospectus. Fund universe includes funds available for sale in the UK. Fund performance is shown in GBP terms, net of fees, gross of withholding tax, with income reinvested, based on closing NAV prices. Sources: Vanguard calculations, using data from Morningstar, MSCI, CRSP, Standard & Poor's, Barclays.

Time to make a difference

As has been shown above, time is a very important factor when it comes to investing. Short-lived forces, such as market cycles and even simple luck, can significantly impact short-term returns and mask the relative benefits of low-cost investing — generally lower investment costs and the lack of persistent outperformance from active funds.

In terms of costs, a short time horizon can reduce a low-cost index fund's performance advantage. This is because the impact of lower costs compounds over time. For example, a half percentage point difference in fees between a low-cost and a higher-cost fund will not have much impact on the funds' performance over a single year, but that same differential compounded over longer time periods can lead to significant differences in the performance of the two funds.

In life, time can be a great healer for a broken heart. In investments, it can equally work wonders for the health of your portfolio.

James NortonJames Norton
Senior investment planner, Vanguard UK

Investment risk information:

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.

Other important information:

This document is designed for use by, and is directed only at, persons resident in the UK.

The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.

The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.

The opinions expressed in this article are those of individual authors and may not be representative of Vanguard Asset Management, Limited.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

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