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It's time to reassess the active/index debate

04 April 2018 | Portfolio construction

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Commentary by Matthew Lumsden, head of distribution for Vanguard in Australia.

Active index debate graphic

As an industry we tend to get hung up on the active/index debate.

Proponents of indexing argue that active fund managers struggle to outperform the market. And proponents of active investing argue that there's room for quality managers to deliver value, particularly in asset classes like small caps.

I'd like to step back a little from the fray and take a wider lens.

It's all about the cost

It's a truism to say that indexing has gained traction over recent years. Bear in mind, though, that in a number of countries indexing is still a small share of the market. To paraphrase Mark Twain, reports of the death of active management have been greatly exaggerated.

But what's more interesting is the following graph, where we've applied a cost-based lens. Since the turn of the millennium, there's been a steady move away from higher-cost funds into lower-cost alternatives.

Investors recognise the benefits of low costs

Cumulative equity fund net cash flows by cost quartiles:

Cumulative equity cash flows

Notes: Figures are in US dollars. Expense-ratio quartiles were calculated annually. Equity funds represented by Morningstar US equity category. Each quartile represents 2016 asset-weighted average expense ratios, determined by multiplying annual expense ratios by year-end assets under management and dividing by the aggregate assets in each quartile. Data are as at 31 December 2016. Source: Vanguard calculations, based on data from Morningstar, Inc.

Many of these lower-cost funds are indeed index funds ... but by no means all. And we shouldn't confuse index investing with index outcomes. Many investors use index funds within a portfolio that delivers an overall active return.

The point is that investors don't care as much about the style of investing as they do about the cost of investing. Whether it's index or active, smart beta or factor, value or growth, the single most important factor is cost.

Ask why before how

The more returns investors keep, the more they can earn over time. That's true whether the low-cost fund is active or passive.

Vanguard's investment philosophy has guided us since our founding more than 40 years ago. We communicate it via just four investing principles: create clear, appropriate investment goals, develop a suitable asset allocation using broadly diversified funds, minimise cost and maintain perspective and long-term discipline.

Investors should select funds based on how well they align with their investment goals. The decision about which investment style to employ is secondary. Once investors have clearly defined goals and an asset allocation plan in place, then – and only then – should they look at the best way to implement their strategies.

  • It might be a core-satellite approach with a low-cost index core surrounded by active satellites.
  • It might be a factor-based active fund that uses factors to seek a specific outcome.
  • Or it might be a combination of low-cost ETFs delivering access to thousands of securities in just a few trades.

For most investors it's likely that a combination of active and index styles will suit their needs. But what's important is not the style of investing, but keeping costs as low as possible to help them achieve their ultimate goal of investment success.

Matthew LumsdenMatthew Lumsden
Head of distribution, Vanguard Investments Australia

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 article is directed at professional investors and should not be distributed to, or relied upon by, retail investors.

This article is designed only for use by, and is directed only at, persons resident in the UK. It is for educational purposes only.

This article was produced by The Vanguard Group, Inc. It is not a recommendation or solicitation to buy or sell investments.

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 the individual author and may not be representative of Vanguard Asset Management, Limited.

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

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