Download The case for low-cost index-fund investing for Asian investors

The case for low-cost
index-fund investing
for Asian investors
Adviser brief
The cost advantages of
index investments can
translate into a long-term
performance advantage for
your clients.
This paper is based on
research by The Vanguard
Group, Inc.1
September 2016
A passive investment strategy such as
an index mutual fund or an index-based
exchange-traded fund (ETF) seeks to track
the performance of an index by mimicking
its holdings. Primarily because of their
low-cost structure, well-managed index
investments have generally offered
long-term outperformance relative
to higher-cost investments.
Advisers who index a solid portion of
their clients’ portfolios often provide their
clients lower costs, broader diversification,
minimal cash drag and, for taxable
investors, the potential for tax efficiency.
The sum of these parts can translate to a
long-term performance edge.
Understanding the zero-sum game
In the aggregate, market participants are
playing a zero-sum game. That is, half of
investor dollars outperform and the other
half underperform the market average.
A bell curve can illustrate the game (see
Figure 1), with the market return shown
as a solid black line. In reality, however,
investors pay commissions, management
fees, bid-ask spreads, admin­istrative
costs and, where applicable, taxes—
all of which combine to reduce realised
returns over time.
The aggregate result of these costs shifts
the curve to the left. A portion of the
after-cost dollar-weighted performance
continues to lie to the right of the market
return, represented by the tan region in
Figure 1. But a much larger portion is now
to the left of the solid black line meaning
that, after costs, most of the dollarweighted performance of investors falls
short of the aggregate market return. Given
the difficulty of selecting an active manager
who may consistently outperform the
market, we believe many investors are
better off using a passive approach,
minimising costs so that, over time, they
can achieve a return close to the market
average.
The zero-sum principle holds regardless
of a market’s efficiency. Even in areas
traditionally considered inefficient, such as
international stocks, our research has
shown most active managers fail to
outperform their respective benchmarks.
1 The case for low-cost index-fund investing (Harbron, Roberts and Schlanger, 2016).
Please note: Due to data limitations, data included in the following analysis is reflective of the Asia region excluding
the Japanese market. Asia ex Japan is defined as the following countries: China, Hong Kong, India, Indonesia,
Malaysia, Pakistan, Philippines, New Zealand, Singapore, South Korea and Taiwan.
Figure 1.
Investing is a zero-sum game
Half of all dollars invested will outperform the market return before costs (blue curve). After costs (brown curve), a much smaller portion
outperforms the market return (tan).
Costs shift the investor’s
actual return distribution
Underperforming assets
Market benchmark
Outperforming assets
Costs
High-cost
investment
Low-cost
investment
Source: The Vanguard Group, Inc.
Notes: For illustrative purposes only. This illustration does not represent the return on any particular investment.
Active managers frequently underperform
After accounting for funds that merged or closed during
the observed time period, it is clear that Asia ex Japan
actively managed funds, on average, fared poorly versus
their benchmarks over the past decade. Figure 2 shows
the distribution of excess returns of domestic equity and
fixed income funds, net of fees.
Note that for both asset classes, a significant number of
funds’ returns lie to the left of the prospectus benchmark,
which represents zero excess returns. A clear majority of
funds fail to outperform their benchmarks, meaning that
negative excess returns tend to be more common than
positive excess returns.
Excess returns provide additional insight
A simple percentage can tell you the ratio of active
managers who outperform a benchmark; however, it is
blind to whether the outperformance was 0.01% or
10%. Figure 2 also displays the breakdown of excess
returns by percentage point for active managers in both
equity and fixed income segments.
It bears emphasising that market cyclicality will alternately
favour or impede various market segments. As the time
period lengthens, excess returns should converge around
the average cost drag of active managers.
Benefits of including indexing
in client portfolios
If you have clients who are primarily interested in
obtaining the market return or who wish to reduce a
fund’s volatility around a benchmark, you should strongly
consider index funds and ETFs for their portfolios. Index
funds and ETFs have three key traits that make them
appealing to investors who may have tired of the vagaries
of active approaches.
Diversification. Index funds and ETFs typically are more
diversified than actively managed funds, a by-product of
the way indices are constructed. Except for index funds
that track narrow market segments, most index funds
must hold a broad range of securities to accurately track
their target benchmarks. The broad range of securities
dampens the risk associated with specific securities and
removes a component of return volatility. Actively
managed funds, on the other hand, tend to hold fewer
securities with varying degrees of return correlation.
Style consistency. An investor who desires exposure to
a particular market and selects an index fund that tracks
that market is assured of a consistent allocation. An active
manager may have a broader mandate, causing the fund
to be a “moving target” from a style point of view. Even
if a manager has a well-defined mandate, the decision to
hold a higher or lower proportion of a security than the
index will lead to performance differences.
Taxes. Broad index funds and ETFs may provide a tax
advantage over actively managed funds because they
generally realise and distribute lower capital gains to
shareholders. This after-tax efficiency is particularly
beneficial within taxable accounts.2
Low-cost ETFs can add value to client portfolios
Primarily because of their low-cost structure, well-managed
index investments have generally offered long-term outper­
formance relative to higher-cost investments.
Investors have embraced ETFs over the past decade as an
efficient means to gain exposure to a broad range of asset
and sub-asset classes. ETFs offer the added advantages of
increased trading flexibility and potentially even lower
costs than traditional index funds. Vanguard ETFs™ can
provide pure, low-cost exposure to investment areas
important in setting and maintaining your clients’ overall
asset allocation strategies.
Please contact your Vanguard sales representative or visit
vanguard.com.hk to obtain additional research on indexing to
help you build lasting relationships with your clients.
Distribution of equity and fixed income funds’ excess return
Figure 2.
a. Distribution of equity funds’ excess return
1000
300
800
250
Number of funds
Prospectus benchmark
200
600
150
400
100
200
50
0
Merged/
liquidated
< –7% –7% to –6% to –5% to –4% to –3% to –2% to –1% to
–6%
–5%
–4%
–3%
–2%
–1%
0%
0% to
1%
1% to
2%
2% to
3%
3% to
4%
4% to
5%
5% to
6%
6% to
7%
> 7%
Excess returns
Active funds
fundsincome funds’ excess return
b. DistributionIndex
of fixed
150
450
Prospectus benchmark
Number of funds
400
120
350
300
90
250
200
60
150
100
30
50
1000
0
Merged/
liquidated
< –7% –7% to –6% to –5% to –4% to –3% to –2% to –1% to
–6%
–5%
–4%
–3%
–2%
–1%
0%
0% to
1%
1% to
2%
2% to
3%
3% to
4%
4% to
5%
5% to
6%
6% to
7%
Excess returns
800
600
Active funds
Index funds
300
Source: Calculations 250
by The Vanguard Group, Inc., using data as at 31 December 2015 from Morningstar, Inc., and Thomson Reuters Datastream.
400
Past
performance is no
guarantee of future results. Charts a. and b. display distribution of Asia ex Japan excess returns relative to their prospectus benchmarks for the
200
10 years ended 31 December 2015.
150
2200
Changes to the composition of an index will require the index to sell or buy shares, and the fund may be required to realise capital gains.
100
50
0
> 7%
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