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PASSIVE MANAGER
The theory of indexing and why low-cost investing matters
M
ore and more institutional investors are
seeing the benefits of holding a portfolio
that represents the market rather than a
portfolio that attempts – more often than not
unsuccessfully – to beat the market.
The theory behind indexing as an investment
strategy focuses on the zero-sum game: before
costs, for every pound that outperforms the index of
a particular market, there has to be another one that
underperforms. Once costs are taken into account, it
means that low-cost index funds will have a greater
probability of outperforming higher-cost actively
managed funds.
Although some investments, after costs, continue
to lie to the right of the market return, in the darker
shaded region, a much larger portion is now to the
left of the market benchmark line. This means that,
after costs, more than half of the performance of
investors falls short of the market return. So the
smaller these additional costs are, the less this
aggregate underperformance will be. This simple
theoretical result is powerful because it is just as
relevant in all markets, even those often thought to
be less efficient, such as small-cap or emerging
market equities.
Steven Charlton,
DC Proposition
Manager, Europe
Vanguard
Investment success
The zero-sum game
The concept of a zero-sum game starts with the
understanding that, at any given point in time, the
holdings of all investors in a particular market
aggregate to form that market. Because all holdings
are represented, if one investor’s position outperforms
the aggregate market over a particular time period,
another investor’s position must underperform.
The aggregation of all investors’ returns can be
thought of as a bell curve (see figure 1 below), with
the market benchmark return as the mean at zero. In
the figure, the specific market is represented by the
black curve, with the market return as the vertical line.
We explore this concept further in our recently
updated paper ‘The case for low-cost index-fund
investing’. The data analysis shows that, in practice,
few active managers consistently outperform or beat
the market, even before costs are taken into
consideration. Once costs are included, investment
returns are of course reduced further.
By keeping costs low, more of a portfolio’s assets
can grow and compound over time, increasing
returns for investors over the long term. So when
considering which strategies and funds are right for
your pension schemes plans, a focus on indexing
and on low cost can help improve your members’
chance of investment success. [n]
Counting the cost
In reality, investors are exposed to costs such as
management fees, bid-offer spreads, administrative
costs and, where applicable, taxes – all of which
reduce their realised returns over time. If these costs
were to affect all investment funds equally, then the
result of these costs would be to shift the investors’
curve to the left but to leave the shape of the bell
curve unchanged.
Figure 1: Market participant returns after adjusting for costs
Source: Vanguard
This document is directed at professional investors and should not be distributed to, or relied upon by, retail investors. It is designed
for use by, and is directed only at persons resident in the UK. The information contained in this article 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 document when making any investment decisions. The value of investments, and the income
from them, may fall or rise and investors may get back less than they invested. Issued by Vanguard Asset Management, Limited
which is authorised and regulated in the UK by the Financial Conduct Authority. © 2016 Vanguard Asset Management, Limited.
All rights reserved.
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PMI NEWS DEC 2016 35