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Vanguard weighs in on Australia’s ‘index revolution’

By Rhea Nath
4 minute read

The investment manager’s Asia-Pacific CIO has discussed the hurdles to active fund outperformance, observing that beating the market is “really much harder than most people think”.

Given both international and Australian equities struggled to beat their respective benchmarks last year, according to S&P’s latest analysis, Vanguard has reiterated why index funds and ETFs should be a consequential piece of a core portfolio amid an “index revolution” in Australia.

Last week, S&P Dow Jones Indices released the latest iteration of its SPIVA Australia Scorecard report, which measures the performance of Australian actively managed funds against their respective benchmarks.

Amid the “best of times and the worst of times” for actively managed funds, according to S&P, international general equity funds struggled the most throughout 2023.

Namely, the majority (81 per cent) of international general equity funds failed to outperform their benchmark – the S&P Developed Ex-Australia LargeMidCap – which had a total return of 24.1 per cent. Over its 10-year and 15-year horizon, around 94 per cent of funds underperformed.

The story was similar in the large-cap Australian equity general space, with more than three-quarters (77 per cent) of active managers failing to keep up with the S&P/ASX 200 – its second-worst performing rate since 2009.

Meanwhile, a majority (64 per cent) of Australian equity mid and small-cap funds managed to beat their respective benchmark – the S&P/ASX Mid-Small index – over 2023, which grew 7.8 per cent.

But underperformance levels across small and mid-cap funds also increased over the longer-term (albeit less pronounced than large-cap funds), rising to 77 per cent over a 10-year time horizon.

According to Vanguard’s Asia-Pacific chief investment officer, Duncan Burns, the report was “another strong data point” in the growing argument for index funds in investment portfolios.

“This year’s results could be summed up simply as – most active managers underperform their passive benchmarks most of the time,” Burns said.

“This is emphasised by the one-year underperformance for active Australian equity and international equity funds rates being at their second highest in recent years. The active underperformance rates are even more dismal over the longer term, with 85 per cent of active Australian equity funds and around 94 per cent of active international equity funds underperforming their index benchmarks over a 15-year period.”

He noted that these findings were not isolated to Australia alone, with the report finding similar long-term results in global share and bond markets.

“This is not to say active fund managers can never outperform the broader market. A number of exceptional active managers do,” Burns said, pointing to active bond managers who performed well in the last 12 months although the majority underperformed when looking at the last three-year period.

In its report, S&P Dow Jones Indices had also highlighted a comparatively “exceptional year” for active bond managers, namely that Australian bond funds posted their lowest one-year underperformance rate since the 2015 launch of the S&P/ASX Australian Fixed Interest 0+ Index, with just 26 per cent of funds underperforming their benchmark.

The longer-term position was also better relative to other categories, with 56 per cent and 46 per cent underperforming over the three-year and five-year periods, respectively.

However, Burns reiterated the report served as a good reminder that “beating the market is really much harder than most people think”.

“Costs, something that all investors are subject to, are a large contributing factor to active fund underperformance as they tend to be much higher than those of index funds, creating a headwind to performance,” he said.

The less-talked-about hurdle to active fund outperformance, Burns believed, is the skewness of the equity market returns.

He said: “The reality is that investors with a well-diversified index portfolio typically experience frequent small losses from the majority of securities, but a few exceptionally large gains from a subset of their holdings.”

He noted that approximately a third (33 per cent) of the top 300 companies outperformed the return from the S&P/ASX 300 Index in 2022, so to outperform the market, an active investor needed to be concentrated in that 33 per cent of outperforming companies.

Meanwhile, over the decade spanning 2012 to 2022, only 17 per cent of companies in the S&P/ASX 300 Index outperformed the broader market average.

“Further, the top three ASX securities accounted for 24 per cent of the total index return. Which meant active investors who didn’t have those three securities in their portfolio would have missed out on a large chunk of the market’s return,” he offered.

For Burns, a key takeaway from the data was that index funds and ETFs should be a “consequential” part of a core portfolio.

He said: “History has shown that investors with a majority active managed investment strategy are more likely to experience portfolio return outcomes in the larger part of the distribution that underperforms, rather than the smaller percentage that outperforms.”

That is an explanation for why “serious money portfolios continue shifting that direction”, according to the Vanguard executive.