Share market investors can take one of two broad approaches: passive investment or active portfolio management.
As the term implies, passive investment requires little activity on the part of the investor. The investor simply acquires a portfolio that is expected to perform in concert with the index. Because the portfolio tracks the index, this approach is often described as ‘indexing.’
Many investors have never heard of an investment approach known as ‘indexing.’ This is despite the fact that there is substantial evidence – academic, theoretical and, importantly, practical – that shows that indexing outperforms the majority of alternative share market investment approaches, especially the active approaches.
Indeed, a properly constructed index-tracking portfolio should always outperform more than half of the market, once fees and taxes are taken into account.
What is an index?
An index is a shorthand way of measuring something. Indices (the plural of index) are a particularly convenient way of measuring changes in share prices across markets as broad as the Australian share market. Shares in more than 2000 companies are traded on the Australian Stock Exchange. Because of this large number, it would be very difficult for market followers to simultaneously consider the daily performance of each company.
Instead, an index is used. An index is a sample of the entire market. Rather than examine the daily price changes of every company traded, the index selects a more manageable number of companies and reports the change in the prices of those shares.
Some of the companies whose shares are traded are very large, but most are quite small. The size of a company is calculated by multiplying the current share price by the number of shares in the company. This is known as ‘market capitalisation’. Changes in the share price of companies with higher levels of market capitalisation are more significant than changes in smaller companies. This is because more money is invested in the larger companies than in the smaller companies.
Because not all companies are the same size, the indices used to measure the market concentrate on the larger companies within the market. The ASX 20, for example, measures changes in the share prices of the largest 20 companies, as measured by market capitalisation. The ASX 50 examines the largest 50 companies.
Most indices make use of weightings. This means that, within the index itself, changes in the share price of larger companies are given more importance than changes in the share price of smaller companies. For example, if BHP has a market capitalisation that is twice that of the National Australia Bank, then changes in the price of BHP shares are given twice the weight that is given to NAB shares within the index.
Most of the commonly used indices in Australia are developed jointly between the Australian Stock Exchange (ASX) and Standard & Poors (S&P). The following are the most prominent indices used:
- S&P/ASX 20. The largest 20 companies by market capitalisation. These companies account for approximately 46 per cent of total market capitalisation.
- S&P/ASX 50. The largest 50 companies by market capitalisation. These companies account for approximately 63 per cent of total market capitalisation.
- S&P/ASX 100. The largest 100 companies by market capitalisation. These companies account for approximately 73 per cent of total market capitalisation.
- S&P/ASX 200. The largest 200 companies by market capitalisation. These companies account for approximately 78 per cent of total market capitalisation.
- S&P/ASX 300. The largest 300 companies by market capitalisation. These companies account for approximately 79 per cent of total market capitalisation.
As this list shows, the total market capitalisation ‘covered’ by the index is quite high, even in the smaller indices. In fact, as the size of the index grows, the ‘extra’ total market capitalisation added to the index starts to fall.
The S&P/ASX 20 index, for example, includes 46% of total market capitalisation. The S&P/ASX 50 index, which has 30 more companies in it, includes 63% of total market capitalisation. The S&P/ASX 300, with an additional 250 companies, only includes an extra 16% of market capitalisation.
What this shows us is that, while there are a large number of companies whose shares are traded on the exchange, relatively few of them are influential in terms of the market as a whole. The market is dominated by relatively few shares. Because of this, the performance of the index becomes a very good approximation of the performance of the market as a whole.
Because the index will provide a very close approximation of the performance of the market as a whole, an investor whose portfolio replicates the index will also enjoy investment returns that closely approximate the market average.
And remember, the historical experience is that the market average is a good result. In the 20 years to December 2014, the average annual return on the ASX was 9.4% (which was slightly less than the average annual return on residential property of 9.8%). Investors who obtained the market average saw their money double every eight years across this period. If they stayed invested for the whole twenty year period, the investment rose by more than 600%.
An ‘unmanaged investment’
The idea of constructing a portfolio based on the index was first floated by two American academics, Renshaw and Feldstein. In 1960, they published “The Case for an Unmanaged Investment Company” in the Financial Analysts Journal.
The article arose from the observation that most professional money managers did less well than the average return in the market or markets in which they traded. That is, most investors who used professional money market managers would have been better off had they merely bought the market index. If a portfolio was following the index, then the investor, or the investment manager, would not have to choose which stocks should be included within it. This is why Renshaw and Feldstein called their article “The Case for an Unmanaged Investment Company”. They were commenting on the fact that management as it was known then (what we would now call active management) actually reduced returns.
These days the terminology has changed. This happened because fund managers (most notably, Vanguard) wanted to provide investment funds that tracked the index. Canning these investment funds ‘unmanaged’ did not create much confidence in the minds of investors. So now, funds which follow an index are known simply as ‘index funds’.
In more recent years, it has become possible to follow an indexing approach with needing a traditional fund manager at all. This allows investors to bypass almost all of the institutional costs that apply to managed index funds.
The efficient frontier
About eight years before Renshaw and Feldstein published their work, another American academic named Harry Markowitz laid the ground work for their report. In 1952, Markowitz published ‘Portfolio Theory.’
Markowitz was one of the first theorists to give risk its due prominence in personal investment management. In particular, he pointed out the benefits of diversification. Specifically, Markowitz showed that holding investments with low levels of covariance – that is, investments which would not act in exact concert with each other – reduced the risk of loss within a portfolio. The idea was simple: if one investment performed poorly, then the impact of this performance on the whole portfolio could be reduced if the portfolio invested in multiple investments. If the multiple investments were unrelated to each other, then the chances of more than one investment performing poorly at the same time was reduced.
Markowitz’ work spurred further work from other researchers, perhaps most notably James Tobin and William Sharpe. These researchers explored how to optimise the relationship between risk and return: how to get the best possible return for a given level of risk. The portfolio that does this is said to be the most ‘efficient.’
Without going into all the science of the matter, the most efficient portfolio was found to be the market itself. This provides the optimum level of diversification (which reduces risk) while still ‘allowing’ substantial returns. An investor seeking the most efficient portfolio should try to buy the whole market.
In a market with 2000 companies, this is not possible. But, constructing a portfolio that tracks an index is very possible, and is the next best thing.
Further benefits of an index-tracking investment
As well as optimising the relationship between risk and return, index-tracking portfolios have a number of other advantages. These include:
Low transaction costs
A true index-tracking portfolio should be a low cost option. This is because the investor and/or their adviser does not have to spend any time deciding whether an individual company represents a good investment. If the company is part of the index, the index-tracking portfolio will invest in it.
In addition, index-tracking portfolios do very little buying and selling. One of the most enduring myths about index-tracking portfolios is that they must buy and sell whenever relative market capitalisations change. That is, if a company becomes more prominent within an index, the index-tracking portfolio will have to buy more shares in the company so that the portfolio continues to replicate the index.
This is not right. If the price of a company’s shares rise such that it’s prominence within the underlying index rises as well, this change will already have occurred within the index-tracking portfolio. The index-tracking portfolio will always automatically adjust itself to reflect the changed situation.
Index-tracking portfolios only sell shares when a company leaves the index (which is quite rare) or when the investor wants to access cash. Neither of these events adds significant selling costs to the investor.
Because they do little selling of shares, index-tracking portfolios typically benefit from the 50 per cent discount on capital gains for investments held for longer than 12 months. This means that, provided that the investor maintains the holding for more than a year, most of the gains that they receive will be in the form of discounted capital gains.
A better than average return – every year
Because of the low fee and low tax nature, index-tracking portfolios will always perform in the top 50 per cent of investments in a particular asset class. Once again, the economics can be quite involved, but in summary the superior return arises because index-tracking portfolios will achieve the market average before fees and taxes. In a large market such as the share market, 50 per cent of investors will achieve a return that is better than average and 50 per cent will achieve a return that is poorer than average. This means that, before fees, 50 per cent of actively-managed portfolios ‘beat’ the index-tracking portfolios.
However, these other investments face higher costs. Active investment involves specific research and it also involves more buying and selling. Because of this, some actively-managed portfolios ‘slip’ behind the index-tracking portfolios once fees are factored in. In this way, the index-tracking portfolios will do better than more than half of all investment portfolios each year.
As the years go by, the index-tracking portfolios will continue to perform in the top half each year. The active members of the top half tend to change each year. That is, while an active investment portfolio might outperform the market average in one year, it is unlikely to do this repeatedly over many years. This means that, over time, the index-tracking portfolio’s relative performance becomes even better.
While index-tracking investments will provide better than average investment returns each period, they will never outperform all of the market in a single time period. An index-tracking portfolio will never be the very best portfolio. This can be the most difficult thing for an index-tracking investor to accept: Index-tracking portfolios cannot possibly outperform the market as a whole. Before fees and taxes are factored in, a proper index-tracking portfolio must achieve the market average. After fees and taxes, the performance will be above average – but only by a small amount.
The real benefit of the index-tracking portfolio is that it will be better than average every year. As the years go by, this has a wonderful cumulative effect.
Accepting the average is a little counter-intuitive. We humans tend to prefer being winners to finishing just in front of the middle of the pack. One financial planner once told us that he actually thought index funds were ‘un-Australian.’ This is because he felt Australians will never accept merely being average.
We have to say, he must be living in a different suburb to us!
Investing is not a race. Investors do not have to beat everyone else to ‘win.’ An investor wins if their investment simply does one or both of (i) preserve their existing wealth; and/or (ii) increase it.
If the first of these is the main aim, then indexing is the best approach.