The case for index investing through ETFs

10 July 2016 | ETFs

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The latest edition of a key Vanguard research paper, The case for low-cost index-fund investing, released on 30 June, emphasises the contribution of exchange-traded funds (ETFs) to the global growth in investor awareness of the attributes of low-cost, index investing.

This paper from Vanguard in the US is updated to include long-term investment returns to December 2015. (It supplements another piece of research, The case for index fund investing in Australia, published this time last year.)

After a relatively subdued beginning when the first ETFs were traded on our market 15 years ago next month, their popularity among Australian investors has truly gathered pace in recent years. (The first US ETF was listed in the early 1990s, while Vanguard launched the world's first retail index fund in 1976.)

Recent ASX research shows that the market capitalisation of Australian-listed exchange traded products – most being index-tracking ETFs – has more than doubled over the past two years to $23.2 billion as at May 31.

Much of this growth in the market capitalisation of locally-listed ETFs is obviously attributable to new investments, not market returns.

Australian investors, including many SMSFs, are increasingly using ETFs to easily and inexpensively create diversified, index-tracking portfolios that can be readily rebalanced on a regular basis back to their strategic or target asset allocations.

The Case for low-cost index-fund investing research paper includes these straightforward points:

  • Whether invested in an actively-managed fund or an index fund, each basis point an investor pays in costs is a basis point less an investor receives in returns.
  • Most investors' best chance at maximising net returns over the long term lies in minimising investment costs.
  • The "drag of costs on performance and the lack of persistent outperformance" creates a high hurdle for active managers in their attempts to beat the market. "This hurdle grows over time and can become insurmountable for the vast majority of active managers."
  • The performance advantage of low-cost index funds is, however, "quickly eroded" if their costs increase. In other words, investors should pay close attention to costs even when investing in index funds.

Significantly, this Vanguard research paper suggests that investors who want to invest at least some of their capital in actively-managed funds should still place an emphasis on low cost and broad diversity.

Many investors who recognise the case for low-cost index-tracking funds nevertheless include actively-managed funds and direct investments in their portfolios.

Such investors often adopt a "core-satellite" approach, investing the core of their portfolios in index funds while holding smaller satellites of favoured actively-managed funds and direct investments.

Unfortunately, discussions about index funds and actively-managed funds are frequently conducted as an "either-or" debate.

While Vanguard, for instance, is best known for its traditional index funds and ETFs, approximately a third of the assets that it manages globally are in actively-managed funds.

 

 

Written by Robin Bowerman, Head of Market Strategy and Communications at Vanguard.
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Robin Bowerman, Principal, Market Strategy & Communications at Vanguard Australia, shares investment and personal finance insights gained from over two decades in the finance industry as writer, commentator and editor.

Robin Bowerman