Written by Tangerine
Wednesday, August 5th, 2015
Index-based investing is becoming more and more popular with investors. The S&P/TSX Composite Index is the main index for Canadian stocks, and when you watch the news, they quote this index to tell you the overall performance of the Canadian stock market. The S&P 500 and the Dow Jones are the two main indexes used for the U.S. stock market. In this video series, Preet Banerjee answers five of the common questions asked by Canadians about Index–based investing.
Note: All securities, including mutual funds present a risk of loss of capital. To understand risk better, you may also want to look at the specific risks for mutual funds and how they could affect their value.
1. I understand with actively managed funds there are professional investment managers who are managing the funds but is there anyone managing index-based funds?
Yes. There are still managers of the fund. In both cases, individual investors’ money is pooled together and the collective funds are invested according to an overall investment strategy. The difference is that with an actively managed fund, the manager(s) of the fund will pick and choose individual stocks and/or bonds that they think will outperform the market. A passively managed index-based fund simply tries to match market performance.
2. What are the benefits of index-based investing? What are the disadvantages of an index-based fund over an actively managed fund?
Index-based investing has become very popular for novice and expert investors alike. It comes down to simple logic: If you separate all investors into two camps – active investors… and passive investors, before accounting for fees, each group in aggregate gets the market return. That’s because all the active investors put together ARE the market, and the passive investors simply decide to track the market. But because the fees incurred by the passive index investors are lower than the active investors (who are trading more often, or are paying for the expertise of fund managers to compete against one another), the returns for the passively invested dollar tend to beat the returns for the average actively invested dollar over the long run.
That doesn’t mean active investors can’t ever beat the market. Some do, and some don’t. But the problem is that no one has devised a way to reliably pick the future winners. That’s the key. It’s easy to see who HAS beaten the market, but so far, no one has come up with a way to reliably predict outperformance in advance.
3. Why do index-based funds tend to have low Management Expense Ratios (fees)?
If a fund only has to track a benchmark, there isn’t much research or analysis that needs to be done. On the other hand, an actively managed fund is trying to outsmart everyone else. They may employ a team of portfolio managers and research analysts and pay them a lot of money. That’s one of the main reasons for the difference in costs between active funds and passive, index-based funds.
4. What's the difference between an index-based fund and an exchange-traded fund (ETF)?
Great question. This is something that most people don’t actually know. First, let’s reiterate what an index-based fund is. An index-based fund is simply a fund that tracks a benchmark index or indexes.
Index-based funds are commonly referred to as “passive” investment strategies. This is as opposed to an “active” investment strategy, where the goal of the fund is to try and beat a benchmark on a risk-adjusted basis. “Risk-Adjusted” means that the performance takes into account the volatility of the fund. For example, if a fund manager picked stocks that were very risky, and the fund was wildly more volatile than the index, but only beat the index by a small amount, they actually did a poor job of managing the risk and return of the fund.
The truth is that either strategy, active or passive, can be used by a fund that is traded on, or off, an exchange. If a fund is traded on an exchange, it’s referred to as an Exchange-Traded Fund, which is often shortened to ETF.
That means you can find either passively or actively managed funds that are traded on an exchange, and are therefore both fully qualified to be called ETFs.
You can also find funds that don’t trade on an exchange that are set up to be actively OR passively managed.
So the real answer to your question: “What the difference between an index-based fund and an ETF?” is that they are actually separate concepts altogether. “An index-based fund” is an investment strategy, and “an ETF” is one of two main structures for a wide variety of investment strategies.
The reason there is confusion here, is that most people (even in the industry) tend to sloppily refer to index funds and ETFs as the same thing. Similarly, many people sloppily refer to mutual funds and actively managed funds as one and the same. But again, one is a strategy, and one is a structure.
5. How does the performance of index-based funds generally compare to the performance of actively managed funds?
This is a tricky question because the comparison is generally not an apples to apples one. Traditionally, actively managed funds include the compensation costs for financial advisors, at least in theory: whether you get any financial advice is a different story. But whenever you see a rate of return posted for a mutual fund, it’s reported after fees have been deducted. Many actively managed funds have higher investment costs, but have additional costs for financial advice added in too. For the most part, index-based funds have lower overall investment costs, and do not have financial advisor costs added in.
Standard and Poor’s publishes a scorecard known as the SPIVA (Standard and Poor’s Index Versus Active) Scorecard that tracks the overall performance of mutual funds against their benchmark indexes. The exact numbers change from year to year, but not by much over longer periods. According to the Mid-Year 2014 report, only 19.57% of actively managed funds in the Canadian Equity Funds category outperformed their benchmark.
But note that they are comparing actively managed funds with the costs of advisor compensation against the pure benchmark. Index-based funds will lag the benchmark by a small amount, and so if you compared the actively managed funds without the cost of advisor compensation built in, to an index-based fund, the performance would likely be closer, but the conclusion likely still the same. On average, index-based funds generally outperform higher cost alternatives.