Photo: Leon Nicholas

Over the past 15 years index funds in the US have received more than $2 trillion in inflows. 

The exponential growth of this style of investing, also known as passive investing, is not limited to the US: the growth of indexing is a global phenomenon. So what exactly is all the fuss about?

Investors frequently tell me that their investment is “performing brilliantly and beating the market”. But when I ask what the investment is being benchmarked against, or what index is being used to measure the performance of the ‘market’, I often get confused looks.

The lack of understanding is common, not because the average South African investor lacks intellect – but because the investing landscape is so complex. This complexity serves the investment industry because investors feel compelled to rely on investment managers, financial advisors, consultants and brokers to steer them through the confusion. And their services usually come at eye-watering prices.

But things are changing. Index funds, such as 10X Investments’ High Equity fund, are delivering above-average  performance at a low cost via this simple and transparent investment product.

What is an index?

An index is a group of shares or bonds assembled on the basis of specific criteria, such as the JSE Top 40, made up of  the largest 40 stocks on the Johannesburg Stock Exchange by investable market value.

2. How do index funds work?

An index fund mimics the composition of the selected benchmark by holding all the shares and/or bonds in that index, in the same proportion as the index.

An actively managed fund, on the other hand, will pick specific stocks or bonds from that index, in the hope that their selection will deliver a higher return than the index itself.

3. What are the benefits of index funds?

a) They perform better than most actively managed funds. The S&P Indices Versus Active (Spiva) scorecard for June 2018 shows that 9 out of 10 actively managed funds failed to beat their benchmark return over five years. This is not surprising considering that it is impossible to reliably predict future returns, or to outsmart the collective wisdom of all other investors (as captured by current market prices).

b) It traditionally costs less to invest in passively managed funds. Because indexing is largely an automated process, with the bulk of the research and design done upfront, it does not require the services of numerous fund managers and research analysts, who tend to be expensive. Indexing also saves on the cost of frequent trading. These  cost savings accrue to investors and the compounding effect of those savings accruing over the long-term dramatically improves the return for investors.

c) The automated processes and uncomplicated pricing make indexing simpler to understand and, in most cases, more transparent on fees and portfolio construction.

The odds of beating the market with an active manager net of fees are low. That’s because active investing is a zero-sum game before fees: half the invested money will beat the market average and half will lag. This means that net of fees, the majority of actively-managed money is destined to underperform.

Some fund managers will outperform some of the time, but no one can say for sure which ones will do so next year, or the year after that.

For long-term investors, the decision of whether to invest with an active manager or index fund should boil down to the probability of success. With index funds, you are likely to capture the return of the market at low cost. With active funds, the evidence shows that, net of fees, you probably have only a 10% chance of doing better, and in all probability, you will do much worse.  

The question long-term investors need to ask themselves is: Do I want to invest in a fund that is simple to understand and guaranteed to deliver an above-average return? Or do I feel lucky and prepared to stake high fees for the one in ten chance of doing better?

‘OWN THE MARKET’

John Bogle, the recently departed ‘father of indexing’, urged retirement savers to invest in the share market using index funds, which he described as owning the market. He explained what he meant in a discussion with Steven Nathan, 10X Investments’ founder and CEO:

“Owning businesses that make money, that have earnings that pay dividends is in the long run the way to collect wealth. You’re a part owner of a business, when you own a share or stock, it’s not very complicated.

“So, how do you pick which businesses to own? The answer to that is: you don’t. You own all businesses. You own every business in your country or every business, if you like, in the world.

“This diversifies you enormously from the risk of a single business, which can fail.”

WATCH:

Hilan Berger, Head of Institutional Business Developments at 10X Investments, shines a light on some investing basics

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