Financial Journalist

Benchmark Third Quarter 1999

Even a dart-throwing chimpanzee can select a portfolio that performs as well as one chosen by the experts.”That devastating indictment of the performance of managed equity funds was written by Princeton finance professor Burton Malklet in his book, A Random Walk Down Wall Street. That comment also acted as a catalyst in the creation of what are now known as index funds. Financial houses came under increasing pressure to justify the huge salaries and research budgets of their Investment teams that were underperforming the dart-throwing chimpanzees. Here, our London-based correspondent Gerry O’Kane finds out why index funds are becoming as popular in the US and the UK as traditionally managed funds.

To a great extent Asian investors have been left out in the cold when it comes to having access to index funds, as much a reflection of the under-developed Asian funds market. Elsewhere they have found much favour and in the US the country’s second largest fund company, Vanguard, specialises in such offerings.

In the US and Europe there has been a growing love affair with the concept of “buying the market”, the foundation of index funds. Personal investment advisors are seeing them as a way to complement actively managed funds for long-term growth. In brief, they offer diversification, the opportunity to increase foreign exposure, returns consistent with market performance but also low annual management expenses, usually less than one percent.

It is important for Asian investors to realise that while there may be a limited number of funds available that are licensed through the various regulatory authorities, they are available if they ask personal investment advisors to purchase them. However, a lack of knowledge has certainly hampered any growth in this market.

Matching the Index
Stock index funds seek to match the returns of a specified stock benchmark or index, for example the S&P 500 index in the US or the FT 100 index in the UK. It tries to match “the market” by buying representative amounts of each stock in the index. This differs to the normal managed fund which pays a manager to take positions on individual stocks, sectors, or investment strategies. An index is a basket of stocks constructed to represent the whole market or a subset of it, for example, a property index. It does not take much skill to create an index fund. One just buys the stocks in the index in proportion to their weight in the index.

A more advanced method of producing index funds is through derivatives, achieving a similar exposure to foreign equity markets. By their nature, derivatives (such as futures contracts) require a much smaller initial investment than investing in stocks directly.

Index funds do not attempt to beat the equities market but try to equal it. For investors the major attraction is their extremely low expenses - they charge low fees for providing the market’s returns.

It is worth noting that any difference between market performance and the return on an index fund is usually the result of management fees or fund expenses but unlike other funds the turnover of stock holdings are low.

But how do they compare to managed funds? Peter Lynch, Fidelity’s guru and former manager of its Magellan Fund, noted for his forthright views, stuck his neck out late last year by saying he believes managed funds will beat index funds over the next five years.

Bluntly put it is a view not supported by the facts. His own analysis argues that the developed stock markets increase in value eight-fold every 25 years and he also points out that managed funds outperformed index funds in the US between 1991 and 1993. But a broader analysis shows a different story.

Peter Macey of Macey Holland & Co., Investment Architects has done fascinating research on the performance of index funds against managed funds. While it is based on US markets, the conclusions reflect investment funds around the world. Using Morningstar, a US based provider of investment fund data, there were 198 US managed funds that met the criteria of using domestic equity, investing in the large stocks, with performance from 1985, through to December 1995 and not being index funds.

They were comparable to the S&P 500 which is dominated by the performance of large companies. Macey compared the performance of these 198 funds to the performance of the Vanguard S&P 500 Index fund for each calendar year from 1985 through 1995. Based on the principle that what one fund manager buys another sells, then at least half of the funds, about 99, should beat the index.

Nine out of Eleven Years - Index Funds Ahead
His analysis showed that the index fund beat the average manager in nine of the 11 years. On average only 36% of the managers beat the index fund in any year. The average annual return of the Vanguard index fund was 16% per year versus 14% for managed funds. This is pretty strong evidence that the average manager has not beaten the index.

For investors in the Asian market, Grand Pacific Securities Investment Trust Co., in Taiwan manages two index funds: the GP Taiwan Index fund and GP Taiwan Stock Index fund. Both aim to achieve an investment return in line with the performance of the Taiwan Stock Exchange index. The former is for expatriates, while the latter is for local Taiwanese.

Ironically interest in these funds has been limited. Jack Huang, the fund manager of the GP Taiwan Index fund says they are not popular for two reasons. “People here have a strong mentality of speculation. They don’t want to just have are turn in line with the index. They want to beat the index and have quick money,” he concludes. His second reason is highly pertinent to the general lack of index products for local investors. “There is not enough promotion of this kind of product and also not enough education here.” says Huang.

All in the Timing
But he also has a negative view on the principle of index funds. As an index fund requires an almost 100% holding of equity, he says this position makes it vulnerable to downside risk. His views however miss the point that managed funds underperform when the market rises if the manager is holding cash.

He argues that any investors putting their money in index funds should do so only for short-term investment, not as a long-term holding. a view quite contrary to views in other non-Asian markets. Again historical data shows that index funds held in excess of five years will nearly always show profit. Even in years of poor index performance, Huang’s view is unfair. In 1994, a bad year for the US market, the average equity fund lost 5.90 per cent compared with the S&P 500’s negative 3.12 per cent return.

Two index funds authorised for sale, in Hong Kong are the US$100 million Hang Seng Index Pooled fund, managed by Hang Seng Bank and the smaller Manulife Index Hong Kong fund, managed out of London. Both funds beat the average of their peers over all the time periods that BENCHMARK track, furthermore, over the past year the Hang Seng Index fund has returned 42.31% ranking it third out of 19 funds in the sector.

Our explanation for the strong performance is that most of the other 19 fund managers thought that the Hang Seng index would not recover as strongly as it has done and were therefore holding too much cash. Proof that with all the research in the world, you just can’t beat the market, and this is why index funds are worth some serious consideration.

Index Funds vs Managed, passive, asset managers