Institutional Investments - Index Vs Tracker Funds

Institutional Investments

Should retail investors invest in index-tracker funds rather than invest in actively managed funds? A critical appraisal

        An on-going debate that has been for several decades is whether if retail investors are better off investing their capital in index-tracker type funds or in actively-managed funds. There are different schools of thought regarding this, and there is much bias and opinion in the markets. There are numerous surveys that show that a retail investor’s capital is best left to sit out in an index-tracker and allowed to grow gradually over time, rather than be left to the discretion of a managed fund from which a portfolio manager decides in which sectors and securities clients capital is best invested and allocated.  

Founder of the Vanguard Group states that” it is a foregone conclusion that active investors, in aggregate, will underperform index investors. It’s the mathematics”

The purpose of an individual investing in an actively managed fund is the expectation that the managed fund will result in higher returns than if they had invested in an index-tracker fund. This is a key difference of having a fund at which a portfolio manager is assigned to undertake the management of a fund in order to produce higher returns, instead of allowing a tracker index that simply replicates an underlying benchmark index to sit passively and generate returns at the will of the market conditions.

According to Redhead” In effect, this involves the belief that the fund manager has superior knowledge or understanding that provides a forecasting ability that is better than that of other market participants”

Although both types of funds have the potential to generate returns for investors, the main question is which type of fund should a retail client choose and why? All types of funds that are advertised in glossy brochures and show the marvellous returns they bring in will do so again in the future? Numerous surveys undertaken over the decades indicate that index tracking funds generally return better results compared to the majority of actively managed funds. Further down in this essay it will be examined whether retail investors are better off investing their capital in index-tracker funds or trusting it in actively managed-funds.  

What makes index-tracker funds alluring is their sheer simplicity of the fund manager in having to just replicate the structure of an existing index, and rebalance it accordingly to which securities are added or removed from the underlying index. This index-tracker fund is then left to weather in the market, and brings back to the retail investor the according returns and value that the index would produce. One could say this is a boring way of investing, but an adage mentions slow and steady wins the race. There are several pluses and minuses from investing in index-trackers.

One of the pluses is when the markets are rallying and the sentiment is quite high and confident, the index-tracker funds reflect this and it results in good returns for the investor. The overall value of the index-tracker fund increases and this is reflected from the positive returns.  One of the minuses though, is when market sentiment is poor and there is less confidence in the equities markets, this also is reflected in the indices as the market participants lessen their exposures and unwind their positions, this as a result will weigh down on an index-tracker and bring its value down, meaning less or negative returns for the investors.

With actively managed funds, this is where the true value of the portfolio manager can be evaluated. The fund manager can manage a portfolio alternatively to an index-tracker in a down market. This would be achieved by offloading the instruments that would weigh the actively managed fund down, and repurpose the capital to other equities or even short-sell the existing equities and achieve a profit. This way an actively managed fund can reduce the risks and even produce a positive return as opposed to an index-tracker fund, as the savvy fund manager would foresee ahead of time the catastrophic shares in his portfolio and would offload it before it pulls the fund weighting downwards. This goes without saying that the complete opposite can happen though, and can result with devastating losses to the investor, as the manager makes a wrong decision and ends up losing money.

A point worth mentioning is what are the costs of following an index-tracker vs. an actively managed portfolio? With index-trackers, nothing special needs to be done except in closely following the underlying index that is being replicated as closely as possible and rebalancing the weight of the instruments involved, therefore there is no need to employ a team of analysts and traders to scout out profitable equities, meaning significantly less fees payable by the investor.

On the other hand, actively-managed funds typically employ a team of analysts and traders to attempt to sift out the best securities in the markets that will be bring superior returns to its investors. This inevitably though incurs added costs and expenses to the active-fund manager (also bearing in mind numerous transaction costs that accumulate as a result of buying and selling frequently), a cost that is passed on to the investor, and it erodes the overall performance of managed funds in comparison to an index-tracker.