For a combination of reasons including low ongoing fees and easy access to a diversified share portfolio, index-following managed and exchange traded funds have become increasingly popular with both individual and institutional investors. In the US, index funds now hold close to half of the listed sharemarket while exchange traded funds similarly dominate the managed fund market in Australia.
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For individuals not wanting to build their own individual portfolios, the alternative to buying index funds is to acquire actively managed funds or listed investment companies. With the notable exception of several long-established listed investment companies, the fees charged by active managers are considerably higher than those of index-based funds.
The marketing push and popularity of index funds is supported by empirical evidence that active managers rarely consistently outperform passive managers. When active managers charge higher fees, the attractions of index funds are obvious unless individual active managers have a track record of consistently matching or outperforming the market.
Against this general background, investors need to be aware of the structure and risks involved with owning index trading funds. Unlike the mandates of managed investments that allow them to take profits and switch to cash or other investments, the charters of index funds require them to religiously track a defined share index.
The investor can choose the share index they wish to track allowing a wide range of options both locally and overseas. Results will vary widely depending on the index chosen. When markets or segments fall, the returns will fall and can even be negative.
The only option available to passive fund investors to protect their capital in this situation is to monitor the performance of markets and be prepared to liquidate or reduce their investments when markets are overvalued. The investor doesn't have the power to sell individual shares in an index tracking portfolio when these are overvalued.
This opportunity is available only to active managers or to individuals managing their own portfolios. The objective of all investors is to acquire shares when prices are low and take profits when prices are high and this is a major attraction of active fund managers charging higher fees.
Passive fund investors following an index don't have this opportunity. Indeed, the situation is totally different. The index weighting of individual shares changes with their prices, requiring index funds over time to regularly reduce their holdings of shares whose prices have fallen and buy more shares in companies that have risen in value.
This bias forcing funds to increase their exposure to shares that have risen faster than the market is an important reason for investors to be prepared to take profits by reducing their passive investment holdings when markets are overvalued.
Daryl Dixon is the executive chairman of Dixon Advisory. comments@dixon.com.au
