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By Ben Johnson, CFA and Christine Benz | 10-05-2016 02:00 PM

Index Funds May Not Always Lead the Pack

Market cap-weighted U.S. equity index funds are performing well now due to both structural advantages and cyclical factors, says Morningstar's Ben Johnson.

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Market cap-weighted U.S. equity index funds have been on a tear, in terms of asset-gathering, as well as performance. Joining me to discuss that phenomenon is Ben Johnson, he is director of global ETF research for Morningstar. 

Ben, thank you so much for being here.

Ben Johnson: Glad to be here, Christine.

Benz: Ben, when you look at the numbers, the S&P 500 is coming off a streak of great returns relative to its large-blend peers, and you really see this across the capitalization spectrum with the capitalization-weighted, mid-cap indexes as well as the small-cap index funds. Let's talk about why this is happening, why the cap-weighted indexes look so good relative to the universes that they're operating within.

Johnson: That's a great question, and I think upfront, it's important to distinguish between what we're seeing in the current cycle in all things cyclical versus those things that are secular, and we would expect to persist over a long period of time. So coming to where we are in the current market cycle, we're now in the middle of what is the second longest bull market in history which has been undeniably good for index tracking funds, which by definition are fully invested at all times. So they don't have any sort of cash drag holding them back the way that an active manager might, either deliberately, by saying they're going to hold a certain allocation of their portfolio in cash as a buffer to be able to exploit opportunities, or just to manage regular sort of redemptions in their funds.

So there's no drag from cash. Furthermore, the index represents the purest expression of a given category. So the S&P, the total stock market index, represents the purest form of any given asset class. So when that asset class performs particularly well, it becomes particularly difficult for active managers in that asset class to beat that index, given that again it's fully invested and that it is in no way clouded or polluted by out of style bets. So a large-cap blend index is not going to have small-cap value stocks in that portfolio. So those two things in the context of the current cycle, the current bull market that we're in, have made the S&P 500, total stock market indexes, a particularly difficult hurdle for actively managed peers to surmount.

Benz: So a related question for you Ben, and this starts to make my head hurt a little bit, but we have seen tremendous flows into some of the capitalization-weighted index funds and ETFs, to what extent are flows perhaps responsible, if at all, for the very strong performance of the indexes that the funds are tracking?

Johnson: Well, the indexes by definition are outsourcing price discovery, if you will. So if I'm an index investor, I'm letting everyone else do all the heavy lifting, the active stock-pickers, the active bond-pickers, who're the ones that are buying and selling those securities based on information that they've gleaned in doing their due diligence and conducting their research to say, "I think this particular stock or bond is undervalued and I'm going to buy it," or "It's overvalued and I'm going to sell it." So index funds in and of themselves and the flows into them, in ETFs as well, are inherently agnostic, in terms of their effects on prices, particularly in large-cap equities. They're price-takers, they're not necessarily, price-setters.

Benz: OK. So you mentioned that there are cyclical forces which you just discussed that have been responsible for the cap-weighted index funds' very strong performance relative to perhaps their actively managed counterparts. Let's discuss some of the more structural forces that you think will be in place and should set the table for decent performance for such index-tracking products over long periods of time.

Johnson: So there's two key sort of structural or secular advantages that index funds will have relative to their active peers. The first is fees. They have an inherent fee advantage, to the extent that the chief cost that is borne by index funds is an index licensing fee, so they have to pay an index provider oftentimes to be able to leverage that index provider's intellectual property, to track the S&P 500 index for example. So that fee advantage is massive in many cases, so the median active fund in the large-blend category will levy a fee that is many multiples of what you might pay for an S&P 500 index fund or ETF. So right out of the gate, that is a big structural advantage. That compounds if you think about costs more broadly speaking. So the cost of turnover for example which is inherently less in index funds relative to actively managed ones. That's another inherent structural advantage. That turnover in turn can create tax costs, can create or result in, distributable, taxable, capital gains, which is another inherent structural advantage.

The other one that tends to get, I think, a bit less attention is the absence of certain types of idiosyncratic risk, and manager-specific risk in particular. So we've seen a number of instances, in recent years, where we've seen either high-profile manager departures, or we've seen star managers who have fallen out of favor. Because the index fund is driven by a set of rules, is just out to track the benchmark, that idiosyncratic sort of manager-specific risk, is absent. And what results is specifically or particularly over long periods of time is just greater survivorship rates among index funds. So we've just celebrated the 40th birthday of the first retail index mutual fund, the Vanguard 500. If you look at the peers that were around back in 1976, when that was launched, very few of them survived, and very few or fewer still managed to outperform that index fund over that four-decade span.

Benz: And you've done research on how some of the idiosyncratic risks might translate into behavioral risks for the active fund investors. So if you're someone who, if you bought a fund really excited about a given manager, and then maybe they fall flat in terms of performance or worse, or maybe that manager leaves, that you're less likely to have a good outcome in that fund if you're hopping around a little bit, based on some of those idiosyncratic factors.

Johnson: That's absolutely the case. A lot of it is about expectation setting. So if you're signing up for a particular manager, and that manager takes their shingle and hangs it up somewhere else, you might leave that fund to follow that manager or to go into a different fund. But I want to stress too, that these behavioral risks, which at the end of the day could prove to be far more costly than differences in expense ratios, or even performance differentials, are by no means unique to actively managed funds. They tend to, at a very high level, be somewhat more muted at least looking back over the current market cycle in index funds. But that's not to say that we might not see another cycle, another scenario akin to what we saw in the case of the tech bubble, whereby relying on market participants at large to price stocks on your behalf proved to be a bad idea in hindsight. Pets.com turned out to be worth absolutely nothing and you were trusting someone else to say, "Actually, we think it's worth many multiples of nothing."

Benz: Right. So that's one thing I want to talk about, expectation setting with index funds. A concern that I've had, as sensible as using a cap-weighted index fund as maybe your whole U.S. market exposure, or maybe for the whole of your portfolios is, that there are times when cap-weighted indexing, like right now, looks really good from a performance standpoint. That may not always be the case. So investors shouldn't derive too much comfort from the fact that near-term results have been spectacular. They may not always be so.

Johnson: Absolutely the case. And I think there's the risk now, that we're almost in this echo chamber of sorts where all the cool kids are doing it. And everyone's jumping on the bandwagon, and directionally, flows are all headed in the same direction, which is toward index funds and low-cost index funds, which I would argue from a very long-term point of view is a good thing. But between here and the very long term, there are going to be cycles. And the cycle that we're in currently has been very favorable for index funds and investors in index funds. But that's not to say that there aren't going to be periods of time in the future, and there inevitably will be, where you're going to feel like the odd person out at a cocktail party, holding on to your S&P 500 Index Fund or your Barcap Agg Index Fund, because inevitably, there's going to be those cycles of performance over a very long period of time. You can hang your hat on those structural advantages I mentioned earlier, but there are going to, again be those bouts of relative underperformance versus active managers or even other index strategies.

Benz: So, absolute losses may be there, as well as underperformance relative to other strategies.

Johnson: Absolutely.

Benz: OK, Ben. Important topic. Thank you so much for being here with us to discuss it.

Johnson: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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