NZ Herald 20 January 2007

AYou should certainly think about such a move. Indeed, I’ve thought about it with my own savings. But whether we should make the move is another question.

For those who didn’t see Brian Gaynor’s column last week, he pointed out that managers of active share funds select and trade shares with the aim of performing better than the market average.

On the other hand, passive fund managers invest in the shares in a market index — such as the NZX50. Their holdings change only when the index changes.

A reader wrote to point out that passive funds don’t necessarily follow an index. They might simply buy and hold certain shares. Index funds are just one type of passive fund.

However, the vast majority of New Zealand passive funds are index funds. So let’s get on with the active v index debate.

Up until now, active funds have had to pay tax on their capital gains while most index funds haven’t — a huge advantage. From April this year, however, active funds will no longer pay that tax. It’s timely, therefore, to look again at the active/index issue.

“Supporters of the passive style say more than half of fund managers underperform the market average and charge too much in fees,” says Gaynor. “This argument is difficult to justify, particularly in New Zealand.”

He goes on to say that the five index funds covered by research firm FundSource, the NZX’s Smartshares funds, had an average return of 16 per cent after fees and taxes in a recent year. This compares with 18.7 per cent for ten active funds.

And over three years the index funds averaged 14 per cent, compared with the active funds’ 14.5 per cent — hardly a difference to write home about, but never mind.

Readers of my column will know that I give no weight to comparative returns over a single year, and three years is still too short a period to judge, given the variability of share returns.

Nevertheless, over longer recent periods the average New Zealand active fund has tended to do a bit better than the main share market index. So why do I keep backing index funds?

Firstly, I recommend that share investors have at least half — preferably much more — of their holdings offshore.

Many industries are not represented on the NZ market, and most of us have too many eggs in the New Zealand basket already, with our homes, our jobs and perhaps other property investments.

A major setback — such as a massive earthquake, foot and mouth outbreak or just an economic slump — could slash the value of local assets. Those with offshore holdings would cope much better.

Also, given that many savers spend a lot of their retirement funds on overseas travel and imported goods, having funds offshore provides a hedge against the Kiwi dollar’s losing value. (This assumes you invest in an unhedged fund — usually the case.)

The best way to invest offshore is via New Zealand-based international index funds.

Index funds are much cheaper to run than active funds. They don’t hire analysts to pick which shares to trade, and they don’t pay much in brokerage and other transaction costs, so they charge lower fees. Lots of research shows that — probably largely because of fees — the average international index fund performs better after fees than the average active fund.

Sure, a few active funds will be top performers over the long term. But nobody knows which ones in advance. You’re better in an index fund, which might come second, third or fourth out of ten funds, than in an active fund that might come top or tenth.

Even Gaynor concedes, “a passive approach can be justified outside Australasia”.

But what about New Zealand share index funds? Several points:

• The tax advantage that New Zealand-based index funds will lose in April was always the icing on the cake.

Even without the icing, the cake looks pretty good, partly because of index funds’ lower fees.

In Gaynor’s comparison, he used Smartshares index funds. Their ongoing fees are 0.6 per cent on Tenz and 0.75 per cent on Midz and Fonz. This compares with around 2 per cent on a typical retail active fund. And entry fees are usually higher on active funds.

There are index funds that charge even less if you are making more than a small investment.

For example, SuperLife, where I have invested much of my retirement savings, charges $80 a year plus just 0.19 per cent of your balance in the NZ index fund and 0.24 per cent of your balance in either of their overseas index funds. If anyone offers lower fees than that, I would love to hear about it.

Low fees can make a huge difference to savings accumulation over the years.

• As Gaynor says, some recent index fund returns have been lower than most active funds despite low fees. This is largely because of Telecom.

Several New Zealand index funds cover the country’s biggest companies, and most use market weighted indexes. That means that Telecom dominates their performance.

As Brent Sheather said in last Saturday’s Herald, “In 2006 it was again relatively easy for fund managers to beat the local index, simply by avoiding Telecom. New Zealand’s biggest company, which comprises about one-quarter of the market, fell by 7 per cent over the year.” This compares with a 19 per cent gain by the market as a whole.

The same is true for longer recent periods. According to Sheather, over the last three years Telecom gained 8 per cent a year compared with 18 per cent for the top 50. Over ten years, the figures are 4.5 per cent for Telecom, and 10 per cent for the top 50.

Of course, when Telecom has performed better than average, Telecom-heavy index funds have also outperformed.

But the Telecom dominance adds to risk. That’s why I like the relatively new Smartshares index fund called Fonz. It follows basically the biggest 50 companies, but with no more than 5 per cent in any one company. An alternative is Midz, which invests basically in the 11th through 50th biggest companies.

Gaynor himself says last year’s return on Fonz was 32.5 per cent, and on Midz 43 per cent — way ahead of the average active funds’ 18.7 per cent.

Another option without Telecom domination is a new SuperLife NZ share fund, which is passive but not an index fund. It buys and holds 15 selected shares, roughly equally, and has low fees like index funds.

• There is no New Zealand index fund that invests in small listed companies, but some active funds do. And in recent years small companies have tended to perform better than big ones.

This is probably largely because small companies are usually riskier. And riskier companies do extra well in strong markets, extra badly in downturns.

Share fund investors who want to take part in the riskier smaller-company end of the market are left with no choice but active funds. But, unless you have a high tolerance for risk, don’t put a large portion of your savings into smaller company funds.

Which brings me to another of Gaynor’s points. Citing the range of recent returns on Smartshares funds, from 9.8 to 43 per cent, he asks, “Is it any easier to pick the best-performing passive funds than it is to choose the best performing companies? What will be the best performing New Zealand-oriented passive fund this year?”

My reply: Don’t try to pick the year’s best. If you’re in shares, you should be in for ten years or more — during which small companies will do well sometimes, and big companies at other times.

The simplest and best strategy is to cover the whole market — perhaps avoiding the Telecom problem — by investing in, say, Fonz or SuperLife’s new passive non-index fund. If you want a smaller company bias, add Midz.

By contrast, choosing an active share fund is a tricky process. Every company claims their fund is best, and produces past figures to support that. But past performance is no guide to the future. For the person in the street, picking a good active share fund is a matter of luck.

One final point from Gaynor: He prefers active funds because their managers sometimes vote at the annual meetings of companies in which they hold shares.

Some index fund managers are forbidden to do that under their tax rulings. And even as the rulings expire, it’s hard to imagine them taking much interest in corporate governance. They don’t have the resources.

Still, many active fund managers also take little part in governance issues. This doesn’t seem a valid reason for investors to shun index funds.

So where are we?

I’ve been following the active/index debate since the late 1970s. I don’t have any vested interests. Index funds are still the winners for me long-term, even after the tax advantage goes.

A final point: I should disclose that SuperLife buys my quarterly newsletter, Holm Truths, to distribute to its members. But that has nothing to do with why I invest in it. I like its low fees, its disclosures and the way it is run.

AIndeed! I must say that your town’s RSA was extremely hospitable one new year’s eve some years back to three strangers looking for some fun.