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Forty years ago last month the first index tracking fund was launched in the USA by John Bogle of what became Vanguard. At the time, they hoped to raise some $150m, but only managed a very meagre $11m as investors were not convinced by the idea of low cost index tracking.
Further, as the fund did not pay commission to brokers who sold it, growth was hard and they only got to $100m when they merged one of Wellington’s funds into the index tracker.
At the time, the media and market were in total opposition to the idea, and there is a great poster (see right) that asked people to help stamp out index funds, as they were labelled un-American.
But Bogle persisted, and today they are the largest passive investment group, with assets approaching $4tr. The key message has been two-fold and remains as true today as it was then. The majority of active fund managers will underperform their benchmark, giving a pronounced edge to passive investing in large part due to much lower fee structures.
In South Africa Satrix launched the first index tracking exchange-traded fund (ETF) in November 2000. This first ETF was the Satrix40* (STX40) and it tracked the Top40 index. At launch it traded at around 770c and as I write this it is around 4 540c. Adding to this return are dividends that have totalled some 925c over the years.
This simple but great return is certainly one of the key benefits of index trackers, but there have been other consequences that are also very important. Back in the Nineties, I owned my first and only unit trust, and the cost on that was about 6% per year and included fund, platform and advisor fees. Back then this was not an unheard of rate for a unit trust.
These days unit trusts probably charge closer to 1.5% per year on average, and while one still needs to add platform and advisor fees, these have also come down and the total cost would likely be closer to 2% to 2.5% per year.
However, this is still massive considering that my STX40 has a total expense ratio (TER) of 0.45% (high for a local “vanilla” ETF) while brokerage costs me 0.2% plus taxes and I pay zero admin fees.
Of course, while investors love index trackers, members of the active-managed industry are not such fans. They promise us that they can beat ETFs over time, but the reality is that very few actually manage to do so after fees.
Further, the active industry still skews their fee structures against the investor. Firstly, far too many fund managers use a basic index as their benchmark. But stocks pay dividends, and as noted above those dividends are significant over time.
By using a non-paying index as a benchmark, the active manager essentially gives themselves a head start since the stock they buy will often pay dividends. They should use total return indices that include dividends paid by the index in order to treat clients fairly.
Secondly, the industry will often charge performance fees when they beat the index. These performance fees are meant to align investor and manager interests, and they do so on the upside. But when a fund underperforms the benchmark the performance fees should be returned. With some exceptions, this does not happen.
So while we have seen many important changes to how active managers do things in the 40 years since the first index tracking fund, I personally still only buy ETFs rather than active funds.
*The writer owns shares in STX40.
This article originally appeared in the 6 October edition of finweek. Buy and download the magazine here.
