Why indexing doesn’t mean settling for average

Advocates of active money management often describe index investing as settling for average. But is it actually true? There have been very few better investments in recent decades than an S&P 500 index fund from Vanguard. Yet when Vanguard’s founder, Jack Bogle, first gave investors the option of simply tracking the S&P 500, the investing industry poured scorn at the idea. It was dubbed “Bogle’s folly” and was even criticised as “un-American”. The response from one of the largest fund managers, Fidelity, was particularly dismissive. Edward Johnson, who was Fidelity’s chairman at the time, is reported to have said, "I can’t believe that the great mass of investors are going to be satisfied with just receiving average returns." Over the years, the claim that index fund investors are “settling for average” has been a common refrain. We still hear it regularly today. But is it actually true? Do indexers really receive average returns? The simple answer is No. Let’s explain.

Market returns, not average returns

Index funds, or passive funds, aim to replicate the performance of a specific market index. The S&P 500, which comprises the 500 US stocks with the largest capitalisation, is one the best known, but there are many others. UK investors are particularly familiar with the FTSE 100, the FTSE 250 and the FTSE All-Share Index. But every major market has its own index. There are also international indices like the MSCI World Index. By replicating, as closely as possible, the performance of an index, passive funds aim to capture the overall performance of the market, which includes all gains and losses of the companies in the index. Investors in these funds receive, more or less, the market return, minus the fees entailed. In most cases, then, investors receive slightly less than the market index. That, however, is just part of the story, because index funds typically have much lower management fees compared to actively managed funds. According to Morningstar, the average fee for an equity passive fund in the UK is 0.17 per cent, compared with the average fee for an active fund of 0.81 per cent. The transaction costs that index investors incur also tend to be much lower than those for active funds. These lower costs mean that a larger portion of the returns from index funds goes to the investor, rather than being eaten up by fees and charges. As a result, index fund investors usually achieve higher net returns than active investors.

Performance varies, but costs never falter

Of course, people invest in actively managed funds in the hope of outperforming the market. But the evidence shows us, again and again, that most active funds underperform for most of the time. It’s true that some funds do beat the market, but it’s generally only for short periods. In the long run, on a properly cost-and risk-adjusted basis, only a tiny proportion of active funds genuinely outperform the relevant benchmark. Sometimes active funds lag the market because of poor investment decisions. In other words, they invest in the wrong things at the wrong time. But most of the time it's simply down to cost: the fees and charges entailed simply create too high a barrier for the fund manager to surmount. By contrast, index funds provide a consistent and predictable way to achieve (near enough) market returns. So, far from ”settling for average”, the average passive investor receives rather higher returns than the average active investor once fees and charges are factored in. Indeed, the disparity in net returns for active and passive investors can be very substantial. The biggest differences in outcomes are over very long periods. This is down to compounding. Over, say, 30 or or 40 years, the compounded effect of active management costs on the size of your portfolio can be huge.

What about shorter time periods?

Yet even over much shorter periods a passive approach will often deliver higher returns. Take, for example, recent analysis by the financial data provider Defaqto, which compares the performance of model portfolio solutions used by UK financial advisers. Defaqto looked in particular at the cumulative return produced by so-called “adventurous” portfolios over the three-year period to the end of May 2024. The dispersion in returns between the best and worst performers was huge. The average return for the ten top-performing portfolios over the period in question was 26.31 per cent. The average return for the whole category was just 10.19 per cent. Notably, nine out of the top ten portfolios were passively managed. The actively managed portfolios Defaqto analysed fared very much worse. 51 portfolios failed to achieve a total return of two per cent. Of those, 27 even managed to record an overall loss. To be clear, three years is a very short period in the context of an investing lifetime, and we should be very careful about drawing firm conclusions from Defaqto’s findings. It also has to be said that the top performers had a significantly higher allocation than their peers to the United States, and a smaller-than-average weighting to both UK and emerging-market equities. Asset allocation is a very important factor in investment performance. US stocks performed especially well over the three-year period Defaqto looked at, while UK and emerging-market equities performed relatively poorly, which partly explains why the active portfolios struggled to compete. Over time, differing geographies and asset classes are bound to fall in and out of favour. Some markets will inevitably perform better or worse than they have done in recent years, when this happens, that may hand an advantage to funds with differing allocations to the recent winners. Nevertheless, the Defaqto research is still significant because it shows us that, even in the short run, index-based solutions can deliver superior results. Out of 261 solutions available to investors at the start of June 2021, the one that delivered the very best returns was a simple, cheap and broadly diversified index tracker. Even if investors in that fund thought they were settling for average, they certainly didn’t receive average returns!

Focus on the long term

Again, three years is not long, and we certainly wouldn’t encourage anyone to have an investment horizon quite that short. Quick fixes in investing, as in dieting, rarely work; the slow and steady approach really is best. Remember as well that it’s over much longer time periods that the benefits of indexing really stand out. In short, index investors who remain patient and disciplined don’t receive average returns; they receive market returns, which, historically, have been very favourable. Crucially, by paying substantially less in fees and charges than active investors, indexers are able to keep a far bigger share of those market returns for themselves, and that’s what really makes the difference.