Share fund winners vs index funds

An index fund invests in the shares in a share market index, such as the NZSE40, which shows how well the biggest 40 listed New Zealand companies are performing.

The fund will perform much the same as its index - although it will lag a little because of the costs of running it. It trades shares only when the index changes.

While Bogle is clearly a big fan of index funds, he is still a respected researcher. I've never seen any criticism of Vanguard research. And there are many people who would profit from discrediting it, if they could.

These would include those who run ordinary share funds, sometimes called active funds because they select shares to buy and sell - as opposed to index funds, which are passive.

Bogle recently updated some earlier research on whether it pays to invest in last decade's best share fund. And I must say his results surprised me.

Other research has suggested that past winners tend to perform worse than average in the future. With Bogle's data, however, that wasn't true.

First he looked at how well the top 20 US active share funds in 1972-82 performed in the following decade.

Their average annual return in the second decade was 14.3 per cent a year, compared with 13.1 per cent for the average fund. "A nice premium," as he put it.

In his update, results were similar. Bogle looked at the top 20 of 1982-92. In the following decade, their average return was 11.1 per cent, above the 10.2 per cent of the average fund.

How useful is this information? Firstly, to capture the advantage, you would really have to invest in all 20 top funds.

If you tried fewer, you could end up with absolute dogs.

True, in the first study, one of the funds ranked second out of 309 funds in the following decade. But another ranked 245th.

In the second study, one fund ranked 14th out of 841 funds; another ranked 823rd.

Secondly, there's no guarantee the top 20 will continue to do better than average in the next period.

Thirdly, Bogle has another point to make. Further number crunching shows that, while each decade's top 20 did better than average the next decade, the S&P500 index did better still.

The S&P500 measures the performance of America's biggest 500 companies. Vanguard and several other firms run index funds based on it.

In 1982-92, the annual return on the S&P500 was 16.1 per cent, compared with the former top 20 funds' 14.3 per cent. In 1992-2001, the index return was 12.6 per cent, compared with the funds' 11.1 per cent.

"While on average winners seem to generate momentum," says Bogle, "the passive strategy trumps the winner strategy, and without all of those added sales charges and taxes."

These extra costs come from active funds' more frequent trading and the costs of researching which shares to buy and sell.

In New Zealand, there is an even greater tax advantage for index funds over most active funds. Under binding rulings from the IRD, the index funds don't have to pay tax on capital gains.

Do Bogle's findings apply to New Zealand? I've never seen such comprehensive research done here.

But, given the extra tax advantage - which can make a considerable difference, especially over the long term - index funds seem to be the way to go in this country, too.

Mary Holm is a freelance journalist and author of "Investing Made Simple", commissioned by the New Zealand Stock Exchange to write an independent personal investment column. She can be reached at maryh@pl.net.

     

Comments from our readers

On 20 October 2010 at 8:34 am Shanti said:

Do you know of a website that lists all of the available index funds that one can invest in from NZ as a kiwi with NZD? Some funds similar to the Vanguard index funds?

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