Investing is a long-term commitment, and that’s especially true for index fund investors. Indexers have time on their side. Because of the effect of compounding costs, it becomes progressively harder for active investors to outperform their passive peers the longer they invest for. It is, however, very possible that index fund investors will achieve higher returns than the the average active investor over short periods as well, as new research in the UK shows.
“The historical data support one conclusion with unusual force,” the late index fund champion Jack Bogle wrote in The Little Book of Common Sense of Investing. “To invest with success, you must be a long-term investor.” Of course, it’s possible to make a quick killing, but it’s essentially down to luck. There are so many actively managed funds to choose from at any one time that there are bound to be funds that have outperformed in the recent past. A much more reliable route to wealth, Bogle explained, was to invest for the very long term in index funds.
The reason for this is largely down to cost. According to Morningstar, the average fee for an equity passive fund in the UK is 0.17 per cent, compared with the average active fee of 0.81 per cent. Once the additional transaction costs incurred by active investors are factored in, the difference is even greater. Compounded over decades of investing, the cost advantage of passive funds translates, on average, into substantially superior net returns.
Yet even over short periods of time, passive solutions can deliver better outcomes than using actively managed funds. This was recently illustrated by the financial data provider Defaqto, which compares the performance of model portfolio solutions used by UK financial advisers.
Huge difference between the winners and losers
Specifically, Defaqto looked at the cumulative return produced by portfolios categorised as “adventurous” 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 three-year period was 26.31 per cent. The average return for the whole category was just 10.19 per cent.
But the most remarkable finding is that nine out of the top ten portfolios were passively managed. The best performer of all was Timeline’s Tracker 100, which has a 100 per cent allocation to equities. Its three-year cumulative return was 29.14 per cent, which was 18.95 per cent better than the overall average. Timeline’s Tracker 90, which has an equity holding of 90 per cent, returned 25.22 per cent, which was 15.03% better than the average.
This was in stark contrast to the worst performers. During the three-year cumulative period in question, 51 portfolios failed to achieve a total return of two per cent. Of those 51 portfolios, 27 even contrived to record an overall loss!
What the best performers have in common
The best-performing portfolios had two main things in common. The first is that they were significantly cheaper than most of their peers. The average cost of the top ten performers was 0.30 per cent, whereas the average cost for all of the portfolios analysed was 85 per cent. Timeline’s Tracker 100 and tracker were the very cheapest at 0.20 per cent.
This gave the Timeline portfolios a huge cost advantage over their rivals. Out of the 261 portfolios Defaqto looked at, 103 had fees in excess of one per cent. Of those 103 portfolios, 27 portfolios had fees of more than 1.30 per cent — in other words, they were six-and-a-half times more expensive than the Timeline portfolios.
The second similarity shared by the top ten performers is that they had a significantly higher allocation than their peers to North America — an average of about 53 per cent, compared to an average of 33 per cent for the group as a whole. The top ten performers also had a smaller-than-average weighting to both UK and emerging-market equities.
Lessons for investors
So what conclusions can we draw from this latest evidence? The first thing to note is that, in the context of an investing lifetime, three years is a very short period of time. Most people invest for 50 years or more, so very long-term evidence is far more useful than a brief snapshot such as this.
Another point worth noting is that asset allocation is a hugely important factor in the returns investors receive. US stocks performed especially well over the three-year period Defaqto looked at, while UK and emerging-market equities performed relatively poorly. That is a major reason why the Timeline trackers and the other passively managed portfolios fared so well.
Over time, the UK and emerging markets are bound to come back into favour. When they do, portfolios with greater weightings to those sectors will perform better, though of course nobody knows when that will be.
All that said, the Defaqto research is still significant because it shows us that, even over shorter time periods, index-based solutions can deliver very positive 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 from Timeline.
Remember, it’s over much longer time periods that the benefits of indexing really stand out. Will Timeline Tracker 100 be the best performer over the next three years? Nobody knows. However, the chances are that, 20 or 30 years from now, it will still be somewhere near the top of the list, and, crucially, the gap between Timeline and the worst performers is likely to be far, far greater.
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