The latest SPIVA Australia Scorecard is out, and the results are telling for investors…

The Australian share market surged towards the end of last year, recording a total annual gain of more than 12%.

That was good news for people who invest in index-tracking funds, including exchange traded funds (ETFs), that have been designed to capture the broad return from the local share market by having holdings in hundreds of Australia’s largest companies.

But the story was different for many investors in Australian equity general funds, where portfolio managers hand-pick specific companies in an attempt to outperform the broader market.

New data released by S&P Dow Jones Indices shows 76.5% of these actively managed funds struggled to keep up with the market’s performance over 2023 – the second-highest underperformance rate on record.

The data was contained in the latest SPIVA Australia Scorecard, which measures the performance of actively managed funds relative to index benchmarks over various time horizons.

Longer term, underperformance rates have been even higher. A majority of actively managed Australian equity general funds have underperformed the broader share market over the last three, five, 10 and 15 years. In fact, the market underperformance rate rises to 85.3% over the last 15 years.

As the chart below shows, it’s a similar story for other types of actively managed funds.

Among international equity general funds, 81.4% trailed the 24.1% total return from the S&P Developed Ex-Australia LargeMidCap Index last year. The underperformance rate of actively managed international equity funds rises to 94% over 15 years.

A compelling argument for index funds

Duncan Burns, Vanguard’s Chief Investment Officer, Asia Pacific, says the latest SPIVA results highlight the benefits of using index funds as the core of an investment portfolio.

“This year’s results could be summed up simply as, most active managers underperform their passive benchmarks most of the time. This is particularly underscored by the one-year underperformance for active Australian equity and international equity funds rates being their second highest in recent years.

“Findings like these are not isolated to the Australian financial markets; the reporting shows similar long-term results in global share and bond markets.

“This is not to say active fund managers can never outperform the broader market. A number of exceptional active managers do.

“Active bond managers did well particularly in the last 12 months, although the majority underperformed when looking at the last three-year period. But the report serves as a good reminder that beating the market is really much harder than most people think.”

Active headwinds

Costs, something that all investors are subject to, are a large contributing factor to active fund underperformance as they tend to be much higher than those of index funds, creating a headwind to performance.

A less discussed hurdle to active fund outperformance is the skewness of share market returns.

The reality is that investors with a well-diversified index portfolio typically experience frequent small losses from the majority of securities, but a few exceptionally large gains from a subset of their holdings.

For example, about 33% of the top 300 Australian companies outperformed the return from the S&P/ASX 300 Index in 2022. To outperform the market, an active investor needed to be concentrated in that 33% of outperforming companies.

Over the longer term, from 2012 to 2022, only 17% of companies in the S&P/ASX 300 Index outperformed the broader market average. Further, the top three ASX securities accounted for 24% of the total index return.

This meant active investors who didn’t have those three securities in their portfolio would have missed out on a large chunk of the market’s return.

Conclusion

“If there is one takeaway from the data, it’s that index funds and ETFs should be a consequential piece of a core portfolio,” Mr Burns adds.

“History has shown that investors with an active-based investment strategy are more likely to experience portfolio return outcomes in the larger part of the distribution that underperforms, rather than the smaller percentage that outperforms.

“And this is why serious money portfolios continue shifting that direction and the index revolution is increasingly taking hold here in Australia.”

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