Index Funds - Do they have a place in Investment Portfolios?

What are index funds? Index funds are funds that invest in accordance with one of the many different sharemarket indices. Common examples of Indices followed by New Zealand based index funds include the Morgan Stanley Capital International Index (MSCI) for World Shares, the NZSX 10 (for example TENZ), NZSX MidCap Index, and more recently the NZSX 50.

Index funds should under-perform the index, simply because of the costs of running the fund. These should be less than for actively managed funds.  In practise we see little difference in the management expense figures of index funds versus the actively managed wholesale funds that our portfolio clients are invested in. Index fund managers do not spend money researching the individual companies that the fund invests in. They buy the index companies warts and all.

When purchasing Index Funds on the sharemarket, you may be paying either a premium or buying them at a discount. They do not necessarily sell at the underlying asset prices. There are also significant transactional costs associated with the sale and purchase of shares.

In difficult times if you are invested in index funds, you need to have a strong resolve to stay fully invested.   Looking back in time, for the year ending 31 January 2002 the MSCI lost 20.73%, significantly worse than what was achievable in client portfolios using an appropriate mix of international share funds.

Unfortunately for Index Fund investors, not all parts of a sharemarket perform the same. There was a long period of time when the NZSX 10 representing the largest New Zealand listed companies, seriously underperformed the market as a whole. Smaller companies at times also outperform the broader market.

History shows that it is not difficult for active fund managers to outperform the index on a before tax basis. There will be periods of strong out-performance, and also periods when they may be marginally behind the index.  One of the biggest factors determining individual investment fund performance is taxation.  Index funds are commonly regarded as tax advantaged over actively managed funds as their gains are tax free. However, an active manager is tax advantaged in falling markets, and for the period of strong market recovery following losses. 

No New Zealand tax paying investor is going to achieve the returns of the benchmark NZSX 50 New Zealand sharemarket index, as the dividends are grossed up in the index. That is they include the imputation credits associated with the underlying shares. With dividend yields around 6%, normally a third of the gross dividend will be paid via imputation credits.

For tax reasons, New Zealand based international index funds only invest in countries not affected by New Zealand’s Foreign Investment Fund taxation regime.  The end result is that there are international index funds investing in only six countries, with one of these being Australia.  We believe that investors need exposure to most European countries and some prudent exposure to Asia.  Index funds do not allow this.

There can be a role for a smallish core of passive investments in the share component of a portfolio. This should be complemented with appropriate actively managed investments.