How advisers can add value beyond the index

The most common answer is to also include actively managed funds with the potential to deliver outperformance relative to funds that track traditional benchmarks alone. However, generating alpha is a competitive-some would argue zero-sum1-high-cost game, and the growth of indexing has exposed closet 'index huggers' and created a shift towards high conviction and index unaware active strategies.

Investing is about the journey, not just the end point

Take the five largest Australian-domiciled, active global equity fund managers for example. By comparing these funds' performance to the benchmark MSCI World Ex Australia Index (AUD), we get a picture of how high conviction active strategies can deviate from market benchmark returns. Figure 1 shows these funds' excess returns to the benchmark over 12-month rolling periods.

Figure 1. Source: Bloomberg, Morningstar, Betashares. Five largest Australian Active Global Equity Managers from Morningstar Large: growth, value and blend categories as at 31 December 2023 selected as 'Selected Active Managers'. Monthly rolling 12 month excess returns relative to MSCI World ex Australia NR (AUD), ten years to 31 December 2023. You cannot invest directly in an index. Past performance is not indicative of future returns of any index or fund.

The myth of outperformance

Active managers will often highlight the importance of their unique expertise, research process and security selection in constructing their investment portfolio.

However, over the last twenty years, a whole new field in indexing has developed around factor or smart-beta investing. And it turns out that factor investing targets the same risk premia that many active managers have long relied on. Investors can now get exposure to these risk premia through lower-cost funds that seek to track a rules-based factor index.

Regarding active managers that pursue a style bias, we have observed the following:

Often, any 'outperformance' above broad market beta is in fact partially or fully attributable to a factor exposure rather than the manager's stock-specific bets-that is, 'true alpha'.

The management costs of rules-based factor index ETFs are generally far lower than those of active funds.