Index funds and the adviser alpha model offer more protection against active losses

Index funds will play an increasing role in investor’s portfolios as advisers reject the risk associated with seeking pure outperformance, Vanguard’s Francis Kinniry says.

Speaking at the firm’s Investment Symposium last week, Kinniry said the traditional approach of adding value by attempting to outperform a benchmark is changing.

He says the use of index funds and the growth of “adviser alpha” are more effective ways to meet investors’ needs and protect them from active management losses.

“No strategy works consistently year over year, and it is during those periods where a strategy is out of favour where clients may not appreciate the long-term track record,” Kinniry says.

“This is where indexing can help. Combining index and active strategies maintains
positive alpha but truncates the extreme downside risk of active management.

“Outperforming passive benchmarks continues to be difficult and there are extremely high hurdles for this model. It requires tremendous alpha after two fee layers and the vast majority of managers do not achieve the outperformance they are aiming for.”

Kinniry claims only 30% of active equity managers are capable of beating the benchmark return over 10 years, while in fixed income the figure is even lower, at about 15%.

“The result of all this is low asset retention rates and high client turnover,” he says. “The ‘adviser alpha’ model emphasises more reliable benefits of a professional relationship.”