#57 Why most fund managers invest in line with the index

Before investing in active or passive strategies, it is worth taking a systematic look at the fundamental relationship between risk and expected return. In order to achieve an appropriate return, you must be able – and willing – to take a certain amount of risk. This is individual: while some people can still sleep soundly when their portfolio is down 50 percent, others reach their pain threshold at just ten percent.

That is why it is crucial to first determine how much risk of value fluctuation you are willing to bear overall. Once you know your personal risk budget, for example, if you accept a volatility of 20 percent, the question arises as to how to allocate this budget wisely.

Part of it should always be reserved for the risk premium that can be expected from the overall market in the long term: the so-called beta. This can be cost-effectively replicated with broadly diversified index funds. With the second part of the risk budget, you can bet on one or more fund managers beating the market – the so-called alpha. It doesn't matter whether a manager tries to do this through stock picking or market timing.

From a risk/return perspective, however, it makes little sense to allocate too large a portion of the risk budget to alpha. It is undisputed that the overall market offers a risk premium. However, whether there is a risk premium for active management in the long term remains speculative.

Alpha is also expensive – and it has to be. It therefore makes sense to separate alpha and beta so as not to pay high fees for just average active management. It is better to allocate only a small portion of the risk budget to active managers who consistently and clearly deviate from the market. This is the only way to assess whether real added value is being created.

In practice, however, many active funds are hardly active at all. Their investment strategies deviate only minimally from the benchmark. Numerous Swiss equity funds, for example, closely resemble the Swiss Performance Index (SPI). A look at individual products shows that the largest positions – such as Nestlé, Roche, or Novartis – often correspond almost exactly to the index. Deviations are often marginal, while fees are significantly higher than for index funds or ETFs.

It is hardly surprising that such funds generate little alpha. Since 2014, a simple SPI ETF has achieved a return of around 100 percent, while comparable active funds have in some cases fallen significantly short of this figure over the same period. Proximity to the benchmark naturally leads to very similar performance – minus higher fees.

So why do many fund managers invest so closely to the index? One obvious reason is career risk. Those who deviate significantly from the benchmark and are successful are considered heroes. However, those who fail risk their jobs. As a result, many managers prefer to stay close to the index – regardless of whether this makes sense for investors.

Do you have another explanation for why so many fund managers stick to their benchmark? Send me an email with your thoughts.