We review the relative performance of Australia’s leading indices and look at the long-term impact of underperformance. We also examine the fundamental limitation of the ASX Small Ordinaries index and why you should never passively invest in it.

7.7% returns are nothing to boast about

With the financial year coming to an end, there’s been a noticeable increase in the volume of advertising from the shrinking number of superannuation funds. With voice-overs proudly boasting “7.7% annual return over the last ten years”, I decided to see just how good that is. In summary, not very.

As shown in Table 1, over the last 10 years, the ASX All Ordinaries index (total return) has returned an annualised 9.1%, a full 1.4 percentage points higher than the boastful (but nameless) super fund. While this might not sound like much, compounding this performance gap over several decades (as super is designed to do) results in a massive difference. Over ten years, the 140 basis points difference puts you 26% ahead. Over 40 years, the 9.1% portfolio is 71% ahead, delivering 31.6x your money, compared to 18.4x with a 7.7%.

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Small caps index: fundamentally flawed

For a lot of investors, passive index funds provide a sensible investment strategy for most (if not all) of their equity exposure. However, not all indices are created equal, and some, such as the ASX Small Ordinaries index (small-caps index), should be avoided at all costs.

As shown in Table 1 and Figure 1, the small cap index has consistently underperformed the three other major indices (All Ords, ASX 300 and ASX 200) in absolute terms. Indeed, over the last 20 years, the small caps index has provided a total return of less than 5%, compared to around 8% for the other indices.

While there are various reasons for the underperformance (greater economic sensitivity, high financing costs, economies of scale, illiquidity), I argue that the underperformance is also a result of the index’s construction.

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