Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 195

You get what you don’t pay for

“You only find out who is swimming naked when the tide goes out” is one of the great lines Warren Buffett has passed on to investors many times.

It appears a lot of people in the fund management industry have been swimming naked for the past 10 years. The S&P Dow Jones SPIVA (the Standard & Poor’s Index Versus Active) scorecard for 2016 does not paint a pretty picture for the performance of Australian active managers for the past decade.

More than 80% of international equity and bond funds underperformed their respective benchmarks for the 10 years to December 2016. For Australian equity and REIT funds, the result was slightly more respectable — only 70% underperformed the index.

In his most recent Chairman’s letter to shareholders, Buffett sent a clear message to investors around the world about how hard it is to find someone who could outperform the market over the long-term.

“There are some skilled individuals who are highly likely to out-perform the S&P 500 over long stretches. In my lifetime though I’ve identified, early on, only ten or so professionals that I expected would accomplish this feat”.

Strong growth in indexing but active still dominates

It should not surprise that there is a global shift by investors to index and index-style investment approaches. Back in 1997, indexing crossed the threshold of having more than USD 1 billion in assets under management. Today, that figure is more than USD 5 trillion.

Yes, growth has been strong, but given recent commentary from some corners of the investment community you could also be forgiven for thinking that the index approach is swamping the active management market. Indeed, some claim the growth of indexing may compromise price discovery, increase market volatility and even lead to outcomes “worse than Marxism”.

In reality, indexing remains a relatively small portion of the market. Even in the US where the indexing take-up by investors has been stronger for longer, indexing represents only about 35% of the mutual fund market. On a global level, indexing represents around 15% of share market value and 5% of global bond market value.

In Australia, investors and advisers have been slower in adopting indexing although growth has been strong in recent years, in part due to the development of ETFs. The market share of indexing according to Rainmaker figures is around 17%. In other words, 83% of funds in Australia are actively managed, so reports of the demise of active management seem altogether premature.

Active and index can be complementary

There is no shortage of cheerleaders for the active cause, many of whom contribute regularly to Cuffelinks, and being a competitive industry, it is not surprising that active managers are fighting back.

Vanguard strongly believes there is a role for active management within investor portfolios, demonstrated by the fact about 30% of our global assets are managed in active funds and in Australia we have recently begun introducing active strategies to give Australian investors and financial advisers new choices when building their portfolios.

While the active versus index debate has been anchored around performance, for which the S&P Dow Jones SPIVA report provides the scorecard, what is perhaps missing is a broader discussion about costs.

Warren Buffett’s recent shareholder letter was as much about the impact of high fees on investor returns as it was the challenge of successfully picking active managers.

The impact of management fees and other expenses

In an Australian context, this goes a lot further than simple fund manager fees. What is critical for the investor is the total amount of fees deducted from their investment, including by the fund manager, platform, advice and fund administration.

Rice Warner was commissioned by Vanguard to study the impact of fees during an average super fund member’s contribution life.

Looking at a 20-year-old female in 2016, the Rice Warner modelling examined the impact on their super balance at retirement, assuming this occurs at 65 years-of-age, if the 1.10% per annum cost (the historical average superannuation fund fee) to their super was lowered.

In the base case, if the 20-year-old continued to pay 1.10% per annum on their super balance throughout their working life, they would have around $1.08 million super balance at retirement. However, a decrease in fees of just 20 basis points (0.20%) to 0.90% per annum would mean an additional $44,585 in their account. If fees fell a further 20 basis points it would mean an additional $91,428 at retirement.

And if we lowered expenses to 0.60% per annum, our 20-year-old case study would have $140,654 extra to support their retirement.

Regardless of investment style, low costs are a critical determinant of manager success. In fact, Morningstar has found that cost can be a more consistent indicator of fund success than its own star-rating system.

Inevitably, some may argue that higher costs are needed to support more labour-intensive active management, but investors and their advisers shouldn’t let this kind of argument blind them to a simple fact: paying more to chase outperformance will likely be a self-defeating exercise.

 

[Latest interview with Jack Bogle on CNN. Draws an interesting distinction between a republic and a democracy, and explains how it took 17 years before indexing really started to gain traction].

 

 

 

Robin Bowerman is Head of Market Strategy and Communications at Vanguard Australia, a sponsor of Cuffelinks. This article is general in nature and readers should seek their own professional advice before making any financial decisions.

  •   23 March 2017
  • 3
  •      
  •   
3 Comments
Jerome Lander
March 23, 2017

As an outcome and client orientated industry professional, when I'm looking at supposedly active managers, I can quickly assess the vast majority of them as being pseudo-index managers, that is managers who are effectively index managers 'in disguise'. That is the sad state of our industry. When considered in this more detailed manner, indexing can be considered much bigger than the figures you propose above and is in fact the dominant investment approach by far. It is hence no surprise that an expensive indexing strategy (or "active management" in general) performs even more poorly than a cheaper indexing strategy.

Again, the reality is that most supposedly active managers are in fact really index managers in disguise. Indexing is a suboptimal investment approach except arguably in bull markets, where it tends to do very well. It may be the only approach accessible to many unfortunate clients who are being poorly served by our industry, but in no way is it the best way to manage a portfolio against client's specific objectives all the time, particularly currently when asset prices are high.

The very few professionals in the industry who are focused on goals based investing better align portfolios with investors' real needs for their portfolios, and hence can and do produce much better results over the long term for their clients. A simple example - if a market is priced to deliver a few poor outcome over time (as many are today), it most probably will deliver a poor return over a full cycle (i.e. not just the bull market we have had recently). Why own it just because it is part of an index if there are other options (and there are)? This is self-evident.

If you want to be a genuinely active investor and produce portfolios aligned to investor goals, you are unfortunately not well served by much of what gets produced by the industry. You need to do things differently, and understand all the details or align yourselves with those who do. You may need to ignore any information showing that cheaper index managers are better than more expensive index managers, when that will obviously be true and born out in the facts. Ignore the obvious such as information showing that practically the entire market will underperform the entire market after fees, because this is self-evident and needs no great statistical knowledge to understand - it can be worked out from first principles.

Laurent
March 23, 2017

Hi Jerome, your post is not very clear to me. You are saying "Why own [a fully priced market] just because it is part of an index if there are other options (and there are)?".
There are several active multisector funds around and most perform poorly too.
What are your other options then?

My "secret formula" for Tactical Asset Allocation is based on 2 main criteria :
1) To select markets, I use the Schiller CAPE (for example https://www.researchaffiliates.com/en_us/asset-allocation/equities.html). At the moment Russia is cheap, Australia is fairly valued and the US are very expensive).
2) To select assets, I use where we are in the business cycle but this is often subjective. At the moment, most think that we are still in the Mid phase as interest rates or inflation haven't raised yet. Growth assets and small caps are supposed to perform better at that stage of the business cycle.

So if I had the guts for it, I should invest in Russian oil companies. But I am a bit of a chicken so I will stick to Australian small caps.

Your turn: what is your "secret formula" then?

Adrian Harrington
March 26, 2017

Robin there is no question some managers don't deliver active performance and charge high fees. However, the issue I have when I hear advocates for Indexing the Australian A-REIT sector is do they, and their investors, fully understand the composition of the Index. The S&P/ASX300 A-REIT index is one of the most flawed indices when it comes to composition. The concentration risk is enormous. The two top securities - SCentre (19.5%) and Westfield (14.2%) account for a mighty 33.7% of the Index. Take the top 8 securities (these two plus Goodman, GPT, Mirvac, Stockland, Dexus, and Vicinity) and it is 83% of the Index. Also, the retail trusts account for 46.7% of the Index (in the US it is just 22%). Add to this the retail property that the diversified A-REITs own - Mirvac, GPT, and Stockland, and the exposure to the retail sector at the underlying asset level heads towards 60%. Given the structural and cyclical issues facing retail, that is a massive bet on the retail sector if you follow the Index. The only sure thing about using an Index fund in the A-REIT sector is you will get an Index return. However, investors need to understand the risk they are taking by following an Index strategy when the Index composition is so skewed to a few securities and one sector. At Folkestone, our A-REIT Securities fund (the Folkestone Maxim A-REIT Securities Fund) follows a high conviction strategy because we are concerned with the flaws in the Index. And the proof is in the returns - at the end of February 12.6% pa. vs 8.2% Index - a 4.4% after fees outperformance over 1 year and 17.4% p.a vs 15.9% p.a - a 1.5% after fees outperformance over 3 years. Adrian Harrington Head of Funds Management Folkestone

 

Leave a Comment:

RELATED ARTICLES

Does Barrenjoey hold the key to Magellan's fortunes?

The 60/40 portfolio is back

Active or passive – it’s time to change the narrative

banner

Most viewed in recent weeks

Retirement income expectations hit new highs

Younger Australians think they’ll need $100k a year in retirement - nearly double what current retirees spend. Expectations are rising fast, but are they realistic or just another case of lifestyle inflation?

Four best-ever charts for every adviser and investor

In any year since 1875, if you'd invested in the ASX, turned away and come back eight years later, your average return would be 120% with no negative periods. It's just one of the must-have stats that all investors should know.

Why super returns may be heading lower

Five mega trends point to risks of a more inflation prone and lower growth environment. This, along with rich market valuations, should constrain medium term superannuation returns to around 5% per annum.

The hidden property empire of Australia’s politicians

With rising home prices and falling affordability, political leaders preach reform. But asset disclosures show many are heavily invested in property - raising doubts about whose interests housing policy really protects.

Preparing for aged care

Whether for yourself or a family member, it’s never too early to start thinking about aged care. This looks at the best ways to plan ahead, as well as the changes coming to aged care from November 1 this year.

Our experts on Jim Chalmers' super tax backdown

Labor has caved to pressure on key parts of the Division 296 tax, though also added some important nuances. Here are six experts’ views on the changes and what they mean for you.        

Latest Updates

A speech from the Prime Minister on fixing housing

“Fellow Australians, I want to address our most pressing national issue: housing. For too long, governments have tiptoed around problems from escalating prices, but for the sake of our younger generations, that stops today.”        

Taxation

Family trusts: Are they still worth it?

Family trusts remain a core structure for wealth management, but rising ATO scrutiny and complex compliance raise questions about their ongoing value. Are the benefits still worth the administrative burden?

Exchange traded products

Multiple ways to win

Both active and passive investing can work, but active investment doesn’t in the way it is practised by many fund managers and passive investing doesn’t work in the way most end investors practise it. Here’s a better way.

Economy

The Future Fund may become a 'bad bank' for problem home loans

The Future Fund says it will not be paying defined benefit pensions until at least 2033 - raising as many questions as answers. This points to an increasingly uncertain future for Australia's sovereign wealth fund.

Investment strategies

Managed accounts and the future of portfolio construction

With $233 billion under management, managed accounts are evolving into diversified, transparent, and liquid investment frameworks. The rise of ETFs and private markets marks a shift in portfolio design and discipline. 

Property

Commercial property prospects are looking up

Commercial property is seeing the same supply issues as the residential market. Given the chronic undersupply and a recent pickup in demand, it bodes well for an upturn in commercial real estate prices.

Infrastructure

Private toll roads need a shake-up

Privatised toll roads in Australia help governments avoid upfront costs but often push financial risks onto taxpayers while creating monopolies and unfair toll burdens for commuters and businesses.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.