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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.

Adrian Harrington
March 27, 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

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 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?

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.


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