If I cast my mind back to my university days (approximately 25 years ago) I recall undertaking a finance subject in which we compared returns from active fund managers to respective index returns that those same managers were being paid to beat. The outcome of the study over varying time periods was dismal if you backed active management. You see, over the long term most active managers underperformed their respective benchmarks.
With the conclusive test results in, the next logical question to ask was ‘Why use active managers at all?’ Well, back then it was very difficult to replicate the index cheaply, this was the time before the rise of the Exchange Traded Fund (ETF). Your only real option was to buy all the shares in exactly the same concentration as the index and then reweight them on a regular basis. As you can imagine the trading costs blew you out of the water.
The other key aspect was that the average active manager underperformed over the long term. The flip side to this statement is that there are some managers who show persistent skill at outperforming the index. The hard part for investors is picking who those managers are ahead of time and staying the course of time.
Recently S&P Australia released their annual SPIVA report which compares the returns of active managers against benchmark returns. In short, the analysis is very similar to that which I undertook all those years ago. So, has active management improved and blitzed the benchmarks? Drumroll please…..
Sadly the answer is no. Today we see very similar results to those witnessed 25 years ago. The most recent report provided the following insights.
Percentage of funds which outperformed the index
Australian General Equity
Australian Mid and Small cap
S&P Developed ex Australia Large-Mid cap
S&P/ASX Australian Fixed Interest 0+ Index
S&P/ASX 200 A-REIT
Source: S&P Dow Jones SPIVA Report 31 December 2016
When analysing the data above a couple of quick observations can be made. Namely that roughly one third of Australian Equity managers outperform, the majority of Mid and Small cap managers outperform and next to no International equity managers outperform.
The big difference today is that you can easily replicate the indexes with cheap ETF’s and you can buy them via discount brokers. And the persistent question remains, ‘Why use active managers?’
Recently there has been a significant amount of press coverage, and well placed adds, raising this very question. The inevitable thematic being, if you can’t beat the indexes just use them. A number of the reports have also tried to link the incredible growth of ETF’s (mainly in the US however, increasingly in Australia) to the same report highlighting active underperformance.
As in any battle, there are strong advocates on both sides ready to shout down the other as heretics. Personally, I belong to neither side – I stand in the middle and try and engage the analytical side of my brain to determine which course of action to take.
The first aspect that I would raise is that these are point to point return calculations i.e. the 10-year data is a return calculation from 1 January 2007 to 31 December 2016. Show me an investor who is prepared to place their money in an index for the next 10 years and only look at it again in 10 years’ time and I will happily say, take the index ETF. Unfortunately, these investors are as rare as hen’s teeth, human nature simply does not allow us to set and forget. We feel compelled to look at how the investment is tracking. The constant barrage of news media shouts each time that the market drops but interestingly stays quiet when it rises.
The risk for these investors was clearly highlighted during the Global Financial Crises (GFC). We have all heard of people who rode the market all the way down only to throw the towel in towards the bottom and then sit out of the market for years, missing much of the upside. Markets do not follow the straight line of point to point returns, there are rises and falls along the path. If it is in your nature to exit markets after the fall then I argue ETF’s are not the answer for you.
So, if these investor types are so rare does that mean we should never use ETF’s? Clearly the answer here is no, I believe that there are times that it is appropriate to use them and times where I question their usage. I do not believe that the rise in ETF use is principally linked to the active versus passive debate, I think it is more about the low cost versus high cost argument.
Jack Bogle, the grandfather of ETF’s who established the Vanguard group, recently presented to the CFA Institute in the US and provided insight into the growth of ETF’s. In the past decade, US$1.3 trillion has found its way into US equity indexes while active managers have suffered outflows of US$1.1 trillion and the bulk of these flows have been in the last five years.
Invariably, investors focus less on fees when markets are providing strong returns. After all, if you are earning 15%+ on your investments you pay less attention to how much the fund manager is charging you. However, when returns drop well below 10% and you are constantly being warned that future returns are likely to be 7% or less, fees become a significant focus. Yes, ETF’s have a place in a portfolio but as investors we need to understand when that time is, how to use them and most importantly which ones.
Many investors have simply rushed into ETF’s due to the lower cost and while costs are an attractive thematic, it should not be the key consideration. The most important aspect to remember when looking to invest in ETF’s is to understand what you are buying. By that I mean, how is the underlying index composed? What does the index cover? How is it replicated? How closely does the ETF trade to the actual index returns?
A number of years ago an Australian Credit ETF was launched onto the market looking to track the returns of unlisted bonds issued by companies here in Australia. Given where credit spreads were at the time this seemed like a great idea and worthy of further consideration. On digging though, it turns out that the underlying holdings were simply four bonds issued by each of the big banks. While the banks are big issuers in our market they are not the market entirely. Or how about the ethical ETF that bans cluster bombs but allows manufacturing and selling of hand guns and rifles?
The importance of understanding the underlying index is also reflected in a common story told by many active fund managers. Some time ago, numerous managers were sitting on holdings in a particular company that they were all looking to divest. The problem was that there were no real buyers and the share price gradually fell away. What was interesting was that as the price fell away the dividend yield of the stock climbed. Please note that this was the dividend yield based on the past years dividend paid which every fund manager knew would not be repeated. As the yield grew new buyers emerged, ETF’s that were looking to replicate high income generating sections of the index. Needless to say, the managers were more than happy to sell and had a few chuckles when the company announced that it would be slashing its dividend.
It is imperative that investors know the composition of the index they are tracking and understand the fundamentals of what is driving that particular index. Think about it, market capitalisation indexes simply buy more and more shares of companies as they go up in price. The more expensive it is the more you buy, the more indebted a country/company is and issues more bonds, the more the index buys. Is that a sound investment strategy for all times?
To quote Jack Bogle ‘The index revolution, like all revolutions—is not without its flaws. The most recent flaw is the focus on the concept of “Smart Beta”. Successful short-term marketing strategies are rarely—if ever—optimal long-term investment strategies.’1
Active management is not dead, the table referenced above shows that there are still pockets where active stock selection adds value. Active funds still represent 60% of the investment market and for the year ended 31 December 2016 global flows into active funds were three times the size of ETF’s. It may interest readers to know that Vanguard is also an active fund manager in the US and it had greater flows into the active segment of the business than the ETF segment last year. This is partly the reason that I think the rise of ETF’s is more about manager fees charged than outright returns.
The positive for investors is that fees will need to keep coming down if active managers want to remain relevant in the broad retail market. Economic and investment markets always move in cycles, so do the opportunities in active and passive strategies.
1 – Bogle, J. Reflections on a Revolution. 70th CFA Institute Annual Conference. May 23, 2017
Keep Wealth Partners Pty Ltd (AFSL 494858). This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different and you should seek advice from a financial planner who can consider if the strategies and products are right for you.