InvestmentsOct 15 2014

A passive-aggressive approach

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Fuelled by the financial crisis – when investors turned their backs on bank-based products – exchange-traded funds have grown rapidly in Europe and today have gathered over £350bn of assets. The flexibility, liquidity and ease of trading helped to fuel their growth. But perhaps the biggest driver has been cost.

The growth of ETFs has been accompanied by growth in index mutual funds (unit trusts and Oeics). Investors can now buy funds with annual management charges as low as 0.07 per cent a year for large equity markets, compared to the 0.75 per cent a year that they would typically pay for an actively managed fund. This may not seem much difference, but with low inflation and low returns of only 5 per cent or 6 per cent a year, this can represent a 90 per cent saving on fees and have a real effect on long-term net returns, especially as the TER does not take account of the potentially higher dealing costs within an active fund.

Table 1 shows the difference in TERs between active and passive funds for a range of sectors. Such is the pace of change that even this data from last year is likely to be out of date. The of clean share classes has seen AMCs for active funds drop to about 0.75 per cent (though TERs will typically be 0.2 per cent – 0.4 per cent a year higher), but at the same time index funds are now available with TERs well below 0.25 per cent a year for most asset classes (sometimes less than half this).

Table 1: Active and Index TERs. Source: Vanguard

CategoryActiveIndexDifference
Global equity1.260.21.06
UK equity0.950.580.38
European equity1.660.371.29
Eurozone equity1.430.411.02
US equity1.360.261.1
Emerging market equity1.450.371.08
Global bonds1.330.081.25
GBP diversified bonds0.73n/an/a
GBP government bonds0.270.32-0.06
EUR diversified bonds0.840.650.19
USD diversified bonds 0.930.650.28

The UK financial services regulator has also played an important role in facilitating the growth of index fund usage. The abolition of trail commission that was historically paid only by active funds has levelled the playing field. But perhaps more fundamental is the move by advisers to the use of risk-profiling tools.

Driven to have a consistent and repeatable process and by the need to show, in clear pound note terms, the value of advice, advisers are using risk-profiling tools to derive a suitable asset allocation for their customers. Once determined, advisers are then seeking to reduce the cost of the whole value chain (advice, wrapper and investment) while seeking to be appropriately rewarded for the financial planning they provide. A portfolio of index funds will be substantially lower cost than an active portfolio (with the same asset allocation) and thus help an adviser show the value of advice compared to historic products, for example, active fund of funds that typically had TERs of approximately 2.4 per cent a year.

While we are still a long way from a consistent and completely accurate price comparison mechanism (life funds often do not show TERs, and funds charges do not take account of dealing and transaction related costs) it is clear that the desire to reduce investment cost is growing.

The index theory is simple – if you take less out you are bound to have more left in. On an average basis this arithmetic is completely sound (for a given set of funds competing against the same index) – the average of all funds will be the index (less the cost of managing the funds) – so those with lower average cost (annual management charge, other TER elements and transaction costs) must therefore outperform. We will look later at whether the evidence bears this out.

In nine out of 11 sectors over ten years the return of the lowest cost funds is greater than the higher cost funds, according to data from Vanguard.

As advisers seek to articulate their investment philosophy and process (to meet regulator need, to enhance business value and to evidence value to customers) greater use of studies, such as the seminal work by Brinson, Beebower and Hood, on asset allocation are being cited.

Two studies by Brinson, Beebower and Hood in 1986 and 1991 showed that the bulk of the variation in portfolio returns came from asset allocation. If this is accepted, along with evidence that low-cost funds beat high-cost funds then it makes sense for any given asset allocation (such as one derived from a risk-profiling tool) to be effected on as lower cost basis as possible, that is, index funds. We are seeing growth in both pure passive models and fund of funds and in hybrid active and passive vehicles as advisers seek to reduce cost for a given risk (asset allocation) profile.

The rise of model portfolios by managers and advisers is also seeing the greater use of index funds in so called ‘efficient markets’. The argument runs that in highly regulated, transparent and cost-effective markets (such as US equities) it is nigh on impossible for active managers to consistently outperform and thus these markets should be invested in through index funds. In ‘inefficient markets’ such as emerging markets there is more scope for managers to add value – for example, using market cap difference, currency effects and the fact that there are a number of countries/economies in the index.

The latest iteration of this is where index fund research houses and active research houses are pooling resources to bring best-in-class core and satellite model portfolios to advisers on modern platforms. The combination of low-cost wrapper, low-cost dealing and a diversified portfolio of active and passive funds leads to the ‘optimal’ solution.

While the theory around index investing is one thing, advisers will need clear evidence that this is borne out in practice as part of their audit trail. Russell Kinnel of Morningstar produced some evidence in 2008, but this has recently been updated. He grouped funds by asset class then expense ratio in 2008, 2009 and 2010. He then looked at the success rate (the percentage of funds that survived and outperformed their sector over the next four or five years). The data below shows the success rate ranked by cost quintile (lowest cost 20 per cent to highest cost 20 per cent).

Table 2 shows a very strong correlation between expense ratio and success rate. So, for example, the success rate for balanced funds was 65 per cent for the cheapest quintile versus 29 per cent for the most expensive. That means your chance of success in a cheap fund were twice as great as that for a pricey one.

Table 2: Success rate by expense ratio quintile, results for 2008. Source: Morningstar

Broad asset class
Expense Ratio QuintileInternational EquityUS EquityBalanced Taxable Bond
159.555.9865.2264.99
249.945.6960.5659.84
346.1738.8452.0451.40
441.932.8242.6839.37
528.2523.5728.8131.98

Mr Kinnel notes: “The expense ratio would have helped your make a better decision in all asset classes in 2008. The pattern continued in 2009 and 2010.”

The and of platforms is also allowing the creation of model portfolios that can be rebalanced by advisers quickly and cost effectively (though a higher level of regulatory permission is required to do this).

An efficient platform facilitating a low-cost model portfolio of index funds allows advisers or their model managers to undercut the TER of many traditional active fund of funds – indeed it is now possible to offer a platform, with model management and underlying funds for under 0.8 per cent a year – and thus offer a compelling offer to customers.

Larger advisers will also see this as a way of enhancing business value by creating an end-to-end branded customer proposition (advice, wrapper, investments).

Fidelity, one of the world’s largest active managers, has recently moved into the UK retail market with an index fund range.

Its US and UK Equity funds have a TER of less than 0.1 per cent a year.

The growth of passive, for at least part of an investor’s portfolio, looks set to grow. Even with markets strengthening the case for reducing cost remains compelling. It seems that advisers and customers are realising that, for both active and passive funds, the less the manager takes out the more you have left.

David Norman is chief executive of TCF Investment

Key points

* Investors can now buy funds with annual management charges (TERs) as low as 0.07 per cent a year for large equity markets

* The rise of model portfolios by managers and advisers is also seeing the greater use of index funds in so called ‘efficient markets’

* The rise and rise of platforms is also allowing the creation of model portfolios that can be rebalanced by advisers quickly and cost effectively