Volatility in stock markets has certainly played its part, although the upsurge did not really take off until 2010, a full two years after the crisis began.
Historical IMA statistics show high positive fund flows into indexing during the bear market of 2002, just as it did during the most recent bear market as investors shifted away from disappointing active management. This time a push for cost-efficient investing has also strengthened the trend, driven in part by the intense press attention focused on fund manager charging in the past few years. But given the strength of the flows, product launches and chatter around the topic, there must be more to it than that. So what else is going on?
As with previous bear markets, the role of active management has come under scrutiny again. This time more research has thrown light on the problem and asked awkward questions about active management. That research has shown that high-cost active management often disappoints in both down markets and up markets. The allure of index management should not be confined to periods of market difficulty. Few market-changing events have been predicted ahead of time. To succeed, an active manager would not only have to time the market and accurately pick winning stocks during each stage of the cycle, but also do so at a cost that was less than the benefit provided. Table one shows how the median active fund manager performed relative to respective benchmarks across all regions in the past three bull-bear cycles. The results show that, in general, there is no systematic tendency for active managers to do better at any particular stage of the cycle.
In addition an investigation into the persistence of performance has revealed that the great majority of the highest-performing funds in one five-year period rarely persisted with outperformance in the next. This makes the possibility of choosing funds a daunting proposition.
Table two shows the results of some recent Vanguard research. The far left column ranks all active UK equity funds based on their risk-adjusted returns relative to their peer group (Morningstar sector) during the five-year period as at the date listed. The remaining columns show how these quintiles performed in the next five years. Reading across the first quintile, 23.4 per cent of top-performing funds ended up in the bottom group in the second period, with an identical percentage closing down. In other words, the chances of a fund staying in the top-performing band from one five-year period to the next-five year period are worse than a simple flip of a coin.
The combination of suspicion on high fund management costs and the growing realisation of the challenges of active management have arrived just as the UK advice industry has undergone its most significant regulatory transformation in decades. Without the retail distribution review the industry ‘may’ have indulged in some backsliding and sneaked back into high-cost, commission-paying active funds when the markets swung into the green. But fee transparency has prompted a radical cultural transformation. Advisers now have to look their client in the eye and explain how they add value year in and year out to justify their fee.
The RDR deadline has come and gone, but the adviser ‘cultural revolution’ still has some way to go. Early adopters of the fee-based model figured out years ago that focusing on investment management (trying to pick winning funds and beat the market) links their value proposition to market and fund performance – an outcome they cannot control. When it all goes wrong, as it often does, the client blames the adviser.
Rather than picking funds, successful fee-based advisers employ some form of asset allocation process to determine the most suitable portfolio for their clients’ particular goals, time horizon and tolerance for risk. They have figured out that they have a greater chance of adding value, or alpha, through relationship-oriented services, such as providing wealth management and financial planning strategies, asset allocation, rebalancing, tax-efficient investment strategies, cash-flow management, discipline and behavioural guidance, rather than by attempting to outperform the market. If it were easy for advisers to beat the market through investment selection and market timing, then these other value-added services might be a less important. But evidence suggests that beating the market is anything but easy.
In my experience of working with fee-based advisers in the UK and overseas, shifting an adviser’s value proposition and implied service promise away from market outperformance to valued-added personal service usually results in improved client retention. When clients understand that services such as behavioural coaching actually add value above and beyond what they could have achieved on their own, they are not as likely to judge you solely based on your performance relative to a market benchmark.
Having decided to focus on asset allocation, advisers need low-cost, high-value, transparent methods of delivering the broad market return to build their client portfolios. Indexing offers the benefit of transparency as advisers and clients can see what they are investing in by looking at the index constituents.
If the experience of other markets where the fee-based model is further developed is anything to go by, indexing will continue to grow as the cultural shift gains strength. The experience in the US in the past 15 to 20 years, for example, shows that as advisers shift to a transparent, fee-based model, low cost takes a permanent and significant place at the centre of client portfolios. Active management has its place, but a concurrent theme will be continued downward pressure on costs, along with more transparency in charges, a trend that is wholly in the client’s interests.
Nick Blake is head of retail of Vanguard Asset Management
Key points
Net retail flows into tracker funds went from -£284.4m in 2006 to more than £2bn in both 2010 and 2011.
The combination of high fund management costs and the challenges of active management have arrived just as the UK advice industry has undergone its most significant regulatory transformation in decades.
Successful fee-based advisers employ some form of asset allocation process to determine the most suitable portfolio for their clients’ particular goals, time horizon and tolerance for risk.
