Fidelity Investments have recently cut charges on their range of very low cost index tracker funds undercutting their rivals and raising again the old chestnut, is it worth paying extra management charges for a fund manager to actively select stocks compared to buying a low cost index tracker? To remind you index trackers and Exchange Traded Funds (ETFs) are passive investments that seek to replicate the performance of a stockmarket index for example the FTSE All Share or S&P 500 indices.
Advisers and professional investors are very much divided with strong advocates on both sides. Historically I have favoured active fund management, inherently it makes sense to select stocks and I think fund managers do have skills (those that advocate passives suggest outperformance is random or not consistent), however I am open minded and with Fidelity’s ultra-low management fees and recent study of high quality research on passive versus active fund management from Vanguard, a leading provider of index trackers and rPlan, an investment platform, I am happy for my convictions (some may say prejudices) to be challenged.
In the words of Donald Rumsfeld, former US Secretary of Defence “there are known knowns and known unknowns.” When it comes to fund management there is a known known at outset, management charges and index trackers are indisputably cheaper than actively managed funds. As an example the newly launched Fidelity Index UK fund which tracks the FTSE All Share Index has an ongoing charges figure (OCF)* of 0.07% p.a. if bought through Fidelity. On other platforms the charge is 0.09% p.a.
An OCF is the annual management charge plus fund expenses such as custodian and auditor fees. Fidelity’s and other index tracker providers’ charges are dirt cheap and compare very favourably with a typical 0.75% p.a. to 1% p.a. OCF for actively managed funds. Although Fidelity’s other trackers carry OCFs ranging from 0.08% p.a. to 0.23% p.a. the latter for their emerging markets fund, actively managed funds clearly start the race with an impediment, and if performance is identical passive funds will outperform. Moreover the long term compounding effect of lower charges is very significant. Finally when equity returns are low or falling fixed fees have a more significant impact than in bull markets; its basic maths. In conclusion If you follow the investment maxim to make decisions based on what you know rather than what you do not know then index trackers are the best choice.
Here we are in the realms of known unknowns as unlike charges performance cannot be predicted in advance, assuming past performance is discounted. What I find interesting however, even with hindsight financial experts disagree whether the evidence shows active or passive fund management has done best! You can wheel out selected statistics to argue both ways. As my wife reminds me, her experience from disputes at work is, “one person says one thing, someone else says another thing, then there is the truth.” Now I do not wish to be arrogant and claim …here comes the truth but I offer the following points in no particular order for and against index tracking.
The claim that passive index trackers outperform is not new. It arises from the 1990s when Virgin Money who launched a FTSE All Share tracker in 1995 observed correctly that most active funds underperformed passives and their higher management fees were often not justifiable. The 1980s and 1990s were a golden period for stockmarkets, with falling global inflation and what was referred to as a Goldilocks economy in the US, not too hot not too cold, stockmarkets rose strongly and steadily. The following graphic of 50 years of the FTSE All Share Index to April 2012 from the Daily Telegraph demonstrates this point nicely:
Markets rose strongly through the 1980s and 1990s until the technology bubble burst in 2000. The index has significantly moved sideways since with V shaped peaks and troughs. What is interesting here is that the value of FTSE All Share index in 2012 was no higher than it was in 2000 and the same is true of the FTSE 100 index even today. This means an investor buying an UK tracker at the peak of the market at end of 1999 and drawing dividends would have lost capital.
It is my view that index tracking funds do well in steadily rising markets, especially when there is a low disparity of stock returns - a recent example is in the last five years, when general market exposure was more important than stock selection (see my blog post of 8/3/14 http://www.montgomuse.co.uk/beta-jockeys-to-fall-at-the-first-hurdle/ ). In periods of volatility, especially when markets move sideways or are falling, disparity of stock returns is higher and active fund management is may outperform. One reason is active fund managers can move to cash, select defensive stocks and avoid the basket cases. In conclusion index momentum is a key factor in whether actives or passives outperform. The last 13 to 14 years suggests index momentum favours actively managed funds.
Passives are Structurally Expected to Underperform the Market
Index trackers although outwardly simple are complex and differ in their methods of replication of the index. A variety of factors contribute to what is known as their tracking difference, the performance gap between the tracker and the index. Index trackers seek to keep this to a minimum. A key element of tracking difference are the charges. In the vast majority of cases index trackers are destined to underperform the index because they carry management fees; the index itself has no such drag. Actively managed funds in contrast have no such inherent structural encumbrance and have the potential to significantly beat the market and vice versa. An adventurous risk investor (like me) is willing to pay higher management costs for the potential for significantly greater investment returns whilst a cautious risk investor may not.
Market Efficiency Favours Passive Trackers
It is widely accepted that highly efficient markets favour index trackers. This is because analyst coverage is so extensive that stock prices accurately reflect companies’ true worth. The potential of good stockpickers to find under-valued gems is very limited when all the news in priced in. The best example of this is the observation that very few active US fund managers beat the market for example the S&P 500 index. In contrast active fund management works best in under researched markets and a good example are smaller companies where there are often significant pricing anomalies. The logical application here is to use passives in sectors where market efficiency is high and actives where it is not.
Passives and Actives are Favoured in Different Sectors
The rPlan research was based on five year returns to 30/10/13. This significantly covers the post financial crash period. Equities rose sharply during the period notably from March 2009 in a classic recovery bull market, which should have favoured passives.
rPlan showed the probability of active fund outperformance of the average index tracker was 100% for China, 99% for Europe, 73% for Japan and 66% for UK. I am not unclear what definitions are being used here but interestingly unlike other research their study included investment trusts which are actively managed and ETFs which are passively managed. In rPlan’s study only the US and property had probabilities of active fund outperformance at less than 50%, i.e. 39% and 31% respectively.
What was also interesting about rPlan’s research was they showed outperformance of passives over actives over the 5 years to 30/10/13 was just 1.5% to 4.5% for three sectors, US, property and gilts. However for the other sectors, bonds, UK, Japan, Europe and China the outperformance of actives in equity sectors ranged from 15% to 35%.
Active Funds are Inconsistent, Passives Remove Fund Manager Risk
Research from Vanguard show that in many cases that actively managed funds that outperform over a five year period fail to repeat that in the following period. In other words performance is inconsistent and you cannot guarantee a star fund manager will not lose his sparkle or the investment style of the fund will not fall out of favour. This comes back to the caveat of past performance not being a guide to future returns.
A key argument in favour of passive trackers is they remove fund manager risk out of the equation. By using trackers the focus can be solely on getting the asset allocation right; it is widely accepted asset allocation is the single biggest contributor to performance, much more important than fund manager skills. The worst performing fund in the best performing investment sector invariably will outperform the best performing fund in the worst performing sector.
Unlike passives actives require the need to review both the asset allocation and fund manager performance. I frequently review portfolios and recommend the replacement of a specific fund with an alternative in the same sector because the fund manager has made mistakes and has underperformed. This increases portfolio turnover and advice costs for clients. In contrast passive funds would only normally be replaced if the asset allocation needs to be adjusted.
Performance Differences are Greater than Charge Differences
In all my years as an IFA it has been my observation that differences in performance are greater than differences in charges. As an example take the IMA UK All Companies sector which UK equity funds are placed in. Data from Trustnet (9/6/14) shows there are 258 funds. Over the last year the average return was 14.3% but the disparity of returns ranged from 3.3% to 34.1%. However the difference between the lowest and highest charging funds would unlikely to have exceeded 1.5% p.a. Whilst I do not think charges are unimportant I principally focus on the performance potential when researching investments. If I find two funds that are equally good then charge considerations will be a deciding factor.
Passives Favoured in Difficult to Access Markets
In certain emerging markets where liquidity is poor, corporate governance is weak and the costs of buying stocks high, an index tracker offers clear benefits, you buy the index rather than stocks themselves. This will require the use of synthetic ETFs which instead of replicating an index by holding the constituent stocks buys the return of the relevant stockmarket index through a third party. This does however require counterparty risk. Moreover ETFs themselves are securities traded on stockmarkets and are not covered by the Financial Services Compensation Scheme in the event of insolvency. Index tracker funds are as they are regulated collective investments.
It is not the case that only index trackers or only active fund managers should be bought by investors. There is a case for holding both in portfolios. An investor may achieve the selected asset allocation through index trackers as a core and then add satellite active funds, where fund manager skills can exploit inefficient markets and add value. Index trackers can also be used for highly efficient or difficult to access markets or for clients who are particularly cost conscious and doubt the value of fund manager skills.
I have to hold my hands up, I have underused index tracking strategies in the past. In future I will use them more for selected investments e.g. large cap, US equities and difficult to access markets. However the research I have studied has not led me to alter my view that active fund management is a logical and beneficial strategy for many clients especially those where potential returns are more important than charges.
* It should be noted that the OCF excludes portfolio turnover costs and may exclude stamp duty reserve tax.
This blog reflects my own understanding, views and interpretations not those of Vanguard or rPlan. It is intended as a general investment commentary and is not an invitation to invest in the areas mentioned. You should seek individual advice before making investment decisions.