“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.
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.