Intelligent investing

it is not easy to find the 50% of managers who outperform

Two things happened this week which led me towards writing this latest blog. Firstly, I was invited to a presentation by Source which offers a range of ETFs (a range of low cost index based “funds”). The second was a question by an individual who had looked at our site and wondered why we appear to favour active funds.

So I thought I would write an alternative blog focusing on active vs passive (often called index, or tracker) funds. Before diving in the difference between the two in simple terms is that actively managed funds have a manager or team “actively” researching investment opportunities in the belief that they can outperform an index (for example, the FTSE 100). In contrast, index funds are largely computer based trading programs which simply replicate the index they follow (i.e. there is no active management).

The debate in the investment world between the two camps is something like this; why spend money on an actively managed fund when you can get better returns for less via a fund that tracks the index? The active manager will go into how this is clearly wrong, and so the debate goes on!

The fact is we can debate this until the cows come home and could still have no final answer, so I want to consider this with the working title “intelligent investing”.

‘Active funds are a con’

There was recently an article in the Guardian which included this title.

The argument being put forward was that the person investing felt he could do better through a basket of tracker funds and ETFs vs a basket of actively managed funds.

This is important because actively managed funds are as their name suggests actively managed by a professional who believes they can beat the market. For this “service” investors pay a higher charge; the average charge is around 0.75% p.a. which is deducted from the fund itself.

However, recent research by Morningstar seems to debunk this theory. Taking five regions their research shows:

70% of active managers outperform in Europe
55% of active managers outperform in Asia
52% of active managers outperform in UK
38% of active managers outperform in Japan
33% of active managers outperform in US

On average it is 50%.

The challenge is finding the “good” managers and as the findings suggest on average you have a 50% chance of getting it right.

If you have a 50 / 50 chance, then it begs the question as to why you would pay 0.75% p.a. for a manager when you can pay as low as 0.05% for a fund that simply tracks the index and has an equal chance of performing as well or better than the more expensive fund.

It’s easy to pick an index fund

If you want to invest in an index, for example the S&P 500, you can pick up a fund that tracks the index for as little as 0.05% p.a.

But it’s not that straightforward.

If you purchase an index fund it is fairly straight forward but there are also ETFs which trade on the stock exchange. ETFs can be slightly more complex; they can physically hold the assets of the index or they use derivatives to track the index. In theory by using derivatives it drives down the cost and more closely replicates the index driving slightly better returns. But there are risks particularly if there is a Lehman style collapse.

ETFs are more transparent in the price you pay and the costs than index funds. However, they can be confusing and bewildering.

To add to the mix there is a new kid in town – “smart beta”. What “smart beta” seeks to do is to track the benchmark but at the same time enhance the returns. So traditionally, an index fund will be weighted across the index. “Smart Beta” looks at the DNA of stocks to identify characteristics which have the potential to enhance performance above the index. It then weights the portfolio accordingly. However, these funds can be more expensive up to 0.65% p.a. (close to an active fund).

So actually going back to the example, investing in index funds is not as simple as picking a few cheap funds it is about understanding what you want to achieve and investing to reflect that.

Taking a step back

In all of this we have considered the investment but one crucial element to investing is deciding where you want to invest. The person I was engaging with on Twitter used the term strategic asset allocation.

Ultimately as an investor we have a choice. Do we put our money in one area, for example the UK or do we spread globally? And we can go further than that, do we turn to equities, bonds, property etc.

The point is that once we have created a model for where we want to invest we can then look at the means to doing that. And that helps in choosing between active, index or a combination of the two.

Why do we focus on actively managed funds?

We have no view on whether active or index funds are “best” but the key to “successful” investing is about doing the ground work.

In the past direct providers have promoted well known funds and fund managers. The assumption is that they are top of their game because they are beating other managers in their universe. As an example; I recently looked at some of the big UK Income Funds and reviewed the performance of these vs the iShares Dividend ETF.

What this showed was that the big UK Income Funds over the last five years have effectively tracked the iShares Dividend ETF.

The question arises as to why would you not hold the iShares Dividend ETF (it is also worth noting the ETF was also paying higher income).?

Of course if you look further you can find funds that perform a lot better than those that are promoted and it is about looking beyond the glossy promotional stuff!

It is also about finding the hidden gems. We sometimes come across funds with amazing two-year performance track records but the longer term track record is poor. The question is why, and if this is a positive sign to buy? Through this we have found some interesting treasure.

Equally we sit and listen to managers and go back and do the figures, and then you realise that what you are being told and what is fact doesn’t match up.

So what we are trying to do is give an insight to different actively managed funds and give people a head start. Give them things to think about.

Ultimately it is not easy to find the 50% of managers who outperform and we don’t always get it right but that is why we go back to the process and the do the work year in, year out. This argument also applies when choosing index funds.

And it is worth adding that you can mix and match. Nothing is written in stone. If you can’t find those managers who can outperform, then an index fund is going to be a really useful option.

Going back to the asset allocation. What is the best combination of funds to achieve the goal? One of the well-made points in the Guardian; it is not a question of picking some funds and sitting back. Whether active, index or both there is a constant need to review and rebalance.

To end…

The research we do is about finding those managers who we think have the skills to do better than the index (or those we think won’t). As investors we are paying more money for these managers and therefore we have to spend more time finding the good ones.

In comparison index funds replicate the performance of the market they match, and most won’t outperform the market they track or good active managers.

Investors therefore need to decide what the best route is for them, and this may mean active or passive (index) or a combination of the two.

Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.

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