November 12, 2018

Are you Active or Passive?

A recent review performed by Zenith Investment Partners has highlighted the risk when making investment choices based purely on fees.

Up until the recent pullback in markets in October, investors that allocated a significant percentage of their portfolios to low cost index tracking funds would have been relatively happy with their performance coupled with the low cost of their portfolio.

Volatility has returned to the markets due to factors such as the current International Trade Wars, US mid-term elections, oil prices, and the state of the Chinese economy. Those investors that purely tracked an index would have seen a substantial reduction to their portfolio value with this increased volatility.

The Zenith review showed that the low-cost groups on average suffered worse losses (drawdown) of 6.4 per cent versus 5.1 per cent.

The three main differences in the way low-cost funds were structured, according to Zenith included:

  1. Lower allocation to alternatives
  2. Less active asset allocation
  3. Increased weightings to asset classes that often had a higher prevalence of low-cost structures such as exchange-traded funds and passive funds.

It begins and ends with asset allocation.

Asset allocation is the implementation of an investment strategy that seeks to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio. This is based on the investor’s risk-taking capacity, goals and the timeframe available to reach those goals. The ultimate objective of asset allocation is to minimise volatility and maximise returns. The process involves dividing the cash among asset categories that do not all respond to the same market forces in the same way at the same time.

A study published by Vanguard in January 2017 showed that strategic asset allocation explained 80.5% of a diversified portfolios volatility (risk) over time, and 23.6% of a portfolios value. In short, the allocation of our capital into the appropriate sector is more important than the actual investments.

How do we deliver higher returns?

When investors place their funds with a passive manager that are subscribing to the “Efficient Market Hypothesis (HMI)”. The origination of HMI can be traced back to the early 1900. The basic principal being that share prices are efficient and they reflect all the information that is known to date. Therefore, it’s impossible to purchase undervalued stocks or sell overvalued stocks.

What HMI doesn’t deal with are the basic human emotions of fear and greed, which can be investor’s worst enemy. These human emotions contribute to events such as market crashes, and contradict EMH and the concept of market efficiency.

In reality the market can swing from being efficient to inefficient. The difficult part is understanding when stocks and the greater market is inefficient.

Unfortunately, this is incredibly hard to predict, with 75% of investment professionals either matching or underperforming the market. So what chance does the average investor have? However, 25% of fund managers not only outperform the market over the long term but consistently do so on a yearly basis. So how do you identify managers that will outperform in the long term?

You need to consider the 4 P’s:

  1. People: Who is in charge? What are the ownership levels of the principals? Do the managers have their personal wealth invested in their product? How stable is the team, how do they work together? A strong team approach lends itself to a measure of stability in that the loss of one individual would not drastically impact fund performance negatively.
  2. Performance: Short-term performance is commonly evaluated and hastily acted upon. Selecting a fund which had high recent performance often leads to a pick which will underperform in the next period. Likewise, leaving a fund for a few months of underperformance, barring anything severe, is a waste of the due diligence which should have been put in to select the fund in the first place. Thus, the best strategy is to put in the effort upfront and develop a thorough understanding of a fund manager and invest in them for a prolonged period of time.
  3. Process: How disciplined is the team to implement their investment process? What is the investment process? Can it be easily defined? Why will their approach result in future outperformance in the near and long future?
  4. Philosophy: Is the manager a value based investor or growth? Are their interests aligned with investors? Do they have a strong business moral and ethical foundation?

Last month: Labor Government Tax Policy - More than just Franking