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Since the Seventies, investment policy and products changed dramatically when the concept of risk was formally incorporated together with the desire for high returns. We were all told that higher expected returns should be accompanied by higher risk. Clearly, risk is a critical issue in prudent investing. However, nowadays the emphasis appears to have shifted away from risk/return ratios towards benefit/ cost ratios - otherwise known as value for your money or bang for your investment buck.
The reason for this change of the collective mindset is that mounting research is unveiling the dramatic affect even tiny costs can have on dragging down the performance of your investments. Our research on the JSE shows that a 5% upfront fee and a 2%/year cost drag would have made your investment underperform the ALSI by 58% over the past 20 years. Put differently, your fund manager would have to outperform the market by about 60% just to cover fee and cost drag over 20 years.
The fact is, investing is a zero sum game and for every rand that outperforms there has to be an equivalent rand that underperforms. Net out costs, and as Nobel laureate William Sharpe points out, the average asset manager must by necessity underperform by the quantum of those costs. This point clearly explains the rapid growth of cheaper passive investment alternatives worldwide over the past decade. It also suggests that a strategy that holds some portion of your investments in both active and passive products could result in a better benefit/ cost trade-off.
Add to this point the fact that in SA there are nearly 600 unit trusts available, and 80% of the money of those funds is invested in the JSE's largest 50 to 60 most liquid stocks, and one can only conclude that there must be a more cost effective solution for investing.
One by-product of these dynamics is that the big move internationally is for fund managers to separate what's called beta (ie performance that comes from the passive movement of the market) from alpha (ie outperformance of the market).
A well-known paper by Morgan Stanley called "The Asset Management Barbell", points out that with new-age products such as private equity, hedge funds and specialist active portfolios at one end of the barbell and enhanced index and passive index alternatives, such as exchange-traded funds (ETFs), at the other end, the in-between space occupied by traditional active core products, such as general equity funds and balanced funds, is effectively being squeezed out.
In the end it's all about rewarding fund managers for their skills. Those that deliver outperformance clearly deserve their reward. But as Bob Litterman of Goldman Sachs points out, this means that smart fiduciaries of assets should either maintain a purely indexed approach or have serious resources and skills for selecting and maintaining skilled fund managers.
"The days of investing with the pack are numbered."
Fees versus costs
This issue of Collective Insight helps investors understand more clearly the difference between fees and costs. Fees are charges that typically are declared and tangible; a fund manager declares that their annual management fee is 1%, for example. Costs, however, are "hidden" charges that aren't measurable in advance, and are often situation-dependent.
Then there are the external incentives, such as commissions, which often have the result that financial advisers invest their clients' money in the product with the highest commission rather than the product that's best suited to their clients' needs.
Other costs such as expensive derivative structures or the transaction costs introduced in trading or transitioning the portfolio are also hidden, but have significant implications for performance.
For example, when large amounts of money, often exceeding several billion, are moved from one fund manager to another, the cost of such a portfolio swap could amount to 3% to 4% of the portfolio's total value. Why? Because the true costs of these transactions not only include brokerage fees, but the price movement caused by forced buying or selling and the opportunity cost of not being in the market when it's moving.
Finally, different manager strategies can also have variable cost implications.
The more a manager trades, the higher your total transaction costs will be, but these costs are never declared. Knowing how much your manager churns is important.
The Plexus Group in the US calculates total execution costs for emerging markets to be about 125bp (ie 1,25%). Put differently, a fund manager who churns 100% of the value of the fund per annum will have to sacrifice 2,50% (1,25% to buy and sell) of the fund's value every year.
This amounts roughly to double the fee earned by the fund manager.
The light at the end of the tunnel
If the investment industry wants to instil trust and confidence we need to be more open about the total charges that go into the products that we sell.
Internationally, a concept that's rapidly becoming popular is the total expense ratio (TER). In fact, since end-September this year, it's become mandatory in Britain for fund managers and product providers to disclose their TERs to investors. TERs can be measured for all kinds of investment products, including more complicated mandates such as absolute return products or inflation linked CPI+ funds.
When will our industry adopt these best-practice principles?
We can expect that the more the consumer understands and demands, the better transparency, lower costs and ultimately better value can emerge.
Gar?, your best Bordeaux please!
PASSIVE will never replace active investing and vice versa. However, the future of how satisfied you are with your investments lies very much in a blended approach.
Morgan Stanley says that the shift is definitely away from traditional general equity investment products towards a blended approach of extremely low-cost passive funds combined with specialist high alpha mandates with low correlations to each other, thus providing important diversification benefits.
By separating market performance from outperformance and then combining the two you achieve a higher benefit:
cost ratio than simply holding general equity exposure.
The fact that 15% to 20% of professionally managed money worldwide is in low-cost passive alternatives indicates that paradigm shift. Typically, the most favoured low cost passive products are currently exchange-traded funds that have total expense ratios as low as 0,10%.
A world-class Bordeaux wine requires you to blend three individually produced, top-quality wines (cabernet sauvignon, merlot and cabernet franc).
You don't go and crush all three different grape varietals together at harvest and hope for the best.
Similarly, it seems the future of investment harmony (ie, investment satisfaction) lies with a blend of pure, highvalue alpha and pure, low-cost beta and not a general equity approach.
