Liquid assets: David Thornton on the quest for simplicity

Has managed funds’ day in the sun finally come to an end as investors turn to index funds and ETFs?

You have money to invest in the stockmarket and you want it invested professionally. Do you put it in managed funds that may outperform the market but probably won’t, or in passive funds that move with a given market benchmark?

There was a time when active fund managers had it good. The value proposition was simple: you pool your money with other investors’ funds, which is then invested by professional portfolio managers whose expertise – it’s hoped – generate superior returns.

“By pooling in with others, retail investors get scale advantages,” says Alex Dunnin, director of research at Rainmaker Information, which publishes Money. “It’s a killer-app of an idea.”

Then along came exchange traded funds (ETFs), which are passive, low-fee listed securities that hold a basket of stocks that mirror an index. They’ve proven hugely

popular, especially with younger investors. According to ETF provider BetaShares, the number of investors using ETFs in Australia rose 58% in 2020, from 455,000 to 720,000, while almost two-thirds of investors entering the market between March and August 2020 were millennials (aged 25 to 40) or the younger gen Z.

“The fact that investors, particularly younger ones, continued to invest in ETFs throughout 2020 suggests that not only are investors attracted to the liquidity ETFs offer in volatile markets, they also appreciate a simple, cost-effective way to diversify portfolios and minimise single stock risks,” says Alex Vynokur, CEO of BetaShares.

If index ETFs do their job, they won’t outperform the market. But at least they’ll match it (before fees).

“They’ve changed the game because they are generally cheaper and a lot more transparent, more open about what they do, what they invest in and how,” says Vynokur.

On the cost front, it would seem they have actively managed funds down for the count. Rainmaker research into more than 1000 wholesale managed funds in 2020 showed that the typical costs are 0.77% a year, while one in five charged performance fees averaging 16%.

By contrast, many of the most popular Australian ETFs charge management fees between 0.10% and 0.20%.

“Regular retail managed funds used to cost retail investors about 2%pa, but now those same investors can get into the average ETF for about one-quarter of that price, though an ETF that exposes you to a vanilla index like the S&P/ASX 200 can cost you just 0.1%, which is one-twentieth of what a regular managed fund doing the same thing used to cost you,” says Dunnin.

Indeed, there seems to be a heightened sensitivity among investors to paying excess fees and the knock-on effect this has on returns.

“In a world where the risk-free rate is zero, people’s expectations of returns from assets are lower,” says Chris Brycki, CEO of Stockspot, an online investing platform. “If your return is 6%, you might be giving away a quarter of your return [through fees].”

Fund managers trumpet their capacity to outperform, but most of them don’t walk their talk.

“A lot of fundies believe they’ll usually outperform, and when there was nothing to compare them to that was an easy argument,” says Dunnin. “Trouble is, the evidence since indexed products came into being isn’t helpful. They should outperform given the costs and all the research they do, but the scoreboard tells a different story.”

The active Australian equities managed funds tracked by Rainmaker returned 4.6%pa over three years, whereas the S&P ASX200 accumulation index returned 5.2%pa.

Likewise, international equities managed funds returned 9.5% over three years, which is good but still short of the index return of 10.7%.

The story has been much the same during the past year’s booming market. The 96 Australian equities large cap funds tracked by Rainmaker returned 8.9%, short of the 9.7% returned by the S&P/ASX 200 accumulation index.

Large cap international equity managed funds reflected a similar story, returning

12.8% compared with the MSCI World ex AU Index return of 13.7%.

The numbers they give can sometimes be misrepresented, too. Just because they beat inflation doesn’t make them good investments.

“A great example why not is that in the 12 months to the end of March 2021 the ASX delivered 38%. While the average Australian shares managed fund beat this and delivered 40%, it’s salutary that four in 10 of all these funds didn’t match the index,” says Dunnin.

Reality check

Often we hear active managers claim that their value is most pronounced during down markets, but here too they’re found wanting.

“The narrative of outperformance when the market is going down is completely false,” says Brycki. “Show me some active fund managers who correctly picked that coronavirus would take over the world, and by the same token show me an active fund manager who picked that governments and central banks would backstop economies and send economies and asset prices higher.”

Nor is the claim that active management outperforms during a down market backed by the data.

The US SPIVA (S&P Indices Versus Active) Scorecard compares active fund managers against their respective benchmarks. In the latest report, which tracked data through 2020, most of large cap actively managed funds underperformed. “While the turmoil and disruption caused by the pandemic should have offered numerous opportunities for outperformance [by active managers], 57% of domestic equity funds lagged the S&P Composite 1500 index during the one-year period ended December 31, 2020,” it said.

Granted this is a better result than in 2019, when 70% of all US domestic funds lagged the S&P Composite 1500, making it the fourth-worst performance since 2001. You have to go back to 2013 to find a year when active US domestic equity funds outperformed the market.

Star power wanes

The attraction of some managed funds is partly an extension of the aura around the people who head them.

“Star fund managers are like star CEOs,” says Dunnin. “They personalise their fund’s story. Can we imagine Tesla without Elon Musk, Fortescue without Twiggy Forrest, or Harvey Norman without Gerry Harvey?” In the past, expertise meant strong performance. “Back in the 1990s and 2000s, there was this idea of the ‘star’ fund manager, someone who could consistently beat the market,” says Brycki. “Over the last 10 or 15 years, a lot of those people who performed well then underperformed significantly. So the consistency of star fund managers really deteriorated.”

Magellan’s Global Fund returned 4.5% for the year to March 31, 2021, well short of the MSCI World Net Total Return Index’s 23.8%.

Hamish Douglass, chair of Magellan Financial Group says the fund moved to cash. “We went into capitalpreservation mode,” he says. “Normally when markets crash out we wouldn’t think of selling stocks and going to cash. Normally we’d be saying, what should we be investing in?”

Granted, not many fund managers predicted the global recovery that followed the crash. But that speaks to the futility of timing the market like this. Magellan responded to the crash and then missed the recovery.

By contrast, the Vanguard MSCI Index International Shares ETF (ASX: VGS) returned 23.60% for the year to March 31, for an annual fee of 0.18%.

Investors give their money to fund managers to invest, not put in cash