Professional Documents
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Investments
Travis Morien
Compass Financial Planners Pty Ltd
travis@travismorien.com
http://www.travismorien.com
Types of Managed Funds
There are two types of fund:
• Index funds seek to capture the performance
of an asset class as cheaply as possible
• Actively managed funds seek to add extra
value on top of asset class performance
through selection and timing, using a variety
of research strategies
Index Funds
• Adopt a passive approach.
• Main focus is on achieving maximum diversification at
a minimum expense by holding a fixed percentage of
every security in the market, or a representative basket.
• Performance is determined by the asset class, index
funds make little attempt to do better. If the asset class
does poorly, index funds do poorly. If the asset class
does well, index funds do well.
• These funds are quite boring because they offer no
potential to beat the market, most investors aren’t even
aware they exist. Many “sophisticated” investors (and
those that aspire to be) flatly refuse to even consider
indexing because it is just too mediocre and too dull.
Active funds
• When you buy an active fund, you are making a
bet on a team of professional investors, and their
ability to generate high returns.
• May perform quite differently to the asset class as
the manager adjusts the portfolio based on their
research.
• You pay extra for this research, usually about an
extra 1%pa.
• It seems defeatist to settle for asset class returns.
Why would anyone settle for average performance
when you can be above average?
What people think of active fund managers
• Active fund managers enjoy a strong
marketing edge over passive
managers. Many attain celebrity
status and their opinions on what the
market is doing are highly sought after
by the media.
• Great faith is often placed in their
abilities, and what they do is often
portrayed as glamorous.
• Some fund managers are paid seven
figure salaries and bonuses and are
often aggressively headhunted by rival
firms.
• Above all, active fund managers are
usually perceived to be “interesting”.
Picture by Vanguard Investments.
What people think of passive fund managers
• In contrast to their more colourful active counterparts,
passive fund managers are seen as the “nerds” of the
investment business.
• Their performance objective is only to match an
index. Is this deliberate mediocrity bordering on
negligence?
• You probably wouldn’t want to be stuck next to a
passive fund manager on a long flight, because all
they ever talk about is tax efficiency, cost
minimisation, diversification, asset allocation and buy
and hold investing. Where is the fun in that?
• Passive fund managers claim to have no special
insights into what the market is going to do, and have
no clever strategy that they intend to employ to “beat
the market” by a large margin, often recommending
investors “stay the course” and hold a diversified
portfolio through thick and thin.
• Above all, passive fund managers are usually
perceived to be “boring”.
Picture by Vanguard Investments.
Percentage of active funds
underperforming their benchmark index
after fees in the 5 years to 31 March 2004
100%
80%
60% 100.0%
40% 75.0% 76.0%
51.0% 52.0%
20%
0%
Aus shares Intl shares Aus listed Aus bonds Aus cash
property
Underperforming Outperforming
Source: Mercer/Morningstar IDPS Survey
Median fund manager return vs comparable
index 5 years to 31 March 2004
15.00%
10.00%
5.00%
0.00%
-5.00%
property
shares
shares
bonds
Cash
Aus
Listed
Aus
Intl
1550
1450
1350
1250
1150
1050
950
850
750
1/04/00
1/07/00
1/01/01
1/04/01
1/10/01
1/04/02
1/07/02
1/10/02
1/01/03
1/04/03
1/10/03
1/01/00
1/10/00
1/07/01
1/01/02
1/07/03
Is index tracking more risky?
You’d think that with diligent professionals at the wheel, even if they can’t
outperform indexes after costs at least they can manage risk properly by prudently
avoiding risky companies. Are active funds less volatile?
Actually, active funds on average are more volatile than index funds because they
are less diversified.
18
16
17.8%
14 16.9%
12
10 14.5%
12.7%
8
6
4
2
0
Return Std deviation
Source: TAM Asset Management, Inc “Investment Policy Guidelines & Strategies Within the
Context of The Prudent Investor Rule, “average active fund” = average of 7125 US domestic equity
mutual funds in the Morningstar Principia Pro Database July 1991 - July 2001.
• The average active fund does not outperform the index,
and the average managed fund unit holder does even
worse because they trade too much.
• Active funds are less diversified and therefore more
volatile than index funds and there is no evidence that
they outperform in down markets, quite the contrary in
fact.
• Especially in the conservative asset classes like bonds
and cash, and even property securities, there are almost
no outperforming active funds and based on the
statistical evidence it is very hard to justify active
investing in these sectors. The stock market has its
Warren Buffetts, Peter Lynchs and John Templetons, but
not other asset classes.
• Research houses in general refuse to even go near index
funds, they won’t rate them, insisting that their job as
researchers is to identify funds that will beat the index.
• While corporate pension funds are taking up indexing
enthusiastically, indexing is still anathema to financial
advisers and private DIY investors share no more
enthusiasm for index funds than the professionals.
• Index funds are unpopular with every type of investor
because almost 100% of investors think they are above
average and possess superior investment skills. Is this faith
warranted based on the evidence from Dalbar Inc and
others? Mathematically, is it possible for most people to be
above average or are investors deluding themselves?
The arithmetic of active management
• The average performance of all investors will be the same as the market. It is
impossible for everyone to be above average, mathematically it just can’t
happen!! Half will fail because somebody always gets stuck holding the bad
stocks!
• The aggregate return of all investors in the market will be the market return,
(obviously), because all the investors own all the stocks. The market return is the
weighted average of passive returns plus active returns.
• If the index funds have the same pre-fee return as the market (which is what they
set out to do), then the other type of investor (active) will also have the same pre-
fee return. If index funds bought, say, 30% of every stock issued, the remaining
70% left to the active investors would still have market index weightings.
• This is a zero sum game, the average return of all active investors before costs is
necessarily going to equal the average return of the market.
• Active investment is usually more expensive than passive investment so active
funds, as a group, will do worse than index funds after fees.
• No amount of trading or research will change that. Some will outperform, but as
a group they will underperform. Like a poker game, money is redistributed but
not created or destroyed by active management.
• Costs drag down the average performance of all investors. The average
performance of all investors will be the market average return, minus the average
expenses. To ensure that your net performance is above average, diversify
extensively and keep expenses well below average.
Whether the market is up or down, low cost diversified investors will still outperform the
majority of investors after costs, even if some investors still manage to outperform. Source: “The
Inefficient Market Argument For Passive Investing”, Professor Steven Thorley, the Marriot
School at BYU. Used with permission.
Figure 1a: Distribution of Simulated Portfolio Returns for 1996 Figure 2a: Distribution of Simulated Portfolio Returns for 1994
Before Costs Before Cost
1000 1000
Index Fund Return Index Fund Return
900 900
800 800
700 700
Portfolio Count
Portfolio Count
600 600
500 500
400 400
300 300
200 200
100 100
0 0
-20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50
Percent Return Percent Return
Figure 1b: Distribution of Simulated Portfolio Returns for 1996 Figure 2b: Distribution of Simulated Portfolio Returns for 1994
After Costs After Cost
1000 1000
Index Fund Return Index Fund Return
900 900
800 800
700 700
Portfolio Count
Portfolio Count
600 600
500 500
400 400
300 300
200 200
100 100
0 0
-20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50
Percent Return Percent Return
Percentage of Australian share funds
underperforming the ASX200 in the three years
to June 30 2002.
100%
80%
60%
40% 66% 66%
20% 56%
0%
1 year 2 years 3 years
Underperforming Outperforming
25%
20% 25%
15%
10%
10%
5%
0% 0% 0%
1997 1998 1999 2000
20
15
10
5
0
1998 1999 2000