How to improve on mixed blessings

Realistically, the best an investor can expect from a balanced managed fund is average returns. But cutting out costs by using exchange traded funds can improve performance significantly.

A modern fund of funds using just ETFs saves 0.48% a year on extra dealing costs and 0.46% on extra fund manager fees (net extra ETF fees) – a total saving of 0.94% a year.

The third performance drag is the failure of managers to rebalance their portfolios frequently. But why should investors focus on asset allocation? In essence, the managers managing funds of funds, according to every academic study, will find that at least 90% of the return of their overall portfolio will be determined by which asset they choose rather than the choice of individual stocks/bonds. In fact, most studies show that stock selection detracts from returns.

Using ETFs allows the manager to tilt a portfolio to where the “free lunches” are:

  • Rebalancing – forcing one to sell high and buy low
  • Bias to real assets – that is equities/property/index-linked rather than bonds or cash
  • Smaller companies – tend to outperform over long term
  • Out-of-favour assets – it pays to be contrarian as this is where real value is found.

Many ETF managers are missing a trick by rebalan­cing only quarterly or once a year. In our analysis of three British managers whose portfolios are heavily invested via ETFs, the returns of the manager who changed assets once a month were significantly higher than those of the once-a-quarter manager, whose performance was higher than that of the once- a-year manager. It really does make sense to change asset allocation continually, as and when opportunities present themselves.

For active managers, ETFs offer a golden opportunity. They can see the price at which they buy and sell an asset rather than deal forward via funds, buy an asset and sell completely different assets at virtually the same time, thereby taking out considerable market risk.

Harnessing the full potential of ETFs means taking advantage of the extra volatility of assets – for example, individual emerging markets or commodities. Added value can be gained by buying out-of-favour assets simply and cheaply and selling them when they become fashionable again.

Many investors think a manager using low-cost liquid instruments must be inactive, but some of the most successful trades have been executed through liquid instruments. The prime example is George Soros shorting sterling in 1992. The cost of executing this via a liquid currency was virtually zero, yet the profit was billions of pounds.

In our view, much of the debate on active versus passive has been misplaced. There is a third choice: being active but using passive instruments (or actively passive). This enables the 0.9% a year cost savings of ETFs to be passed on to investors, combined with a much more diversified portfolio, with many more underlying securities/bonds. If you can then add value by either being overweight the right assets or being successful in trading assets – or even better, both – investors can receive a higher return for less cost.