Rise of the machines?

Adam Lewis looks at the possibility of a price war between active and passively managed funds. Could judgement day be looming for one or both of these approaches, and what could this mean for investors?

A war against the machines is on the way, so goes the line in the Terminator series of films. While the result may not be so apocalyptic, a war versus the machines may also be on the way in the world of retail fund investing.

Far from being a nuclear war created by a self-aware computer system (Skynet), the impending war in this case is a price-based one between active and passively managed funds. Manager versus index rather than man against machine.
The debate concerning the merits of active versus passive funds is one that will never go away. However, in recent months several pieces of news have hit the headlines which have brought the argument sharply back into focus.

The first is that the sales of tracker funds are on the rise. In February, the Investment Management Association (IMA) said that in the fourth quarter of 2008, net retail flows into trackers hit £280m. This represented the highest quarterly retail sales for trackers since 2002.

More interestingly though, in the same week news came through that Vanguard, an American mutual fund giant which specialises in passive products, announced its entry into the British retail market.

Vanguard, founded by John Bogle, launched the first tracker mutual fund in America in 1976. Today the group has assets under management of $1.1 trillion (£760 billion) and its entry into the British market, for some, is the sign of an impending war of the prices investors pay for funds.
This is because the costs Vanguard charges investors to use its funds are a fraction of those British retail investors pay for the use of actively managed funds.

According to Thomas Rampulla, the managing director of Vanguard Investments UK, the average total expense ratio (TER) across its range of passive funds is about 17 basis points. The group also manages active strategies and on these the average TER is 26 basis points.

Using figures from Lipper, the combined average for British managed unit trusts and Oeics is 163 basis points. The main reason for this is the higher management fees active funds charge coupled with higher transaction costs.
So the main question is – are active funds worth 146 points more than a passive strategy managed by Vanguard or another low cost index-tracking fund?

The answer, as you would expect from Vanguard, is a resounding no.

“Costs really matter for investors,” says Rampulla. “The difference between 17-25 basis points versus, say 125 basis points, is huge over the long-term because of the effect of compounding these costs.”

Management fees, operating exp-enses, sales charges, the cost of portfolio turnover and broker commissions all add up for active funds. While this can be overcome by short-term periods of outperformance, Vanguard argues over the long-term, the compounding effect of charging higher fees can detract significantly from actual performance.

By contrast, lower-cost index funds would be expected to track the benchmark more closely, so helping them to outperform higher-cost actively managed funds over time.
Rampulla argues while you cannot control what happens in stockmarkets, one thing an investor does have a degree of control over is what they pay for it.

“The idea you get what you pay for is not valid.” he says. “People spend more time looking at their mortgage costs than they do their investment costs.”

The argument for the use of active funds over passive funds has always revolved around performance. Active managed funds charge a higher fee in the belief that they can outperform their respective indices.

However, those fighting in the passive camp disagree. Ian Shipway, the investment director at Thinc Destiny, questions the performance of active funds.

“On average, the active management industry has proved in this current downturn that it can’t protect on the downside,” says Shipway. “With active funds you pay for a manager’s competence to create alpha. When this is not being achieved you start to question their validity.”

Indeed, according to Skandia, in the 12 months to February 20, 2009, of the 502 retail IMA funds focused on UK equities, 238 failed to beat the FTSE All-Share.

James Norton, the director of Evolve Financial Planning (which only offers clients passive funds), says he hopes that Vanguard’s entry into Britain does trigger a price war. “Compared with the US, UK private investors pay too much,” he says. This is not only for active funds, but passive funds also.

“A lot of good quality financial planners and advisers have access to institutional index funds from various providers which are keenly priced. However, for retail investors, the availability of cheap tracker funds is limited. The best bet is some of the ETFs (exchange traded funds) rather than the Oeics or unit trusts.”

Norton uses the example of the Virgin tracker fund which has a TER of 1%, which he brands a “disgrace”.

“Index tracking is all about keeping the costs down,” says Norton. “We don’t yet know what the Vanguard costing structure will be when it launches funds in the UK, but I am sure it will be well below that of the Virgin fund.
“We have good relationships with the groups we currently use [for passive funds], but the more passive players in the market the better, provided the pricing is competitive. They [Vanguard] know how important it is to keep costs down, which is refreshingly different from the City’s ‘greed is good’ culture.”

Indeed, Shipway says because Vanguard is such a big name in the passive market, it is likely to raise the profile of passive management and index tracking among the British public. However, he does not expect its entry into Britain to trigger a price war.

He says: “For there to be any kind of price war there needs to be competitive demand for passive funds. I am not sure whether or not there is sufficient demand from the retail market for index funds to start such a war. Passive funds have been about for some time, many with low charges, so I am not sure the entrance of another passive manager is enough to start such a war.

“What may happen is a price war between passive funds, or a price war between active funds, but a war on fees between the two is unlikely.”

“There is a lot of misunderstanding in the UK about passive funds,” says Rampulla. “The perception is why invest in a fund that just looks to match the market place and as such settle for average?

“However, we have carried out research which shows that
over the long-term passive funds outperform 75% of active managers [in America].”

It is a theme explored in John Bogle’s The Little Book of Common Sense Investing, which was published in 2007. In the book, reviewed by Fund Strategy on May 7, 2007, Bogle states that out of 355 equity funds launched in the past 36 years (in America and till 2007), only 24 managed to outpace the S&P 500 by more than one percentage point a year.

Bogle singled out Legg Mason’s Bill Miller as an active manager worthy of praise. Up until 2006, the manager boasted 15 consecutive years of outperforming the S&P 500. However, since 2006 his fortunes have taken a tumble.

In December last year, the Wall Street Journal reported over one year Miller’s fund was down 58%. This is 20 percentage points more than the fall in the S&P 500. Miller admitted in the article that he “didn’t properly assess the severity of this liquidity crisis”. Holdings in Washington Mutual, Countrywide Financial Corporation and Citigroup, explain why in 2008 the fund’s assets fell from $16.5 billion to just $4.3 billion.

Norton adds: “People argue that active funds come into their own in falling markets, because of their ability to go defensive and use cash. However, over the past year, the numbers do not support this.”

Indeed a white paper published by Vanguard in 2008, entitled The Case for Indexing, used average excess returns to find that in three of the six bear markets since 1970, active managers failed to outperform the American stockmarket.

The paper notes that while the likelihood of outperforming the market decreases over time, actively managed funds do offer the opportunity to add value at any point in time. However, the key sticking point is outperforming consistently. As such, the main conclusion was that an indexed investor is not at a disadvantage when investing in the bull and bear market.

So what, say the proponents of the active funds, as so far this piece reads in favour of those fighting on the passive side of the battle-line.

Robert Burdett, co-head of multi-manager at Thames River, does not use any passive funds across his suite of five funds of funds, yet he admits finding active managers who can outperform their benchmark consistently is not easy.
According to Thames River research, only 10.6% of all unit trusts and Oeics – both active and passive – have managed to outperform their respective benchmarks in each of the past three years. Similar to the conclusion of the Vanguard white paper, Burdett says this highlights the problem of finding managers who can consistently outperform.

Mark Dampier, the head of research at Hargreaves Lansdown, does not agree that passive funds suffer a bad press. “If anything they enjoy a good press,” he says. “The biggest con is that passive funds track the market. There are many trackers that have underperformed over the past 10 years, owing to their own high management fees or tracker structure. None are absolutely perfect. If the market rises by say 50% over 10 years and you were tracking that, you would expect 50%. However, what you get is closer to 42%.”

This is a statistic borne out by Morningstar. It shows that over the past 10 years to March 16, the average UK tracker fund has fallen 17.68%, compared with the FTSE All-Share, which is only down 10.35%. Meanwhile, the FTSE 100 was down 17.76%, over the same period, which is a similar fall to those registered by the tracker funds.

Norton admits there are many trackers which do lag their respective indices. “There are trackers and then there are trackers,” he says. “A lot of the bad publicity comes from bad trackers. For a tracking strategy to charge any upfront fee is not acceptable and any TER close to 1% is wrong. The passive industry has shot itself in the foot in keeping these bad funds.”

Because of this, Dampier says while the fees on index trackers are lower than active funds, investors who use them are “guaranteeing themselves underperformance”. This is because any fee they charge will mean the return for the investor is less than the index.

In terms of an impending price war with other tracking funds in Britain, Dampier says Vanguard will have to go some to undercut some of the existing tracker fees. “M&G offer a FTSE All-Share tracker which has a 0.2% TER and ETFs charge about 0.3%, so the fees being touted by Vanguard are not revolutionary. It will put pressure on the likes of Virgin though.”

According to a recent report by Lipper, entitled The Growth Pattern of the Pan-European ETF Segment Defies the Rough Market Conditions, the only way for annual charges on actively managed mutual funds to come down is if there is a competitive advantage to a fund company to do so.
“Quite simply, such an imperative does not exist, or at least it does not exist to a sufficient degree to change retail fee levels for actively managed funds,” says Detlef Glow, author of the report and head of central, North and Eastern European research at Lipper, Frankfurt. “This is where one of the niches has opened up for passively managed products to market themselves.”

The TERs on Lyxor Asset Management’s range of ETFs range from 15 basis points to 85 basis points, says Dan Draper, the global head of ETFs at Lyxor. However, he says looking at just TERs does not tell the whole story.

“Costs do matter,” says Draper. “Most people just look at TERs but these are just a sticker price. You also need to look at tracking error, trading and liquidity costs.” From this perspective, he says, ETFs are more transparent than mutual funds because their trading costs are more transparent.

Dampier freely admits that out of a universe of about 2,000 actively managed Oeics and unit trusts, some 90% “drag the industry down”. This is why Hargreaves Lansdown created its Wealth 150 listed of recommended funds, because it only thinks about 10% of the active universe is worth investing in.

In addition Dampier argues that active fees are rising, with many groups upping their AMCs from 1.5% to 1.6% or plus. So he says more passive players is good from a competition perspective.

Yet, for Dampier, the active versus passive debate is a boring one. “Investors should use both,” he says. “I am not averse to tracking the S&P 500 because, given the efficiency of the US market, it is very hard to find an active manager that can consistently outperform it.

“However, areas such as the Far East, emerging markets and small caps are less efficient because there is less available information and more market anomalies. In these markets it is easier to find active managers who can outperform. For example, Harry Nimmo [UK Smaller Companies manager] at Standard Life and the small cap team at Old Mutual have slaughtered the small cap index over the long-term, so there is no point in tracking it.”

Burdett says while the percentage of active managers who consistently outperform is low, there is a subset of less consistent managers who “are worth owning in cycles”.
According to Burdett, the choice of whether to go down the active or passive route all depends on personal preference. “If an investor is simply concerned with how much they have invested in the market, they should go down the tracker route. However, if they want to do better than the average, they should opt to go active or use a multi-manager to pick the active funds for them.”

So how has Burdett, and his co-head Gary Potter, fared in picking active funds? Burdett says that the Constellation range of funds they managed at Credit Suisse Asset Management almost tripled the value of the FTSE World index over five-and-a-half years, net of fees. Over the past 12 months, he says the five Thames River funds have outperformed their respective benchmarks by between 5-9%, again after fees.

One of Burdett’s peers, John Chatfeild-Roberts, the head of the independent funds team at Jupiter, also notes problems with the passive industry. Aside from those already argued, he says passive investment does not exist.

He says: “You are always making choices – there are more than 13,000 indices in existence, each with different characteristics. By picking one rather than another you are, in effect, being forced to take a view.”

Following the increase in demand for trackers, Skandia announced two weeks ago that it has increased the range of passively managed funds on its Selestia Investment Solutions platform and its life and pensions fund range.
Skandia had already added eight passively managed funds this year from Pictet, taking the total number of funds available to 21, and expects to add a further 10 passive funds.

Graham Bentley, the head of investment marketing at Skandia, says: “In the current market, advisers who believe they are better served delivering beta, that is market returns, with as low a charge as possible, understand that passive funds provide a straightforward solution. We are responding to this by pursuing a strategy of adding a raft of low-TER passive funds, such that asset allocators can easily populate the asset class strategies.”

Norton expects the current level of inflows into trackers to gain momentum, and says it simply reflects a general level of disillusionment with the City. “Investors are happy to pay for funds if they are delivering something special, but they are not doing this at the moment,” he says.

Detlef Glow at Lipper says an increased appetite for lower-cost ETFs in Europe does not yet represent a wider shift among retail investors toward greater cost sensitivity. This is because, he says, the inflows are mainly coming from the institutional side.

In 2008, Draper says Lyxor’s global assets under management rose 7.5% as demand for ETF index trackers ballooned. However, he welcomes the introduction of Vanguard into the British retail funds market.

He says: “Our position is not to comment on competitors, but Vanguard is obviously a world leader in indexing. Their arrival here is a sign of the market opportunities for investors in the passive space.”

What investors and advisers alike will now be waiting for, is the detail of what Vanguard will launch and, more importantly, how much it will cost. Only then will we know if judgement day (the day the machines take over in Terminator) for many active funds, is truly on the horizon.


A game of luck?

A large part of the active versus passive debate has always revolved around whether an active manager’s returns are through luck or judgement.

The debate was reignited at the end of last year when Inalytics, a specialist firm that helps pension funds to select and monitor equity managers, published research which showed managers typically get only half of their decisions correct.

The research, based on an examination of 215 long-only funds worth a combined £99 billion, found that the average manager’s ability to identify winners and losers was no better than 50-50. Put simply, they would do no worse tossing a coin.

The research looked at two measurements of fund manager skill: what it termed the hit rate and the win/loss ratio. The hit rate shows the number of correct decisions as a percentage of the total number of decisions. The win/loss ratio is a comparison of the alpha generated from good decisions with the alpha lost from the poor decisions. To judge these, Inalytics daily analysed every purchase/sale, underweight and overweight made by the fund managers.

Rick di Mascio, the chief executive and founder of Inalytics, says: “The industry maxim suggests that six correct decisions out of 10 would constitute good performance. However, we did not find one manager who got six out of 10. The average was five out of 10 (49.6%) and the really good managers only managed to get a 53% hit rate, which was a surprise as we expected the best manager to be a lot higher.”

To compensate for this, di Mascio says the average manager is able to generate good gains from “winners” to offset the losses from “losers”. According to the research, the average win/loss ratio was 102%, which means the alpha gained from good decisions was 2% higher than that lost from the poor decisions.

“The good managers had a win/loss ratio of 120%, with the best getting up to 130-140%,” says di Mascio. “This is where the skill comes in, running your winners and cutting out the losers. It’s what differentiates the also-rans from the best. There is nowhere to hide with these numbers.”


Active versus passive performance


Net retail sales of tracker funds