Our job as an independent financial adviser is to give clients the best advice and use the best instruments to achieve their objectives. But in the past four years we have been struggling with the possibility that actively-managed unit trusts cannot beat the market. What this means is that funds will deliver poor returns, and many of our clients' financial goals may not be achieved. If this is true, we should not continue to use these funds to execute our investment strategy. But first, is there truth to this claim?
The accompaying chart shows one of the many researches showing that most actively-managed fund cannot beat the market index. In a study done by Morningstar Principia in 2005, it shows US top managers between the years 1995 to 1999 could not repeat their stellar performance again in the years of 2000 to 2004. Space constraints only allow me to quote 2 studies done in the US, arguably the biggest financial markets in the world. But we have many other researches done in other developed markets with similar results. The conclusion of these studies is clear: Most active fund managers cannot beat the market. For those that do, they cannot beat it consistently. There are many reasons why this is so but let me just list down a few:
Expenses
In reality, more fund managers could have beaten the market if not for cost. After subtracting all those management fees, brokerage commissions associated with trading and operating costs, it will be hard for these fund managers to outperform the market. The irony of actively-managed funds is that in order to perform, they need to hire very smart people to try and pick the right stock, choose the right time, read the right charts, execute the right trades, so that they can beat their peers. They also need to motivate financial sales people to sell your funds. And guess what? Smart people are expensive to hire and good salespeople want good commissions. These expenses eat into returns.
Stress on fund managers to perform
At the end of every year, every fund management company will want to win the top position in a fund award ceremony. Champagne is popped and accolades are given. The next day, advertisements are splashed across the media bragging about the achievement. This 'resume' will then be used by the fund houses' salespeople to get more financial advisers and wealth managers to sell the funds to investors. In short, awards mean more assets under management. Unfortunately, many of these awards are based on short-term performance like one year and three years, and as a result, managers may make short-term decisions at the expense of long-term performance.
Problem with active management
To beat the market, fund managers must pick the right stocks from the entire market. It's a risky game and one that can work for you or against you. In addition, because the stock market is a zero-sum game, you need to beat the competition. Your fund managers must face top investors like George Soros, Warren Buffett and many others. How often can fund managers win? Sometimes, but not all the time. Even very smart people cannot make the right decision all the time. Those that make more right decisions than wrong ones get headhunted by the competition next door. The result: Inconsistency in fund performance.
So what options do investors have? Passive instruments such as low-expense index funds and exchange traded funds (ETFs) could be the solution. These instruments do not try to beat the market. Instead, they replicate the market and only hope to achieve market return. By investing in the entire market through these passive instruments, you get the aggregate performance of all investors, including the better active managers.
Who are the proponents of passive instruments? You have Benjamin Graham (the teacher of Warren Buffett and so-called founder of the profession of financial analysis), John Bogle (founder and former CEO of Vanguard), Eugene Fama (father of modern finance) to name but a few - and many other Nobel laureates. The greatest investor of all time, Mr Buffett, says himself that most investors are better off investing into an index fund.
However, as much as we believe in the concept of index investing we do not have many of these instruments available in Singapore. There are fewer than 20 ETFs (and mainly investing only into emerging markets) and only a handful of index funds available to investors here. Private banks have access to these instruments out of Singapore, but instead, structured products are usually recommended to clients. Why is this so?
Some years back, I was having lunch with Jon Robinson, the former managing director of Vanguard Investments Singapore. I asked him why he was not bringing the slew of index funds that Vanguard is so well-known for to Singapore. His answer was simple and straightforward: 'There is no demand.' What he really meant was that there is no demand among the distributors. One of the biggest advantages of passive instruments is low cost. Low cost means no or low front-end sales charges and management fees. This means low front-end commissions and trailers for financial salespeople. Hence, the lack of demand. In our commission-driven wealth management industry, it may be some time before we see more financial advisers embrace passive instruments. I hope I am wrong.
To be fair, active managers can still do better in emerging markets where it is not so efficient and the use of passive instruments may not be suitable. But by and large, index-based instruments should still form the core of a portfolio. Investors who wish to invest in these instruments can buy them offshore. But if they want their wealth managers to advise and buy for them, they can only do so, if they meet the 'Accredited Investor' definition of having $2 million net worth and $300,000 income in the preceding 12 months.
Other investors will have to continue to use actively-managed funds. For these clients, we have to regularly review the performance of such funds, interview the managers and check the movements of their key managers just so we can help clients reach their target returns needed for their financial objectives. We are not banking on achieving above-market returns but simply on the required returns of our clients. So far this has worked, though investors may be paying too much to achieve the same results available from a passively-managed fund. However, with the current regulatory constraints, this is the best solution.
This article was first published in The Business Times on September 13, 2008.
