We need to change the conversation on investment management fees.
Kiwi Wealth recently released an insightful article on the case for having your money managed actively.
This article has, inevitably, being meet with a passionate defence of Index Management (also referred to as Passive Management). A debate that has been going on for some time, and we really need to move on!
Kiwi Wealth make the following comment in the introduction:
“The “active versus passive” debate has been a fixture in the investment industry for nearly 50 years. Passive investing is one of the cheapest ways to access equity markets globally, and has helped to drive down fees across the board. Passive investment managers and their suppliers have gone further than just offering low cost products however, and have portrayed actively-managed portfolios as a bad option for investors. We disagree, and believe, headlines supporting passive investing are largely driven by passive investment managers and index providers looking to frame the debate to their own advantage.”
I can’t disagree with that.
As the Kiwi Wealth paper touches on, there is a role for passive and active in constructing a robust portfolio.
The debate has moved on from black vs white, active vs passive, there are shades of grey in return outcomes (but maybe not 50 of them!).
The black and white debate is evident in this GoodReturns article, Passive Managers Reject Criticism. Also note the comments section as well.
I have written a number of Posts on Index management, highlighting their limitations, and risks, albeit I can see a role for them as part of a portfolio, as I can active management.
As with active management, it is important to understand and appreciate the limitations of what you are investing in.
I also hope we don’t follow Australia’s lead as an industry and focus too much on investment management fees. There is an appropriate level of fees, but it is not the lowest cost provider.
We need to change the conversation on investment management fees as recently highlighted by BlackRock, a large Index/Exchange Traded Fund (ETF) provider.
Index Funds do buy high and sell low, primarily because companies move in and out of indices.
Analysis by Research Affiliates highlights the trading costs of Index Funds (Passive Funds). Index Fund providers understand this and seek to minimise these costs.
As an aside, passive index funds are not passive, they are actively managed.
Albeit, there are huge trading costs around market index changes over time. These costs are incurred by the Index Funds, yet the costs are not evident given they are also included in market index returns. Index Funds incur these costs.
These costs are high, Research Affiliates estimates the difference in return between a company exiting and entering an Index to be 9.52%. The majority of this performance difference occurs on the day of index changes. It also only occurs on that proportion of the portfolio that is changing.
Stocks entering an Index tend to underperform over the next 12 months, while those leaving an Index tend to outperform over the following year.
For more, see this article on why low cost index investing is not necessarily low risk.
In another Post I highlighted that Index Funds have exposure to unrewarded risks and are often poorly diversified e.g. think when Telecom made up over 30% of the NZX and the US market is currently highly concentrated.
These articles are separate to the current issue of overvaluation in sectors of the US market, recently labelled, rather misleadingly, an Index Bubble, by Michael Burry, who was one of the first investors to call and profit from the subprime mortgage crisis of 2007-08 that triggered the Global Financial Crisis.
Just on active management, there is a growing level of academic research challenging the conventional wisdom of active management and in support of active management, as I highlight in the Post Challenging the Convention Wisdom of Active Management.
The research Paper attached to this Post is the most downloaded paper from Kiwiinvestorblog.
Closely related, and what has busted open the active vs passive debate, leading to the shades of grey, is the disaggregation of investment returns – the isolation of drivers of investment returns.
As the Post highlights returns can be broadly attributed to three drivers: Market returns (beta), factors and hedge fund strategies beta, and alpha (returns after the betas, which can be purely attributed to manager skill).
The disaggregation of investment returns is prominently expressed by factor investing (e.g. value, momentum, low vol) and that investors can now access “hedge fund” type strategies for less than what some active equities managers charge. These are “active” returns.
The disaggregation of returns and technology will drive future ETF innovation, particularly within the Fixed Income space and alternative investments.
As you know, the isolation of the drivers of investment returns is also driving the fee debate, as the Kiwi Wealth paper infers, investors do not want to pay high fees for an “active” return outcome that can be sourced more cheaply.
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