Why I’m passionate about passives
Investment alpha lies not with the fund manager but with the adviser, argues Abraham Okusanya, founder and director of outsourced investment research company FinalytiQ
Really this article’s headline should say Evidence-Based Investing or as I prefer to call it Beta Investing, but you get the gist.
I know these sorts of discussion tend to turn people off but hear me out. For me, this is something that goes into the heart of what we do as a profession – the evidence that what we do is in clients’ best interests.
Having taken the trouble to review the work of economists and academics, including notably Nobel Laureates William Sharpe (after whom the famous Sharpe Ratio is named), Daniel Kahneman, Jean Fama and even Robert Shiller – to name but a few, I concluded the demonstrable evidence required when selecting active funds, could only really be justified in exceptionally rare circumstances.
Their work has been critiqued their fellow academics and practitioners alike, and rightly or wrongly their ideas seem to have risen to the top. I had to admit that I couldn’t possibly be smarter than anyone of these Nobel Laureates, let alone three or four of them, and I don’t know any adviser who is either, even though I have met some exceptionally brilliant advisers! Accordingly, I take the view that selecting active funds suggests that I know something about investing that these Nobel Laureates somehow don’t know. That can’t be plausible, can it?
Even Warren Buffet, who is arguably the smartest investor on the planet, was willing to stake $1m and his reputation by betting six years ago that Vanguard’s S&P Index Fund will outperform a selection of hedge funds (Protege Partners’ hedge funds of funds) over the course of a decade. Year on year, Buffett’s el cheapo index fund is winning handily at 43.8% to 12.5%, as at the end of 2013. There are four more years to go, who knows what the outcome will be? But I find it intriguing that the world’s smartest investor was willing to stake his reputation on this.
Index funds as default
The overwhelming body of work on evidence-based investing should at least lead advisers to approach active investment with a high degree of skepticism. Yet, what I see is exactly the opposite. I would go even further and say that the default starting point for advisers should be index funds – with active fund selection only undertaken where evidence goes beyond past performance, taking in areas such as expense ratio and active share score as predicators of potential future performance.
The other relevant question is how best to capture Equity Risk Premium – which in most developed market is around 3% to 4%pa in the long run. Today, you could access any developed market equity for around 15bps. In fact, when you consider the net effects of stock lending, capturing value, size, profitability and momentum premia, it is even possible to push performance difference into positive territory (i.e. beat the benchmark without even trying).
Contrast that with paying 90bps to a fund manager to try to beat the benchmark? And some advisers even go as far as bringing a DFM into the picture, typically costing the clients an additional 30bps. When you add the adviser charge (typically 0.75%), which in my view is the most valuable to clients, and the platform at 35bps, the client is down nearly 2.5% before they even start! That’s a big chunk of the equity risk premium swallowed in charges. There aren’t many managers who can beat their benchmark, let alone by 2%pa on a consistent basis. And remember, it’s peoples’ futures we are dealing with here – their retirement, their children’s education, etc.
My final point is that I truly believe that it is with the advisers, not the fund managers, where the real ‘alpha’ lies.
There are many areas advisers add demonstrable value – tax planning, rebalancing, providing clarity through cashflow modelling.
But let’s talk about just one of these. Research tells us that helping clients avoid the so-called Behaviour Gap – the tendency to buy high and sell low – is worth as much as 1.5%pa. This requires advisers to wean clients off their addiction to chasing performance. But, of course, advisers can only really do this effectively if they aren’t making the same mistakes.
For more on FinalytiQ go to: www.finalytiq.co.uk