Investing Your Capital – You Get What You Don’t Pay For

Both Ray & I started our financial advice lives with an insurance company, and realised over time that we needed to get out of sales.

Working for a product provider was something we had outgrown, and our aim then was to simply work for you, the client.

So, freed from our shackles, we became independent financial advisers and started to look at what was best for you and not what best suited an insurance company.

There were many challenges and the subject of investment was one of the main ones. It was clear to us that we needed to fundamentally review everything and so began a journey that we are still very much on (and we’re sure it’ll never end!).

We realised it was important to ignore the pundits and the whole investment industry who had their own interests to push forward. We simply wanted to educate ourselves on what is ‘the truth’?

We were aided here by reams and reams of academic research, which was carried out by some of the most illustrious names of the late 20th century.

For us the evidence was conclusive and we were able to formulate our investment process based on solid academic research. We had also found a way of making theory into practice with the discovery of ‘Wrap Platforms’, basically letting us buy the investment funds that we needed for our clients at a low cost.

We’ve refined the process over time, and are immensely pleased with the results, as are the most important folk – our clients.

Some fundamentals that we adhere to are:

use passive, not actively managed funds
buy & hold over the longer term
keep costs to a minimum

(Active fund managers believe by trading stocks they will outperform the stock market index. Passive funds basically track a chosen index and trade very little aiming to capture the market return).

So it is always good to see even more academic evidence that we are giving our clients the best advice we can.

This came from Vanguard, a firm that actually offers both passive and active funds, in a paper titled:

“Shopping for Alpha: You get what you don’t pay for”.

It is a detailed research document looking at ways of identifying superior funds over different time periods taking into account risk factors.

Essentially they were asking can active funds provide consistent ‘alpha’- above average performance – over 1, 3, 5 and 10 years, on a rolling 36 month period?

These were the results, bearing in mind that a random distribution would give 25% in the top quartile:

Probability of remaining in top quartile

1 year 22%

3 years 26%

5 years 21%

10 years 19%

But it gets even more interesting when you take into account what is known as survivorship bias.

Vanguard reminds us that fund management groups are well known for closing their poor performing funds or merging them with better funds to improve their published performance. When these funds are taken from the overall performance figures it makes active managers look significantly better than the true picture.

So when this was taken into account, the 10 year figure reduced from 19% to 9%!!

To emphasise matters, Vanguard took a look at Morningstar Ratings. These range from 1 star (the worst risk-adjusted performance relative to peer group) up to 5 stars.

Vanguard research (Philips and Kinniry 2010) looked at whether these ratings could help identify top performing funds over the next 36 months using data from June 1992 to August 2009.

The result was that star ratings were no guide to future performance. Indeed, 5 star funds were less likely to outperform their benchmark than 1 star funds!

Finally, they looked at the effect of costs on performance, namely expense ratios and portfolio turnover costs (trading costs).

The conclusion here was that, on average, for every 1% increase in expenses, alpha declined by 0.78% p.a. In other words, there was a significantly negative correlation between expenses and alpha.

Portfolio turnover rates produced a similar, but less pronounced, result with every 1% increase in portfolio turnover giving a 0.22% drop in alpha. In other words, trading within a portfolio was also destroying alpha.

So, in summary, Vanguard found that alpha does exist, but it is small & patchy at best and impossible to predict in advance which fund will deliver this.

So we are back to the key fundamentals:

use passive, not actively managed funds
buy & hold over the longer term
keep costs to a minimum

Key Considerations

Over the last 20 years, study after study has shown that an active fund manager will almost certainly fail to deliver over time and after costs.

What you are paying him/her for is above average performance – but as Vanguard say:

“You get what you don’t pay for”

Action Point

We find that when we start to work with a new client that has investments, they almost always have a random collection of active funds and are usually taking more risk than they need to.

Being able then to transform this into a risk assessed portfolio, using passive funds with lower costs is an eye opener for them.