Chapter 01 – Managed Funds

As of November 2015, Dover has over 250 advisers. Many of these advisers have previously been advisers within other groups, and those other groups had group-specific rules when it came to the role of managed funds in a client’s financial profile, and, indeed, which managed funds could or could not be recommended. Dover has always avoided any alignment with a fund manager. This means our approach to managed funds is quite different to that of most other AFSLs. For example, Dover has a stronger liking for index funds and industry super funds than is commonly the case. This can sometimes be a point of polite contention with some of our advisers, who prefer more active management. This contention is fine by us – our interest lies in the fact that our advisers are really thinking deeply about their client’s best interests. If and when individual advisers develop an opinion that their client’s best interests lie in managed funds other than index funds or industry super funds, this is fine. It is one of the pleasures – for us and our advisers – of being unaligned. Advisers are free to exercise professional judgment. Our advisers are free to apply their own thinking to their client’s situation. As long as the adviser can show why their preferred managed fund truly best meets the client’s best interests, Dover is happy for that fund to be recommended. So, in reading the material below, if you are not such a fan of index funds and/or industry super, do not be put off. Reading our thoughts can only make your position better informed. Creative tension is good tension.

Introduction

According to IBISWorld, Australians have the highest rate of managed fund investment in the world. This is because of Australia’s long-held compulsory super provisions, whereby all employed Australians are forced to save at least 9.5% of their remuneration in the form of retirement savings. Again, according to IBISWorld, the largest five fund managers in Australia are:

  1. The Commonwealth Bank of Australia;
  2. The National Australia Bank Limited;
  3. AMP Limited;
  4. Macquarie Group Limited; and
  5. Australia and New Zealand Banking Group Limited.

This chapter introduces the common types of managed funds and then examines various elements of one of the most important distinctions between different funds: active versus passive management.

Common types of managed funds

Cash management funds

Cash management funds are account based. They typically invest in short term (between 1 and 365 day) fixed interest investments. Cash management funds invest in fixed rate securities via the ‘short term money market.’ Investments in the short term money market are made in large denominations. They can only be purchased by approved entities. For example, the Federal Government issues treasury notes via a tender process. The minimum value of the notes is $100,000 and only entities approved by the Federal Government are allowed to tender. In a cash management fund, the fund manager is an approved entity. The fund manager receives investments from many small investors, pools them and uses them to buy the larger fixed rate investments. Cash management funds provide relatively low risk investment options for their investors. This low risk follows directly from the lower risk that applies to the fixed rate investment asset class as against other asset classes. Because they are account based, cash management funds only provide income return. These returns can also be relatively low, compared to funds which invest in other asset types. Cash management returns typically follow the prevailing money market fixed interest rates, adjusted downwards to allow for the fund manager’s margin.

Bond funds

These trusts hold investments in longer term fixed interest securities. These longer term investments are typically known as bonds. Bonds generate both income and capital returns. Income returns derive from the payment of interest on the bond, and capital returns derive from the sale of bonds in the bond market. Bond trusts can invest in both Australian and international fixed rate securities.

Mortgage funds

These funds use investors’ funds to provide loans to borrowers. Mortgages are taken as security for these loans. These mortgages can then be traded on a secondary mortgages market, although this is usually only done to access short term cash – it is rare for mortgages to be sold for profit. Therefore, mortgage funds tend only to offer income return.

Property funds

Most property funds are property trusts. As the name suggests, a property trust invests in property assets. Once again, property trust risk and return profiles reflect those of property generally, although the fact that the fund will usually own more than one property does introduce diversification which, if the properties are sufficiently different, should reduce risk. It should also be noted that there are multiple property markets into which property trusts can invest. These markets can all have different risk profiles. Because property trusts typically perform in accordance with the sector of the property market in which they have invested, they allow investors to access these property markets without having to buy an entire property. There are two broad types of property trust:

Australian Real Estate Investment Trusts (A-REITs)

These are property trusts which allow their units to be traded on the Australian Stock Exchange. They are traded in the same way that shares in companies are traded. Because the units can be traded on the exchange, the price of each unit is affected by two things: the value of the net assets to which the units have beneficial rights, and the interplay of demand and supply in the exchange market. The main advantage of listing a property trust lies in the increased liquidity provided by the stock exchange. Stock exchanges have large numbers of buyers and sellers. This means that there is generally a readily accessible market for investors who need to sell their holdings. A property securities trust is a different type of property trust. It is a managed fund that then invests in listed property trusts. Often, A-REIT’s tend to be less volatile than other shares. This is because the value of the underlying asset – property – tends to move in larger, slower cycles. The ASX has calculated that LPTs are about 40% less price volatile than other types of share.

Unlisted property trust

In unlisted property trusts, unit holders buy and sell units directly from and to the fund manager. The value of each unit is calculated using the unit price formula given in the previous unit. The trust pays for an independent valuation of the property it owns each year and these asset values are used to calculate the net assets of the trust. Units in unlisted property trusts are even less price volatile than units in listed property trusts. This is because there is no demand and supply influence on the price. Units are less liquid, however, with sales of units back to the fund (often known as ‘withdrawals’) needing to be financed via the fund’s cash reserves. If the number of units being redeemed is too large for the cash reserves to cover, the trust will have two options: firstly, it may have to sell one or more of its property assets. This introduces timing risk, as the fund needs to sell immediately to pay its investors. Given that times of property down cycles (when unit prices will be falling as property values fall) are the common times that many investors will seek to withdraw their units, this often means that the trust is forced to realise a loss. This loss puts further downward pressure on unit prices. The second option is for the fund to borrow. Funds may only borrow when the rules of the fund allow it. This borrowing creates an interest expense, which will reduce net assets and thus reduce the unit price of the remaining units. In an attempt to reduce the risk of a large number of withdrawals being made at once and causing downward pressure on the unit price, the rules of some funds allow the fund to limit the number of units that can be withdrawn in any given period of time. Unlisted Property Trusts are financial products and accordingly are regulated by ASIC. They must comply with the various compliance requirements for financial products, including the issuing of a Product Disclosure Statement.

Geared property funds

As the name suggests, a geared property trust is one that supplements investor funds with borrowings. This allows the trust to purchase more property than they could using investor funds only. As with all gearing, a geared property fund introduces a new risk element, in the sense that the amount of debt that must be repaid does not vary, even if the value of the investment assets falls. This means that relatively small reductions in the value of the underlying assets have enlarged impacts on the net assets of the fund.

Split property trust

A split property trust offers two types of units. Income units entitle the holders to a share of the trust’s income. Capital growth units entitle the holders to a share of the fund’s capital growth. Splitting allows one trust to cater for investors who have a preference for one or the other type of return. These preferences will often vary according to the investor’s tax situation, time of life, etc.

Equity funds

Equity funds invest in shares. Depending on the fund, these shareholdings can either be domestic (i.e. Australian shares) or international. The key advantage of an equity fund is the diversity that it affords the investor. An individual investor might find it difficult to invest in the shares of more than one or two companies. This is because there are often minimum amounts that need to be invested in shares of a particular company (this minimum amount will be a function of the share price and the minimum number of shares that need to be held). By pooling their funds, multiple investors can use a managed fund to buy the minimum number of shares in a greater number of companies. Thus, they are investing more diversely. In the domestic market, different equity funds might specialise in different sectors within the equity market. This means that they will only hold shares in companies from a particular sub- group of the market. Typical subgroups include: large companies (as measured by market capitalisation); resource companies; industrial companies; smaller companies, etc. Each specialization increases risk (as compared to a non-specialised holding). The funds specialise in the hope that the sector in which they invest will perform better than the wider market. In this way, they hope to get a higher return to offset the higher risk. The risk profile of equity funds derives from the risk profile of shares. Generally, individual shares are seen as higher risk investments. This risk is reduced by diversification, and also reduces over time. That is, in general, a well-diversified share portfolio becomes less risky the longer it is held. Funds that invest in international shares tend to experience different risk profiles than those that invest in Australian shares. In particular, the presence of foreign exchange dealings can introduce extra risk. This risk can be managed via a hedging strategy. In terms of risk management, the larger number of shares that may be accessed in international markets can also allow for greater diversification. International equity funds usually invest in subgroups of the international share markets. Common subgroups include geographical areas, emerging economies and industry types (e.g. resources stocks from different parts of the world).

Listed investment companies

A listed investment company is a company that makes its money by buying and selling investment assets. As the name suggests, shares in an LIC are traded on the stock exchange (and thus ‘listed’ on that exchange). LICs can buy and sell investments from any asset class, so strictly speaking they are not necessarily equity funds. We include them under this heading because they are traded on the share market. Because the investor is using an intermediary to buy and sell investments, LICs are a form of managed investment. In addition to the return that can come to the investor via the performance of the underlying assets, an LIC allows the investor to experience market-driven influences on the return. LICs are known as ‘close ended’ funds. This means that they do not typically issue new shares to investors. (The exception is when the LIC does try to raise capital via a share offer). Once the LIC is operating, the only way that investors can enter into the company is by purchasing shares on the stock market. Similarly, when investors want to ‘cash in’ their investment, they must do so by selling to another investor via the exchange. Proponents of LICs claim that the managers of the company are able to focus on managing the business with the view to maximising long term returns. This is because the company does not have to give the shareholders their money back once they have issued the shares. This is distinct from a managed fund where the fund must pay unit holders out. In such managed funds, the size of the fund is affected by investor sentiment: if many investors seek to redeem their units at the same time, this can have severe consequences for the fund, which may need to sell assets to fund the withdrawals. Managed funds are vulnerable to increased withdrawals after periods of short term poor performance. Proponents of LICs claim that this vulnerability encourages open-ended managed funds to concentrate on maximising short term performance, at the expense of longer term success. Another distinction between LICs and other types of managed funds is that the LIC provides an income return in the form of a dividend. Dividends are paid at the discretion of the directors of the company. By contrast, managed funds typically must distribute all surplus income to the unit holders. The ASX requires that LICs inform the market regularly of their net tangible assets per share. This allows investors to quickly discern whether the market price of the share represents a premium or a discount to the net assets that the shareholder would be entitled to in the event of a wind up.

Blended managed funds

The discussion of the various types of managed funds above has described the core asset type invested in by the fund. Many funds invest in more than one type of asset. Such funds are sometimes known as blended funds. They may also be known as diversified funds. This second name suggests the main reason for investing in more than one asset class: to diversify. Blended funds usually calculate their blend to achieve some sort of investment objectives. These objectives often give rise to the name given to that type of fund. Some common types of blended funds include:

Capital stable funds

These funds typically hold more than half of their value in fixed rate securities. The capital value of fixed rate securities tends to be steady over time – hence the name ‘capital stable’. Of course, the potential returns earned by these lower risk securities are lower than those of higher risk assets such as shares. Therefore, capital stable funds are preferred by investors who need to maintain the capital value of their investment and are looking for predominantly income return. Capital stable funds are not the same as capital guaranteed funds. Capital guaranteed funds are discussed below.

Balanced funds

These are funds which seek to invest in both capital growth assets (such as shares and property) and income assets (such as fixed rate securities). The proportion, or balance, given to each type of asset varies according to the aims of the fund. Balanced funds allow investors to have some access to higher returning assets (the capital growth assets such as shares and property), while at the same time also having access to lower risk assets (the income assets). Funds with a higher proportion of assets from the higher growth types (shares and property) are sometimes known as growth or high growth funds.

Master funds

Master funds are funds which invest in other managed funds. There are three main types:

Feeder funds

A feeder fund is one where money invested by the initial investor is invested in other managed funds provided by the same fund manager. The typical example is where a fund manager operates both retail and wholesale funds. The feeder fund is a retail fund. Money invested in the retail fund is then invested in the wholesale fund. A feeder fund system allows a fund manager to offer a broader range of retail funds to individual investors, while only needing to actively manage a smaller number of wholesale funds. In addition to allowing the fund manager to manage a broader range of retail funds more efficiently, the wholesale funds used in the feeder system can receive investments from sources other than the retail fund. Again, this should increase the overall efficiency of the fund manager.

Fund of funds

A fund of funds is one in which the fund manager can invest in any other funds of their choosing. These secondary funds do not necessarily need to be managed by the same fund manager. This discretion allows the fund manager to try to increase the return for their fund by accessing well performing funds wherever they may be found. The concept behind the fund of funds is the same as that for feeder funds. Fund managers can offer a greater variety of retail funds, while avoiding the need to individually manage each one. The difference between a fund of funds and a feeder fund is that the feeder fund only invests in other funds offered by the same fund manager. A fund of funds can invest in any other managed fund, regardless of who the manager is. In addition, a fund of funds may also invest in a direct investment. Like all funds, a fund of funds is regulated by its constitution, which usually places limits on the type of investment it can make. Investors choose a suitable fund of funds based in part on this constitution. Funds of funds often market themselves according to categories such as capital stable, growth or high growth. The names of these categories typically reflect the risk profile of the total investments. Funds of funds are sometimes also referred to as member non-discretionary funds.

Investor directed portfolio services

These master funds are also known as member discretionary master funds. They allow the investor to choose the specific investments in which their funds will be invested from a designated list of available investments. In this way, the sum total of the master funds’ investments is the sum of all the individual investor’s decisions about where to invest. The list of available investments is usually a list of wholesale investments. An IDPS allows the investor to access wholesale funds which would normally be unavailable to them.

Capital Guaranteed funds

Capital guaranteed funds guarantee that investors will receive, at a minimum, their investment back. That is, they guarantee that the capital return will not be negative. Typically, a capital guaranteed fund will distribute income returns as they are earned by the fund. However, in periods where income returns to the fund are better than average, the fund manager may place some of the return into reserves. These reserves are then used for distributions in periods when the fund’s income return is less than average. This is known as smoothing, and is consistent with the lower risk profile typical of investors in this type of fund. Returns of capital to investors are also paid out of these reserves. APRA designates a minimum amount of cash that must be held in reserve by registered capital guaranteed funds.

Annuities

An annuity is a periodic payment made to an investor who has invested in certain types of managed fund. The investor invests an initial amount of money – the principal – into the fund. The fund invests this amount. Periodically, the fund makes fixed payments to the investor. The amount of the payment may be indexed for inflation. These payments are a combination of (part of) the principal and (part of) the return that being generated by the fund. Over time, the amount that remains invested in the fund is reduced by the amounts of principal that have been repaid to the investor. This reduces the income return being generated by that part of the total funds under management that come from the investor’s principal. Over time, this means that the mix of principal and interest in the regular payment changes: increasingly, the payment comprises more principal. Eventually, when the entire principal has been returned, the annuity ends. There are various types of annuity. Some annuities guarantee a payment to the investor until the investor’s death. In most cases, such annuities will require greater initial investments and provide smaller periodic payments than other types of annuity, reflecting the fact the fund manager may need to make payments over a longer period of time. These ‘life annuities’ can be held jointly by couples, where an annuity continues to be paid to the surviving member of the couple. Any funds that are still in the fund when the annuity holder dies are typically kept by the fund. Other annuities will be for a specific period of time. This may either be a minimum time, beyond which annuities may continue to be paid if sufficient funds remain, or ‘term certain,’ whereby the period of the annuity is set. Annuities are often used by retirees to fund their retirement. There are various tax and social security considerations to be made when selecting an annuity. Such retirees should always be referred to a registered tax agent. Note for Dover advisers: Dover Financial Advisers is a registered tax agent. ASIC include a discussion of annuities on their Moneysmart website (here). Dover’s observation is that annuities should typically only be used sparingly. There are various reasons for this, which we detailed in a Friday’s Reflection in October 2015.

Index funds

Index funds are a relatively new form of managed fund. The first fund for retail investors was created in the US in 1976, by a group called Vanguard Investors. In Australia, Vanguard introduced the first retail indexed fund in 1997. Index funds are typically equity funds. The name derives from the fact that the index fund seeks to construct a portfolio that matches the performance of an underlying index. An index is a number. This number represents the change in the value of a number of securities that have been grouped for the purpose of ‘measuring the market.’ A commonly quoted index is the ‘All Ordinaries Index’ (AOI). The ASX website defines the AOI as follows: “The index is made up of the weighted share prices of about 500 of the largest Australian companies. Established by ASX at 500 points in January 1980, it is the predominant measure of the overall performance of the Australian share-market. The companies are weighted according to their size in terms of market capitalization (total market value of a company’s shares).” So, when Alan Kohler on the ABC news says ‘the All Ordinaries was up .6 of a percent today,’ what he means is that the top 500 companies on the exchange went up by an average of 0.6%. Some companies will have gone up by more than this, some by less. Some might even have gone down. The AOI is the weighted average of the largest 500 shares. The largest 500 shares account for about 99% of the entire Australian share market. Therefore, the AOI is basically the average performance of the entire market. An index fund is therefore sometimes described as an investment in the stock market as a whole. Indexing involves the fund purchasing a representative sample of shares, in accordance with the proportion of the index that company represents. For example, if a company’s shares make up 2% of the total value of the index, then the index fund will allocate 2% of its investment funds to shares in that company. This strategy is often described as ‘passive’ because the fund manager does not try to predict the future performance of individual shares. Instead, the fund manager merely follows the market’s estimation of this future performance. This is because market share prices are essentially the sum total of the market’s expectation about the future performance of the company involved. The opposite of passive management is known as ‘active management.’ Active management is where the fund manager deliberately tries to pick those stocks that will do well and/or avoid those that will perform poorly.

Management style and asset allocation

A fund’s management style is important for at least two reasons. Firstly, it affects the way the manager selects and manages the assets of the fund. This is of obvious importance to the performance of the fund. Secondly, the style of management affects the level of cost involved in managing the fund. These costs also affect the fund’s performance in obvious ways.

Passive management

Index funds use what are known as passive management strategies. This is where the fund manager purchases and sells assets according to some pre-determined formula. The manager does not apply ongoing strategic analysis to the allocation of assets within the fund. Depending on the pre-determined formula, this style of management can offer lower risk than active management, as it removes any specific risk that can arise from the fund manager’s analysis. In investing, a positive relationship between risk and return (where increased risk is associated with the prospect of increased return), is often assumed. However, research has suggested that, in the longer term, the risk introduced by active management may not be justified by higher returns.

Neutral Asset Allocation

The passive investment strategy of buying pre-determined assets and then holding them for the long term gives rise to what is sometimes termed a ‘neutral asset allocation.’ Neutral asset allocations are adjusted infrequently, in response to specific ‘trigger’ events. An example of such an event is the listing of a new company. If a fund’s neutral asset allocation is that it will hold shares in the largest 300 companies on the exchange, and a newly listed company becomes such a company, then the fund will need to adjust its shareholdings accordingly.

Part Passive Management

Passive management may be complete or partial: a fund manager may use a passive strategy for some of its investment assets, and an active strategy for the remainder. Where the passive part of the strategy follows an index, this can be known as an ‘enhanced index style.’ Such funds usually designate an approved proportion of total investment funds that may be actively managed. The remainder are managed passively.

Limits of Passive Management

The restrictions placed on the fund manager by a neutral asset allocation are intended to reduce the risk of the investment. These restrictions may also limit the potential returns of the fund. Funds which limit the manager’s flexibility may restrict growth. For example, a fund may designate that only 90% of its assets can be held as shares. It might require, for example, that at least ten percent be held in fixed interest investments. If the share market is performing strongly, the increase in the value of shares may increase the proportion of the funds invested in shares beyond 90%. As a consequence, the fund may be forced to sell some shares so as to reduce the proportion of funds invested in shares back down to 90%. This may mean selling shares that are rising in value. A more flexible management style might keep these assets and enjoy prolonged growth. Similarly, if the share market drops, the fund may be forced to keep, or even buy more of, an underperforming asset, so as to meet the neutral asset allocation prescribed for it.

Active management

Active managers seek to analyse prospective investments with the intention of identifying those that will provide the best return. An active manager will seek to maximise the presence of well-performing assets and minimize the presence of poor performers in the fund’s asset mix. Active management can be further delineated into two sub-categories:

  • Top down. Using a top down strategy, a fund manager tries to identify sectors of an investment market (e.g. resource stocks) that are likely to perform well. The manager then invests accordingly;
  • Bottom Up. Using a bottom up strategy, a fund manager tries to identify specific assets that are likely to perform well, and invests accordingly.

Managers vary in the way they develop their investment strategies. For example, share market managers may use some combination of fundamental analysis (where individual shares are assessed according to the performance of the company), and technical analysis (where share market performance is analysed in the hope of identifying trends that predict future price movements).

Tactical Asset Allocation

Where a passive strategy often leads to a neutral asset allocation, an active strategy may give rise to a ‘tactical asset allocation.’ Such allocations are adjusted by the manager as they see fit to make such adjustments. The ability to adjust the allocation allows the manager to be more flexible in responding to particular market events. This flexibility allows the manager to seek above-average returns. However, it also introduces the risk that the manager will perform below the average.

Growth Management

This is typically a longer-term management style where the manager tries to select assets that are likely to provide a high level of capital growth. A growth management style may be either passive or active, but will tend to concentrate on assets known to produce higher long term capital growth. Property and shares are the main assets of this type.

Contrarian Management

This is a management style that operates in markets where assets experience ‘boom and bust’ cycles. In such cycles, prices tend to rise for a period of time and then fall for a period of time. For many asset types (for example, property and shares) these cycles have been clearly established over time. In periods of boom, the market tends to be driven by an increase in buying relative to selling. This drives prices up. In periods of bust, the opposite occurs. The market tends to be driven by an increase in selling relative to buying. This drives prices down. The contrarian seeks to do the opposite to the market. Contrarian managers seek to buy in times of bust and thus be ready to sell in times of boom. Of course, this sounds sensible. But it is not necessarily easy. Firstly, many commentators point out that buying when prices are falling takes courage, as does selling when prices rise. Secondly, the contrarian is usually trying to ‘time’ the market, in the sense that they will seek to buy at or near the bottom of a price trough and/or sell at or near the top of a price increase. Contrarian management is usually an active style of management. The manager is responding to changes in market sentiment. Few funds apply an exclusively contrarian approach. Those which do tend to be aiming for high, longer term growth. Contrarian managers usually require longer periods in which to implement their plans because the fund’s performance needs to wait for subsequent shifts in market cycles before an assessment can be made as to whether the fund has performed well.

Qualitative Management

The term ‘qualitative management’ refers to situations where investors look at factors other than those related specifically to financial considerations. Qualitative criteria can include environmental impacts, workforce management issues, moral issues such as alcohol and tobacco, etc. In response, some fund managers now offer funds that invest only in companies who meet the qualitative criteria desired by the investors. To learn more about qualitative investment, visit the website of the Responsible Investment Association of Australia.

Past Performance

It is sometimes said that the best way to predict the future is to look at the past. In investing, information about past performance needs to be looked at critically. Managed funds will often report their past performance as a way of demonstrating their ability to manage money. An assessment of past performance needs to include the context within which the performance occurred. Benchmarks may be useful providers of context. For example, an Australian equity fund manager who advertises a 10% return for the 2009/2010 financial year might look like it has performed well. But, given that the All Ordinaries Index rose by more than 9.6% for the same period, this manager has actually done only slightly better than the index. Conversely, an equity fund manager who advertises a 5% return for the 2008/09 year might look like a poor performer. But, in this case, the AOI fell by about over 20% for the same period. This manager well and truly beat the index (and managed not to lose any money in the process). The comparative performance must be assessed. In addition to these benchmarks, an investor needs to consider the prevailing circumstances at the time of the performance. When considering past performance, it can also be prudent to examine more than one period. This allows the investor to decide to what extent a particular period’s performance was consistent with its long term performance. Finally, an obvious point about past performance is that it does not necessarily say anything about the current and future situation facing an investment. The adviser – and the investor – still needs to make calculated judgments about the future.

Criticisms of managed funds

Managed funds are an indirect way to own each of the three major asset classes, shares, properties and fixed interest, and the various derivatives of them. The managed fund industry is huge and much of its explosive growth has been driven by mandatory super contributions. The industry directly and indirectly employs tens of thousands of people, from research analysts to marketing consultants to financial planners. Despite this, most managed funds have not beaten the market average over the last 40 years. Perhaps unsurprisingly, this is largely due to high operating costs. Even if a particular manager beat the market one year, it usually did not the next year. Picking successful fund managers is a challenging task. Few do it well. This is the basis of all criticisms of managed funds: that the fees payable for active management actually reduce the return to the investor when compared to what could have been accessed via a passive investment strategy.

Dover’s response to these criticisms – and Dover as a response to these criticisms

Historically managed funds have not performed well. For example, the S&P Dow Jones released the SPIVA Australian score card for the 2014 year and noted that “there is no consistent trend in the yearly active versus index figures, but we have consistently observed that the majority of Australian active funds in most categories fail to beat the comparable benchmark indices over three and five year horizons”. The under-performance is due to the presence of fees. This includes fees to consultants, managers – and financial planners! Some of these fees are disclosed to investors and some are not. For example, few investors know about so called shelf fees. These are fees paid by product makers to AFSLs just to be listed on their approved product list, i.e. the list of financial products financial planners are allowed to recommend to clients. These fees get their names from similar payments made by manufacturers and distributors to super markets. Volume based shelf fees have been banned since 1 July 2013, but non-volume based shelf fees are still common. The position is made worse by endemic institutional bias: 80% of Australia’s 17,500 financial planners are controlled by a handful of powerful financial institutions, principally banks and life insurance groups. ASIC regularly criticises the financial planning industry for a strong bias to products created by the controlling institution. Clients can never be certain whether they are getting genuine advice or a sales pitch when a controlled financial planner says “buy this managed fund”. ‘This managed fund’ is always an in-house fund. an ‘adviser’ controlled by the NAB simply will not recommend a managed fund owned by the ANZ. It cannot be the case that every institutional, controlled financial planner is working for the best fund manager. That is like saying that all drivers are above average. Dover’s status as an independently-owned AFSL means our advisers simply do not have this conflict of interest. The lack of institutional obligation means our advisers are free to conduct their own research and then recommend the managed fund that they truly believe best suits their client. This may be an actively managed fund. But the adviser is simply not restricted to actively managed funds that are offered by one institution only. As long as the managed fund is on the Dover approved products list, the adviser is free to consider it – and to recommend it when the adviser believes that the fund is truly in the client’s best interest.

Dover’s unusual liking for index funds

Dover is one of the few AFSLs that expresses a clear liking for index funds. Index funds are conservative and low cost, and the simplest and cheapest way of making sure that clients achieve a return as close as possible to market rates of return. Index funds such as the Vanguard Index Funds are well managed, low cost. They have also never paid commissions – which is why they have not been liked by most AFSLs. Dover routinely suggests that clients invest in index funds, particularly index funds based on the Australian share market, such as the Vanguard Index Australian Shares Fund. Dover’s reasons for liking index funds include:

  • clients have had great results with index funds over the last two decades;
  • no clients have lost all their money investing in index funds;
  • no clients have had their index funds “frozen”;
  • no clients have woken up to find their advisor has run off with their money (since clients invest directly into the index fund and do not need financial planners as middlemen);
  • index funds have never paid commissions;
  • the low cost structure means over time it is highly probable index funds will outperform actively managed funds operating in the same investment sector. This probability increases with time;
  • they are simple and easy to understand;
  • accounting is easy, keeping costs down even more;
  • most clients do not have the time, energy or inclination to be more actively involved in their investment strategies; and
  • modern portfolio theory predicts managed funds will outperform most actively managed funds over time: this is actually what financial planners and accountants are taught in university.

Index funds are a different type of managed fund. In fact, for reasons discussed below, the name ‘managed’ fund might be a misnomer. Index funds could be more accurately described as ‘administered,’ rather than managed. (As it happens, there is a good argument that index funds started their life being called ‘unmanaged funds.’ This might be a good description of the fund but was probably not a great idea in terms of promotion). This is because the index fund manager tells investors exactly what it will do with money that they invest. The only management they provide is to act as a conduit between the investor and the share market.

Other benefits of index funds

There are some other benefits of index funds. These benefits come down to effective risk management. The way in which index funds help to manage risk include:

Automatic diversity

The predominant retail index fund in Australia is the Vanguard Index Australian Shares Fund (‘VIASF’). The VIASF tracks the ASX 300. To do so, it buys shares in approximately 265 companies traded on the exchange. (It does not hold shares in the smallest 35 shares in the ASX 300, as these shares make up such a small component of the index that holding them would not affect the return). This represents optimum diversity. While it is a given that the 265 shares that are held will include some lemons, most of the shares will perform well over time (using history as our guide; the long-term return on the Australian share market is around 9.5%). It would be virtually impossible for any individual to own shares in these 265 companies in their own right. The administrative and brokerage burden would be too great. Therefore, the index fund offers the most efficient (in terms of time and money) means of owning a diversified fund. This automatic diversity is actually a feature of most managed funds. But because we think index funds are typically better than other managed funds, we think they are the best way to achieve this diversity. Diversification allows the investor to manage what is known as specific risk. Specific risk is the prospect that a particular share will perform poorly. The index fund owns shares in more than 200 companies, which means the effect on the entire portfolio of one company’s shares performing poorly is minimal.

Ease of management

In addition to automatic diversity, index funds also facilitate easy management. One of the main arenas in which we see this advantage is where a SMSF is used. At the end of the financial year, the index fund manager will provide the investor with a short but complete summary of all the transactions during the year. The summary will also show how the information should be accounted for. A SMSF has to be audited and accounted for each year. The information provided by the index fund manager makes the accounting and auditing task a lot less time-consuming. And because accountants and auditors charge according to time, the accounting and auditing fees are a lot cheaper. This provides a ‘double whammy’ effect: not only is the index fund the most efficient way of accessing the markets; the associated costs are minimised as well.

Index fund returns get better with age

Forbes Magazine carried an article on 4 April 2013 by Rick Ferri and captioned “Index Fund Returns Get Better With Age”. The article discusses USA studies demonstrating over time index fund returns are more likely to achieve better returns than actively managed funds. The studies show that over a 40 year period the number of actively managed funds that beat the index fell from 40% over 1 year, to just 12% over 40 years. Remember, one would expect 50% to beat the market every year, so even 40% is a statistically significant under-performance. The increasing under-performance over time has two main causes. These are:

  1. The compounding drag of higher management fees over longer periods. Actively managed fund expenses are about five times greater, and over time this significantly depresses accumulated earnings; and
  2. The high volume of fund closures and mergers: poor performing funds are usually closed down. Over the 40-year period nearly two thirds of all managed funds were shut down due to poor performance. When the historical data is adjusted for this “survivorship bias” the true under performance of actively managed funds emerges.

There is nothing to suggest that the USA experience is not replicated in Australia. In fact Australian managed fund costs are generally higher than USA managed fund costs, and this means it is likely that the under-performance over time will be even greater than in the USA.

Index funds and dollar cost averaging

Index funds also lend themselves to a simple strategy known as “dollar cost averaging”. Dollar cost averaging involves regularly buying the same dollar amount worth of assets. For example, on the first day of the month the client might invest $1,000 into the index fund – regardless of the price on that day. Because the client is investing the same amount of money each time, the number of units will vary according to the price on the day of purchase. Clients using dollar cost averaging will buy a greater number of units when the price is lower, and a lesser number of units when the price is higher. This usually skews the average cost within the portfolio downwards. Hence, dollar cost averaging usually allows the client to reduce the average cost of units over time. Some commentators do not like dollar cost averaging. But Dover does, particularly with lower risk assets such as index funds. This is because:

  • investing a smaller amount regularly over time is often easier than investing a large amount at one time; and
  • it is hard to beat the market by timing entry and exit perfectly; and
  • index funds, with their high diversification and low risk, are suited to long term investing strategies (particularly if any debt is involved).

One critic of dollar cost averaging is Neil Hartnett. In Introduction to Individual Financial Planning (Pearson 2009), Hartnett recognises points (i) and (ii) above are good, but observes that if the investment falls in price the investor has lost money no matter how or when the investment was acquired. Neil is right, and we agree wholeheartedly. This is why we say the target investment should be units in an index fund and the holding period should be very long term, measured in decades not years, and even generations.

Alternatives to index funds

Some ‘Listed Investment Companies’ (LICs) are held up as examples of an alternative to index funds. This may or may not be the case, depending on the management strategy within the LIC. This will be disclosed in documents such as the prospectus or the annual report for the company. Our preferred index fund manager is Vanguard. Their website is www.vanguard.com.au. We like Vanguard because they are the cheapest actual index fund manager available. There are other products around that are badged as index funds, but when the fee structure is examined the level of fees are higher than they should be. By way of example, Vanguard do not charge entry or exit fees, and their ongoing Management Expense Ratio (MER) is 0.75% for the first $50,000; 0.50% for the next $50,000, and 0.35% for everything above $100,000. If you know of an index fund manager who is cheaper than this, please let us know.

Disadvantages of index funds

Index funds do have some drawbacks. These are discussed in the following paragraphs.

Ethical investing

Some clients prefer to not invest in companies involved in certain activities. Gambling, alcohol, mining, timber etc. are commonly avoided by what are known as ‘ethical investors.’ Index funds, almost by definition, cannot avoid these types of company. So, an investment in an index fund that seeks to track a substantial index such as the ASX 300 will include shares in companies that the investor might like to avoid. Some investors get around this by quantifying the amount of their return that is attributable to the undesirable companies and offering this amount to charity. For example, the investor might calculate that they made $500 from their investments in gambling companies, and donate this amount to gambling helpline or similar. But of course, doing this reduces some of the advantages of the indexing approach.

Cannot possibly beat the Index

The index fund cannot possibly outperform the index. We have actually heard a financial planner describe them as un-Australian for this reason, asking what Australian would make of a cricket team that happily accepts average performance! As cricket lovers ourselves, we do wonder what this adviser would have made of the 2015 Ashes in England. We just hope he did not ‘invest’ all of his client’s investment money by betting on the Aussies. If clients want their investments to beat the market, they need to steer clear of index funds. As to where they then go instead… well, this is a hard decision. Dover does not know which managed fund will beat the index repeatedly in the years to come. We are quite happy to admit what we do not know, because it puts us in fine company. One of the reasons we like index funds is that they come recommended by none other than Warren Buffett, often described as the world’s most successful investor. In 1993 he said: “By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.” Nothing has changed since then. Anyone who followed this advice in 1993 would have beaten most fund managers in the ensuing 22 years. Anyone who follows this advice over the next 22 years will beat most fund managers too.

Why Warren Buffet likes index funds

At the 2004 Berkshire Hathaway shareholders’ meeting Buffett was asked whether investors should buy Berkshire, invest in an index fund, or hire a broker. Buffet responded: “We never recommend buying or selling Berkshire. Among the various propositions offered to you, if you invested in a very low cost index fund — where you don’t put the money in at one time, but average in over 10 years — you’ll do better than 90% of people who start investing at the same time.” “If you like spending 6-8 hours per week working on investments, do it. If you don’t, then dollar-cost average into index funds. This accomplishes diversification across assets and time, two very important things.” “Just pick a broad index like the S&P 500. Don’t put your money in all at once; do it over a period of time. I recommend John Bogle’s books – any investor in funds should read them. They have all you need to know. Vanguard. Reliable, low cost. If you’re not professional, you are thus an amateur. Forget it and go back to work.”

Other responses to the criticism of managed funds

Another response to the criticism that managed funds tend to cost more than they are worth lies in industry super funds. These are also a form of managed fund. But as they are ‘not for profit,’ they are relatively low cost. The administration that they do provide, centred as it is around super (quite a complex area for many clients) tends to be worth the cost. Occasionally a managed fund has a positive feature that allows it to be recommended, notwithstanding our general concerns about fees and institutional bias. For example, some managed funds specialise in gearing shares. They do the gearing bit well, with low interest rates, and they stick with blue chip Australian shares paying reliable franked dividends. These sorts of funds can be good for clients interested in gearing, but who do not want the bother of doing it themselves, and do not want to give guarantees and security over other assets. They can be particularly good for SMSFs interested in geared share investments.

The Dover Group