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A differentiated approach to asset allocation and product selection. Travis Morien Compass Planners Pty Ltd http://www.travismorien.com Tribeca Targeting High Net Worth Investors Conference 25 th and 26 th October 2004, Four Seasons Hotel Sydney. Active vs. passive investing.

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a differentiated approach to asset allocation and product selection

A differentiated approach to asset allocation and product selection

Travis Morien

Compass Planners Pty Ltd

http://www.travismorien.com

Tribeca Targeting High Net Worth Investors Conference

25th and 26th October 2004, Four Seasons Hotel Sydney

active vs passive investing
Active vs. passive investing

Pictures by Vanguard Investments

slide3
“Properly measured, the average actively managed dollar must under-perform the average passively managed dollar, net of costs” (Bill Sharpe)

Distribution of Manager Returns vs. Benchmark

Pre-fees:

Post-fees:

Good Managers

-4%

+4%

-5%

+3%

Average = -1%

Average = 0%

Source: “Arithmetic of Active Management”, Financial Analyst Journal, Jan 91.

slide5

Number of Australian Share managers outperforming the S&PASX300 Index, post fees (12 months to 31 July) and value minus growth returns

Value outperforms

Growth outperforms

Top chart source: Mercer/Morningstar IDPS Survey Bottom chart source: Dimensional Fund Advisors

slide6

Every US large cap fund with a 15 year history vs the S&P500 and CRSP 1-10 indexes. 15 Years ending 31 December 2001 (285 Funds)

Graphic by Dimensional Fund Advisors

slide7

Survivorship bias: amount median prices are overstated per year

Source: Russel Investment Group, periods ending 30 June 2004, “Insights” IN107.

slide9

"Investors continue to sour on stocks. So far this year, investors have made net withdrawals of $11.3 billion from their stock mutual funds according—including a hefty $3.7 billion just last week—according to AMG Data Services.” Source: Gregory Zuckerman, "Investors Rush to Buy Bonds, Fleeing Stocks," Wall Street Journal, March 11, 2003

S&P500 data source: http://finance.yahoo.com

slide10
Annual returns of “buy and hold” index vs actual annual returns enjoyed by US mutual fund investors from 1984 to 2002

Source: DALBAR, Inc. Media release of 2003 update of “Quantitative Analysis of Investor Behaviour” study.

the diverse world of passive investing
The diverse world of passive investing
  • Traditional index funds (BGI, Vanguard)
  • Enhanced index funds (BGI, Macquarie)
  • Exchange traded funds (Streettracks)
  • “Style indexed” funds (Vanguard ASHY)
  • Asset class funds (Dimensional)
fama and french s three factor model
Fama and French’s Three Factor Model

Graphic by Dimensional Fund Advisors

slide14

Fama/French indexes on the US market

Annualised returns July 1926 – August 2004

Figures do not include fees, taxes or other costs and past performance may not be indicative of future results.

Source: Dimensional Fund Advisors

slide19

Global value 17.75%pa

Global small 16.06%pa

Global large 13.78%pa

Figures do not include fees, taxes or other costs and past performance may not be indicative of future results.

Source: Dimensional Fund Advisors

slide20

Australian value 19.97%pa

Australian large 13.02%pa

Australian small 12.06%pa

Figures do not include fees, taxes or other costs and past performance may not be indicative of future results.

Source: Dimensional Fund Advisors

slide23

Adding emerging markets to an international shares portfolio

MSCI World Index + MSCI Emerging Markets Free Index, January 1988 to September 2004

Percentage emerging markets

what do we want from active funds
What do we want from active funds?
  • Active funds potentially can have higher performance
  • Passive funds are not available for all asset classes
  • Perhaps something very different to the index for diversification
core satellite approach

Cash

Australian Shares

Fixed Interest

Property

International Shares

Active “Satellite”

Index Core

Core/Satellite Approach

Sector Index Funds:

  • Tailor strategic allocation
  • Increase index core where confidence in active is low

Graphic by Vanguard Investments

slide27

The cost of active management from a low tracking error manager

80% x 0.286%pa + 20% x 6.356%pa = 1.5%pa

Wholesale index MER + aggressive fund MER = low tracking error MER

slide30
“The whole concept of dividing it up into "value" and "growth" strikes me as twaddle. It's convenient for a bunch of pension fund consultants to get fees prattling about and a way for one advisor to distinguish himself from another. But, to me, all intelligent investing is value investing.”

Charlie Munger

the style universe

Value

Perpetual, MBA, Dimensional

Growth

Colonial FS, Credit Suisse

Relative Value

Lazard

GARP

BT, ING

Neutral

UBS

Indexed

Vanguard

The Style Universe

Growth

Value

Graphic by Vanguard Investments

tax efficiency
Tax efficiency
  • Income/growth and franking credits
  • Turnover
  • Tax loss selling
  • Hold range
  • Short vs. long term CG realisations
  • Tax liability on existing portfolio
  • Consider your turnover as well, how often will you switch an active manager compared to a passive one.

Vanguard is now reporting after tax returns, Morningstar will start tracking them from next year.

capacity issues
Capacity issues
  • Market size (large cap vs. small, domestic vs. international)
  • Portfolio turnover
  • Contrarian vs. momentum
  • Active positions/index weightings (tracking error)
  • Large size offset by possible new opportunities and market clout.
why does turnover matter
Why does turnover matter?
  • Ruins tax efficiency
  • Increases brokerage and market impact costs, making it increasingly difficult to outperform as the portfolio gets larger.
  • According to a US researcher, the Plexus Group, managed funds incur costs of around 0.8% on each side of a transaction. It costs about 1.6% round trip to buy and sell a stock.
key person risk
Key person risk
  • Skill vs. process
  • Incentive structure
  • Institution vs. boutique
  • Staff equity ownership
  • Eating their own cooking
suggestion for picking active funds
Suggestion for picking active funds
  • Avoid “index huggers” that charge a full active MER. Funds with concentrated high conviction portfolios may actually represent better value on a price per active position basis.
  • Avoid tax inefficient funds for investors on high tax rates. The tax inefficiency penalty can cost several percentage points per year. If you must use inefficient funds, use super.
  • Avoid “growth at an unreasonable price” funds and funds with excessive turnover. Seek out funds with a value philosophy, but not necessarily funds pigeonholed into a “value” classification.
  • Look for fund managers with a performance culture rather than a FUM gathering culture that adequately reward their key staff.
slide38
"The essence of risk management lies in maximising the areas where we have some control over the outcome while minimising the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us."

Peter Bernstein

Bernstein, P. L. Against the Gods: The Remarkable Story of Risk. Wiley; New Ed edition (1998)

slide39
“The determining question in structuring a portfolio is the consequence of loss; this is far more important than the chance of loss."

Peter Bernstein

Bernstein, P. L. Management of Individual Portfolios. The Financial Analysts Handbook; Levine, S. Ed.; Dow Jones Irwin Inc: Homewood Il, 1975.

slide40
Risk is the probability of not having sufficient cash with which to buy something important.
  • Risk is a function of a portfolio's assets and its liabilities, in particular the cash flow between the two over time.
income planning for pensions
Income planning for pensions
  • Dividends are fairly reliable for diversified portfolios
  • We can’t eliminate capital volatility but we can make it less relevant through portfolio structuring.
  • Fund near term capital withdrawals with cash, if you aren’t drawing down on shares then share market volatility is sidestepped.
  • This turns asset allocation into a mere budgeting exercise! Put aside enough cash to cover the dividend shortfalls and you’ll reduce your need to sell shares.
three dimensions of risk profiling
Three dimensions of risk profiling
  • Tolerance of loss
  • Timing of cash flows (time frame)
  • Tolerance of tracking error, unconventionality and complexity
slide45

20% Australian large

20% Australian value

10% Australian small

20% global large

20% global value

10% global small

50% Australian large

50% global large

Source: Dimensional Fund Advisors

portfolio drawdown maximum loss
Portfolio drawdown (maximum loss)

Source: Dimensional Fund Advisors

slide47

Disclaimer:

This article contains the opinions of the author but not necessarily the author’s employer or any of the individuals or companies mentioned in this presentation, and do not represent a personal recommendation of any particular security, strategy or investment product. The author's opinions are subject to change without notice.

Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.