News & Commentary

Markets, Regulation, Call for a Rethink 30 Jul 10

By James Dunn

The New Financial Year brings with it plenty of challenges for financial advisers – but also opportunities.

As if the changes to their business that have arrived in the government’s Future of Financial Advice package were not enough to deal with, advisers are also dealing with an investment outlook that is still clouded with uncertainty. Concern over the global economy, the US sharemarket and how China handles its deliberate slowdown mean that the troubled ride for investors since 2007 will continue.

Volatility curves show that six months out from here, investors are signalling heavy concern. US Treasury bond yields reflect growing alarm that the US economy faces a double-dip recession later this year. Sovereign debt worries have not adequately been eased, and the austerity measures undertaken by European governments will crimp economic growth.

Because investors are concerned at the outlook for the developed markets over the next few years – as excess debt washes out – there continues to be a focus on the de-risking of global investment portfolios.

Worse, investors are taking increasingly seriously the risk that Europe and the US follow Japan into a damaging period of deflation.

None of these things are certain outcomes. But if there is one thing that investors have learned, it is to expect the unexpected.

In many ways, advisers are in the same boat as the typical long-only fund managers: if we are to remain in a long-term period of subdued equity returns, advisers can all too readily see a net outflow of funds from their business.

Also, if they’re charging a fee for assets under management, they can see weak (if not negative) equity returns crimping their business’ income flow.

The correlation effect has hit advisers hard. Not only have the asset classes tended to correlate more, so has correlation increased among managers. It has not been much use to diversify clients’ funds between four different fund managers, if those managers are doing much the same thing – this applies particularly to the long-only relative-return managers.

Advisers faced with weak markets are going to look much more carefully at the long-only relative-return-oriented style of manager than ever before.

There is a business risk to advisers in the current environment, to the extent that they use ostensibly active managers, but whose portfolios show correlation to the underlying benchmark that is quite often very high (90–95 per cent). And yet these managers charge active fees, which the clients have been willing to pay.

The market turmoil in the wake of the GFC has changed this proposition for many investors – and by extension, for their advisers.

Many clients realise now that a fully invested, long-only manager which is using as its risk measure tracking error – which is a relative risk measure – is closet indexing. If the benchmark rises, these funds go up; if the benchmark falls, they go down with it.

If the fund manager is fully invested and is tracking an underlying benchmark, it is likely to deliver close to benchmark returns. The only way you can actually diversify away market risk is to remove it: that is, the manager either has the ability to have a very high cash balance if required – which means there can’t be a tracking-error limitation – and/or the ability to ‘short’ the market if it feels there is a significant amount of market risk.

This is especially important in international equities, where most investment has a huge bias to the benchmark, the MSCI World Index – which is more than 70 per cent weighted to the developed world. Advisers looking to diversify into international equities and get some growth must be aware of that strong developed-world bias.

Investors are beginning to wake up to these realities. And in the brave new world envisioned in the government’s ‘Future of Financial Advice’ legislative package, which comes into force in July 2012, they will expect their adviser to advise that way, too.

As in any far-reaching change, there will be many advisers who cannot adapt to a business in which fees are charged for service. But for those advisers who can alter their way of thinking, to become a truly strategic investment partner for their clients, the changes will be a great opportunity.

Over the next decade, investors are likely to concentrate on real – not relative – returns; they will scrutinise the leakages in returns, and focus on what comes to them after tax; and they will be aware of the return to which they are entitled (that is, the index). Above all, they will want to get what they pay for and pay for what they get.

If they are seeking to have one part of their portfolio giving them the market, they will want that to come from an index fund or an exchange-traded fund (ETF) – not from an active fund that delivers index performance.

That is not to say that they will not use active management: smart investors will still want to use managers that show skill. Smart advisers will still choose to invest their clients’ money with managers who are genuinely active – as in benchmark-unaware – but they will only pay for products that “do what it says on the tin.”

An index fund, for example, does what it says it intends to do – it provides an investor with the index return, at minimal cost. If every product is called a spade, there’s no confusion. And investors won’t pay for confusion anymore.