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Sustaining performance in today's markets 31 Aug 10

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By James Dunn.

Earlier this month, the Vanguard National Adviser Forum heard Roger McIntosh, the head of Vanguard’s Investment Strategy and Research Group, and Paul Chin, the Senior Manager of the Research and Technical Services, present “Noise versus Reality,” sub-titled “sustaining performance in today’s markets.”

The theme of the presentation was that while there are always high levels of “noise” surrounding investment markets, these levels reached unprecedented heights in the lead-up to the Global Financial Crisis (GFC) – and that some of that noise has not subsided.

Investors always face the difficulty of filtering out noise, but before the GFC, some of it reached the level of a siren’s song – and was just as tempting.

The main noise was the temptation to believe high returns were normal, said Chin. “A long bull market had created an unreal environment for risk-and-reward: very generous returns were being generated across the asset classes, but some of the risks were not being properly assessed.” Chin explained that both investors and advisers had lost sight of the fact that for greater returns, you assume greater risks.

“A classic example of that is where fund managers had marketed hybrid or mortgage funds as a more defensive asset class – or structured credit as a portfolio diversifier – but during the financial crisis, it became difficult to value those underlying securities or indeed to transact in those funds. There were very real issues around fund liquidity for investors.”

Chin said risks such as illiquidity and counterparty risk suddenly became tangible to investors, instead of theoretical possibilities mentioned in the fine print of the product disclosure statement (PDS). Post-GFC, he said, the situation was now the “mirror image” of that, with transparency and liquidity now commanding a premium.

The asset class that was picking up this flight to transparency was definitely fixed-income, he said. “Fixed-income did its job in the downturn and has a role to play even in the upturn. In the downturn, it defended really well in your portfolio, it preserved returns, it delivered solid coupon repayments to investors, and in the upturn – despite a series of interest rate rises – Australian fixed-interest still delivered 7.9 per cent during 2009-10”.

“Fixed-interest is an evergreen allocation, it has lower correlation to your growth assets and it does what it is expected to do. Investors value that,” said Chin.

Choosing active managers that consistently outperform is difficult, he said, because outperformance can only be seen in hindsight. The problem with that is the onus is on the portfolio constructor to pick the manager who’s going to outperform: we see this as putting the pressure on the investor, rather than on the actual manager.”

Attempting to ‘time’ the market was also a risky strategy, he said. “In the GFC, a lot of investors moved towards cash and term deposits, thinking they were being defensive. If they did that, they have probably missed out on the secular rally that occurred in 2009-10 in most of the traditional asset classes. That’s their opportunity cost: they have most probably been a spectator rather than a participant in the rally.”

This has reinforced the fact that sticking to an investment policy or an asset allocation rather than trying to time the markets is an optimal strategy, said Chin. “Strategic asset allocation remains the most important decision an investor can make. The water has perhaps been muddied during the GFC, but it remains clear that asset allocation is the key. The best thing an investor can do is have long-term strategic investment weightings, and rebalance frequently back to those weights, rather than trying to ‘time’ the markets.”

McIntosh presented fresh Vanguard research that reiterated the limited persistency of active management returns, especially when survivor bias is taken into account: the active funds that have gone out of business do not show up in the performance data. Adjusting for that bias, he said, shows that the performance of active funds was “essentially random.”

Comparison of the five-year annual excess returns and volatility of Australian active equity funds to their style benchmark clearly showed that
active management can mean lower returns and higher volatility, said McIntosh. In this context, he said, the cost advantage of indexing was readily apparent: higher costs clearly correlated with lower returns.

Investors should pay close attention to the elements in investment that are directly under their control, said McIntosh. “One thing we know that you can control is your expense ratio: we know that there is a negative correlation between the expense ratio and the excess return, as demonstrated across the Morningstar database, which means that the higher the expense ratio, the lower the excess return expected over the past ten years.”

McIntosh said the “burden of proof” had shifted to active managers, who must be able to defend the proposition that their insights should produce superior returns in a “somewhat efficient” market. In contrast, he said there was a “growing recognition” of indexing’s value given regulatory developments: regulators were recognising that indexing makes no big, risky bets – and delivers low-cost, low-turnover investment exposure with better tax outcomes for investors.

James Dunn is a financial journalist and media consultant. The views expressed are those of James Dunn, not necessarily those of Vanguard.

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