News & Commentary

Helm July 2010: Pay Attention - Costs Really Do Matter 08 Jul 10

• Pay attention - costs really do matter
• Editor's letter
• A strategy for life
• 1975 – 2010: Three and a half decades of Indexing
• Your say

Pay attention – costs really do matter

by Michael Laurence

Investors can not control volatile investment markets but what they can control is their investment costs.

When markets are extremely volatile and returns are subdued or negative, the handicap of high costs on investment returns becomes most evident.

Astute investors often adopt an all- encompassing approach to controlling their investment costs. They take into account the combined impact of investment management fees, transaction costs, taxation and the potentially high price payable for attempting to time the market.

Each of these costs can, depending on the circumstances, transform what may have been a positive return into a negative return. And excessive investment costs take a mounting toll over the long term.

Lower-cost funds
The growing focus of individual and institutional investors on tight cost control – including their selection of managed investment funds – is something of an international phenomenon.

A recent Vanguard study in the US – Costs Matter: Are Investors Voting With Their Feet? – examined Morningstar fund research data for the 10 years to December 2009 to measure the extraordinary popularity of lower cost investment funds among American investors.

Based on a close analysis of net inflows and outflows for equity and bond funds, the researchers decisively concluded: funds with lower expense ratios received the “lion’s share of investor dollars over the period”. The research covered actively managed funds, index funds and exchange traded funds (ETFs).

“… many investors are likely recognising that lower costs help them to keep more of a fund’s returns – [and] have been ‘voting with their feet’ and gravitating to low-cost investment options,” the researchers added.

The study’s key findings included:

• Equity funds in the lowest expense quartile received a dramatic 86 per cent of the net inflow into equity funds
  in the fund quartiles with net positive inflows.
• Equity funds in the most expensive two quartiles suffered net outflows of $81 billion over the 10 years.
• Index funds and ETFs took 80 per cent of the net inflows to equity funds described by the researchers as the “lowest of the low” in fee terms.

Investors who were more likely to be the best informed – such as institutions and high net wealth individuals – were more likely to understand the relationship between costs and performance, according to the study’s authors, “and as a result, favour lower cost products”. In turn, this cost cutting attitude among such investors should be of great interest to everyday personal investors.

Perils of market timing
Among the costliest of exercises for investors are attempts to time the sharemarket – that is, trying to pick the best times to buy and sell shares.

Even highly experienced investment professionals rarely succeed in consistently timing the market over an extended period.
In reality, investors who try to time the market tend to sell after share prices have sharply fallen only to reenter the market after share prices have sharply risen.

Most market timers gain an unwarranted sense of security by adopting an investment herd mentality. This leads to investors rushing in and out of the market in response to prevailing sentiments be it fear or overconfidence.

The US Investment Company Institute – a national association of investment managers – has truly highlighted the costly consequences of running with the investment herd and attempting to pick the best times to buy or sell.

The institute has compared movements in the MSCI All Country World Index with the inflows and outflows of US equity funds over the past 17 years. There is an astounding resemblance between the two.

In short, whenever the market was bottoming and share prices were about to rebound, investors were heavily withdrawing their money from the equity funds. And when the market had rocketed upwards, investors were pouring their money into the funds in effect chasing past performance.

This was the broad pattern displayed, for instance, from the 2000 tech wreck through to the last bear market. Any investor who is tempted to chance their arm in market timing should find this salutory reading.

Australian superannuation fund researcher Warren Chant, principal of Chant West, wrote an article earlier this year that may also convince investors to think twice about trying to time the market.

In his article, Staying the Course Pays Off, Chant examined the possible consequences for a super fund member with a typically diversified default portfolio with a major fund of either staying the course in that portfolio during the bear market or switching to an all-cash portfolio.

“During the GFC, some [super fund] members despaired of seeing their account balances fall and switched out of growth options into cash,” he wrote.
“…what they did was to lock in their losses and give themselves the added problem of when to get back into growth assets.”

According to this research, the only fund members who benefited from switching to cash had switched prior to October 2008 – “before the full brunt” of the Lehman Brothers’ collapse was felt. (The research was based on the median return to February 2010, and assumed fund members who switched to cash still had all- cash portfolios at that time.) “The reality is that most of the people who did switch [to cash] left it too late,” Chant added. “Not only did they bear the worst of the negative returns, they also missed out on the best of the positive returns when markets turned up.”

Of course, some members would have been no doubt lucky to switch back to growth or balanced portfolios at an opportune time. Luck is generally the operative word.

A crucial factor with market timing is the often overlooked opportunity cost of being out of the market when share prices are rising.

Dollar cost averaging
An effective way to sidestep any temptation to try to time the market is to adopt a dollar cost averaging approach to investing in equity funds and direct shares.

Dollar cost averaging involves investing equal amounts regularly – perhaps monthly or quarterly – regardless of prevailing market conditions. This means the investor buys more units or shares when prices have fallen and fewer when prices have risen.

Significantly with dollar cost averaging, investors reduce the risk of investing large sums just before the market suffers a big downturn.

Finally, dollar cost averaging removes emotion and other potentially distracting behavioural influences from investment decisions.

A decision not to participate in market timing does not, of course, rule out the regular rebalancing of your investment portfolio. Rebalancing does not involve trying to second guess the market with market timing.

Rebalancing of a portfolio simply means returning it to its already determined long-term asset allocation with assets broadly diversified between different asset classes in accordance with an investor’s circumstances including needs and risk tolerance.

After large movements on investment markets, investors who do not rebalance portfolios may become over or under exposed to particular asset classes such as shares or property.

Taxation costs
Tax effective investment strategies are essential for keeping investment costs as low as possible. Unfortunately, numerous investors would not realise the extent that tax can erode their real investment returns.

A simple way to reduce tax on investments is follow a general buy and hold strategy if appropriate given an investor’s circumstances, the investments involved and any professional advice received. Keep in mind that an investor can trigger a capital gains tax (CGT) each time an investment is sold for profit.

Another straightforward way to save tax is to invest in tax-efficient managed products such as index funds and ETFs. These funds trade relatively infrequently, thus reducing CGT.

Superannuation provides a series of opportunities to keep tax costs down. Salary-sacrificed contributions are taxed at 15 per cent rather than at marginal tax rates, and a super fund’s income is taxed at a maximum of 15 per cent, with the capital gains taxed at 10 per cent.

Fund-held assets backing the payment of a superannuation pension are not subject to tax, and pensions or lump sums paid to members over 60 are not taxed in their hands.

Without doubt, investors have plenty of opportunities to reduce their investment costs.

Go to top

Editor's Letter

by Robin Bowerman, Principal and Head of Retail

Risk comes in many shapes and sizes and in the first half of this year markets provided us with a sober reminder that there are no guarantees the concerns flowing from the global financial crisis had been consigned to the history books. Nor that the strong sharemarket rally of 2009 would continue to sail on through calm waters.

But as we rule the books off on another financial year the outlook for the second half of 2010 looks challenging for a range of different reasons. Market risk is omnipresent and given that the global financial crisis was a one in 70 year event we should expect aftershocks and concerns – not to mention sovereign debt levels – to remain a concerning factor for the foreseeable future.

At Vanguard we regularly talk about three types of risk – security risk, manager risk and market risk. But from an investor’s perspective the next six months a fourth should be added to the list – regulatory risk.

The resources super profits tax is the hot issue of the day – sadly overshadowing much of the good work contained in the Henry Tax Review - and regardless of which side of the debate you sit it is likely to remain that way until the next election is decided.

The other significant pieces of regulatory change heading investors’ way in the second half of the year are the proposals from Jeremy Cooper’s review of our superannuation system. Unlike other reviews this one has done an outstanding job of consulting and providing regular reports on its thinking and recommendations so there is unlikely to be any radical surprises in the final report.

Despite that it is still likely to provoke considerable debate once the government responds. The big unknown with the Cooper review is how much of it the federal government will choose to adopt.

When you combine the super review with Henry’s blueprint for the tax system and the proposals to overhaul financial planner remuneration structures it is clear the government is surveying a reform agenda that covers a very broad sweep of the investment landscape.

The interim reports released by the Cooper review point to reforms aimed at driving cost out of areas of inefficiency within the super administration system but also focusing attention and trustee scrutiny on the costs of investing. Superannuation is by nature a long-term investment so small savings on investment costs can deliver significant benefits to the retirement incomes of fund members.

A review that is making recommendations aiming to lower costs for investors, improve transparency, reduce cross subsidies within funds and lift the quality of financial advice would seem a relatively risk-free proposition. But the biggest risk of all could be that be that nothing changes.

Go to top

A strategy for life

Vanguard’s LifeStrategy Diversified Funds offer a comprehensive low-touch portfolio solution. Assets are efficiently rebalanced to predefined strategic asset allocations to ensure target weightings are maintained for optimum performance.

Vanguard’s LifeStrategy solutions are available across four investment profiles to suit conservative through to more aggressive investors. Each portfolio’s asset allocation and underlying investments have been carefully constructed to match the appropriate investor profile.

The broad level of diversification and efficient rebalancing within each fund makes them an ideal choice as a set and forget option. Each offering invests in a strategic blend of Vanguard index funds and can either be used as part of your portfolio mix or as a standalone strategy.

Aligning the risk/return profile of a fund with your own risk profile provides a low-maintenance, all-in-one portfolio solution. This means simply choosing which risk profile suits you in your current stage of investing and letting a professional investment manager take care of the rest.

Some of the benefits of investing in Vanguard’s indexed diversified funds include the simplicity for the investor. Vanguard manages the asset allocation ensuring the funds are efficiently rebalanced back to their strategic asset allocations on an ongoing basis.

The indexing approach used also minimises portfolio turnover to take advantage of available capital gains tax concessions.

The compounding effect of having more money invested rather than paid out as taxable income is a distinct advantage over the long term.

Diversified funds provide the investor with security holdings across a market index which can help mitigate exposure to performance fluctuation of individual securities. This offers the potential for greater consistency in returns relative to the market.

Vanguard’s range of diversified index funds offer competitive long-term performance. For example, the table below compares Vanguard’s Balanced Index Fund returns against the average multi-sector fund returns over one, five and seven years to 31 May 2010. Over this period Vanguard’s Lifestrategy Balanced Index Fund has maintained competitive performance, while offering similar comparative risk to other funds in this sector.*

Go to top

1975 – 2010: Three and a half decades of Indexing

This year, The Vanguard Group, Inc. celebrates its 35th year in operation. Opening its doors on May 1, 1975 Vanguard was built from the ground up by John C Bogle, a passionate pioneer of indexing. His theory of why indexing works was simple:

“Investors as a group cannot outperform the market because they are the market.”

“And from that theory flows the reality: Investors as a group must underperform the market because the cost of participation – largely operating expenses, advisory fees and portfolio transaction costs – constitutes a direct deduction from the market’s return.” Bogle said.

Vanguard was different from the start. The company was created as the first fund company that was owned by its member funds and built to provide management services at cost.

In 1976, Vanguard launched the First Index Investment Trust (now called the Vanguard 500 Index Fund) which was the first public offer index mutual fund - a Vanguard innovation. It took time for indexing to take off among individual investors but just over 10 years later, Vanguard was fourth in the list of top 10 mutual fund firms in the US and today is a cornerstone of the funds management industry.

The 1970’s in the US saw new laws and regulatory changes which ultimately aided the growth of managed funds and led millions of Americans into investing including the establishment of individual retirement accounts, the creation of the 401(K) plan which developed into a substantial source of growth for Vanguard and its competitors and the emergence of discount brokerage funds which ended the system of fixed-rate brokerage commissions.

Less than two years after launching the First Index Investment Trust, in February 1977, Vanguard opted out of the dealer- distribution system and made an unprecedented switch to a “no-load” distribution system. It was a critical – and brave decision made at an early stage that was to help define the Vanguard approach to investing.

Over the years Vanguard’s line up of products and services expanded to meet varied client needs and provide low-cost access to new asset classes and market sectors.

In 1982 Jeremy Duffield was appointed as assistant to John C Bogle. Duffield, Australian born, would later go on to establish Vanguard’s operations in Australia. Under his leadership Duffield took Vanguard’s Australian operations to its current standing as the leading index fund manager in Australia with over $80 billion in indexed funds under management. Last year Vanguard launched its first exchange traded funds (ETFs) in Australia, following the success of Vanguard’s US ETFs, which have just surpassed $100 billion funds under management. In May 2010, Mr John James took the helm as Vanguard Investments Australia’s new managing director seeing Duffield move into Vanguard’s international operations.

Globally Vanguard has now established offices across Europe, Asia, Australia and the US with over 12,000 staff globally.

Go to top

Your Say

Martin Carr, Head of Investor Relations

What are the superannuation rule amendments and changes to taxation for individuals announced in the 2010 Federal Budget and Government’s response to the Henry Tax Review? Below is a summary of some of the key changes:

Taxation
As announced in the 2008 budget, personal tax rates from 1 July 2010 will be:

The low income tax offset will increase to $1,500 from 1 July 2010 to provide an effective tax free threshold of $16,000 for individuals with an income of up to $30,000.

The Medicare Levy income threshold will increase to $18,488 for singles and $31,196 for couples. The additional amount of threshold for each dependent child or student will also increase to $2,865.

The government plans to introduce a 50 per cent tax discount from 1 July 2011 on the first $1,000 interest earned from savings accounts, bonds, debentures and annuity products. This discount will also be available for interest income earned indirectly via a trust or managed investment scheme.

From 1 July 2012, individuals will have the option of a $500 standard deduction (without the need of receipts) to cover work- related expenses and the cost of managing their tax affairs in order to simplify their tax returns. The standard deduction will increase to $1,000 from 1 July 2013. People with deductible expenses more than the standard deduction amount will still be able to claim their higher deductible expenses.

Superannuation
The government will permanently retain the 100 per cent matching rate on co-contributions. Individuals who earn less than $31,920 can receive the maximum co-contribution of $1,000.

From 1 July 2012 individuals 50 years and over with superannuation balances less than $500,000 will be able to make concessional contributions of $50,000 per year.

Also from 1 July 2012, government will contribute up to $500 to offset contributions tax for those on an income up to $37,000. Those eligible will pay no ax on superannuation guarantee contributions from 1 July 2012.

To incentivise people staying in the workforce, the government will raise the superannuation guarantee age limit from 70 to 75, with effect from 1 July 2013.

** Many of the points raised in this taxation and superannuation summary will only come into effect once legislation has been enacted.

Go to top