Index funds: taking a smoother ride

More and more planners chasing consistent returns are happy to blend indexed and non-indexed products.

Why? Because it all comes back to the view that outperformance involves risk and indexing can smooth out the peaks and troughs better in some asset classes — particularly over the longer term.

Indeed, more than nine million Australians have seen their super funds plough into indexed funds — whether they like it or not.

In that context, it works well because this investor universe is so large and the super funds can get a quick and cheap exposure.

The critics

However, some financial planners remain diehard doubters in the active versus passive debate. That’s largely because of their views and research about actives, concern about their role and desire for optimum real world outcomes.

For example, take the view of dealer group ipac. It’s about a core portfolio using multi-managers with a satellite portfolio of actives.

Manager of planning strategy John Dani says ipac would still use indexing for those clients who request it, or for those who perceive the fees on actives are too high. Mostly, they would use it on local and international share indices.

But as Robert Keavney, head of Centric Wealth, sums up: “Our view on indexing varies on asset class … The reality is that when you look at an historical analysis on all actives, you don’t find organisations that have beaten the market consistently, so the proof is in the data.

“In some classes, especially equities, indexes have been beaten, but in others, such as bonds, this is not so,” he adds.

And research manager at Navigator, Stuart Fechner, maintains the real issue is still about recovering fund costs.

For example, Morningstar’s data on ongoing fee differences between the active manager for a retail Australian equity fund against the indexed version shows a 50 basis points difference and yet the average returns are very close.

Boutique managers also charge more, so if there’s underperformance, the investor is the loser.

In a poor market, index hugging (up to 3 per cent) is common and that’s no good either.

“The median Australian equity manager for the year to March end has slightly underperformed the benchmark by 0.3 per cent, so if you had a range of 20 managers, half haven’t added value,” Fechner adds.

The supporters

Barclays Global Investors (BGI) and Vanguard are two major indexers against the benchmarks in all asset classes.

As Vanguard’s Robin Bowerman says: “We’re seeing more planners understanding the value of blending index funds as part of the portfolio. Costs are a big issue and the industry funds have made everyone more aware of that.

“Index funds and their low fees have attracted adviser attention. The shift to fee-for-service and more strategic advice has also meant that planners are moving away from just picking winners and are more about setting up proper allocations and using an index product to build that.”

Vanguard chief investment officer Eric Smith says that retail investors should behave more like super funds and think long term, as well as keeping their allocations more stable rather than just chasing the best performers.

“Don’t market time is our mantra, but our main argument [for indexing] is about risk.”

Vanguard’s retail offer includes Aussie property, bonds, shares and cash and, more recently, global bonds (sovereign), global credit and global property.

“You will get performance differences [with actives] but we think that in a short-term time frame, prediction is difficult … so being well diversified is important,” Smith says.

Bowerman adds: “What indexing does is follow the market up and down. Where an adviser’s role is critical is in asset allocation. The Australian market may suffer a correction, but if it’s divided up, the value of indexing allows you to concentrate on asset allocation, which is where most of the returns come from, so manager selection is less relevant.

“Yes, it can make a difference picking winners but long term, asset allocation is a major driver in terms of volatility and long-term returns.”

Bowerman adds that financial planners need to be clear about where they add value.

“Is it about picking one fund over another or is it about strategic advice in setting up a client on a raft of issues and portfolio construction?

“One thing that comes out in the shadow shopper exercise is that strategic advice is highly valuable.”

Portfolio turnover

According to Mercer Investment Consulting principal Rashmi Mehrotra, index funds are seen as tax effective due to their low portfolio turnover while active funds are not. But the problem here is the lack of available data.

“There are a number of different factors affecting portfolio turnover: cashflows and the unrealised gains embedded in the fund. Say I enter a fund after a manager has held stock for a long time with good share price increases and then the manager sells the stock — now the gain is distributed to all unitholders.

“In the US, I believe, the manger tells you how much unrealised gain is in the fund. Here, there’s no way to know.”

Mehrotra adds that turnover is a separate issue.

“The more managers churn, the more realised gains are passed back to unitholders. This is good when managers are selling stocks at profits and are able to reinvest for higher potential gain.

“Currently, data providers, such as Morningstar do not have detailed tax break-ups of distributions to allow us to understand the true picture.”

Market impact

Over the longer term, markets do most of the work, Mehrotra adds.

“Over one year, the market may do 30 per cent and managers may return between 20 and 40 per cent, but in the longer term, you will see the gap between the median return and the index narrow — so the manager value-add is small.

“But in the real world, you are likely to review and move your portfolios, so that’s a consideration too.”

Mehrotra says the case for indexing is different for different classes.

“For the Australian market, you could have a return assumption for just under 10 per cent and add another two for manager alpha,” she explains.

“But in small caps, for example, the managers have historically done a better job and in hedge funds, the skill component can be even higher.”

Mehrotra believes international share funds are one group that you wouldn’t index, in theory, as the opportunity set is quite wide but she adds that “the median available in Australia has not outperformed the index so maybe it just reflects more upon the managers”.

“We haven’t seen enough choice of high conviction managers in this class. This is an area that distributors Macquarie and Zurich are seeking out.

“Multi-manager funds have also been able to access such managers because they’re not confined to those locally available,” Mehrotra says.

Mum and dad investors

Peter Foley, a planner who previously worked on the product side with Westpac, IOOF and Perpetual and is now with the Matrix dealer group, still reckons the index story is a convincing one — albeit for the ‘mum and dad’ end of the investor spectrum

“For simple things, it works well and if you have less than $25,000 to invest, you need to worry about fees as much as earnings. The only good thing for non-super investing is that there’s low turnover,” he explains.

Foley says one problem of active funds is that the value styles have target prices and they incur capital gains and costs. “So for tax paying purposes, it’s not necessarily good,” he adds.

“It came up last year with IOOF’s Perennial Value Share Fund and Perpetual’s Industrial Share Fund. These funds had reached their ceiling price on some stocks and they took profits so there was a very large distribution of realised capital gain. Now, for investors building up wealth by not turning capital into income, that’s a problem, but you have to balance it out.”

Brad Matthews, economic research manager for Hillross, prefers indexing for Aussie equities and property — less so for overseas equities and fixed interest.

However, his group offers both unlisted and listed index funds.

Domestic versus global

Matthews believes indexing works better for Aussie shares given that it’s a cheap spread, but less effective internationally because of the US tilt.

Furthermore, he points to the regional risks indexing can bring, such as the salutary case of Japan in the 1980s, which represented a giant slice of indexed fund product.

When the market slumped, the weightings dropped substantially. In other words, people had been chasing markets rather than returns, and that’s hardly diversified.

“Indexing gives you exposure to a big number of stocks domestically; it’s a diversified option … but internationally, it can be risky as it doesn’t provide a geographic spread,” Matthews says.

Foley says his concern with the international side is that you’re also picking up 2 per cent growth in Europe and choppy economic prospects and yet, Asia represents only a 5 per cent weighting on the MSCI with more growth potential.

“So I prefer an active, such as Platinum Asia, which covers China with a 45 per cent allocation to India.

“Meanwhile, you have Vanguard’s emerging markets index, which covers Europe and Asia, but the problem here is that the fund is mostly invested in Korea and Taiwanese companies, which is hardly emerging markets. So they’re stuck with how the MSCI is structured.”

Listed versus unlisted

Foley says he’s looked at exchange-traded funds (ETFs), although they don’t appear on the Matrix approved list.

“In practice, EFTs should trade on a 15 per cent discount to NTA [net tangible assets]. They appeal to people with some share market knowledge and allow a way into the market that’s theoretically cheaper. This should attract a DIY super fund, for example.

“Two-and-a-half years ago, they were flavour of the month for a month ... But it’s pretty much a small segment of market.”

Matthews adds: “We don’t have a strong policy either way; we see a role, but the customer needs to understand how the index works and what the concentration is.”

However, a small group of innovative planners, particularly those advising the self-managed super fund (SMSF) market, see a real role with listed index funds using the core and satellite approach.

As a major player in ETFs, State Street head of structured funds Susan Darroch says their retail clients are mainly SMSFs, DIY direct or through an adviser.

“Advisers take advantage of the key benefits of ETFs — diversification, transparency, and low cost — as an efficient way to gain broad market exposure and then add direct shares or model portfolios to implement client-specific style tilts, growth or yield.”

For example, she says, one common strategy is holding the streetTRACKS S&P/ASX 200 Fund (STW) and combining that with an Aegis Model Portfolio for a classic ETF core-satellite style.

Or the streetTRACKS S&P/ASX 200 Listed Property Fund (SLF) is another strategy to gain exposure to the index, and then the investor or planner can add in several of their preferred listed property trusts (LPTs) to enhance yield or growth or combine with other property exposure like syndicates or direct.

StreetTRACKS S&P/ASX 50 Fund (SFY) provides exposure to the largest national and multinational companies listed on the ASX and this is used as a core large cap exposure.

These funds are easy to use, Darroch says, because you just buy them through your stockbroker or online broker and the holdings go into your normal share account with one annual tax statement for each fund. This can make the paperwork of a DIY or SMSF very easy.

“We also have a large number of offshore investors that use the ETFs to gain exposure, particularly New Zealand investors and global fund managers.”

Exchange-traded funds

There are a number of advisers now using ETFs.

One financial planner, who didn’t want to be named because it flew in the face of the dealer group approach, said he liked the ETF one-stop shop idea and the reduced administration.

“It’s our belief that financial planning tends to revolve around fund managers and that’s more about product homogenisation these days. It’s hard to establish value over active funds.

“Many of our clients like passive holds with top 100 stocks … these people are very busy and can’t watch their portfolios. ETFs sit well for SMSFs, where typically you may have a 15 to 20 stock selection in a portfolio.

“You have to get the stock right … but who’s going to watch it and cull out the losers? It may be driven by market sentiment … and clients don’t want to make the hard decisions on selling. When you look at ETFs, it’s a lot more convenient,” he says.

Essentially, ETFs should have the same result as an unlisted fund.

A major benefit is the availability on main board and the price, which is close to asset backing. The market maker is the issuer who replicates the indices with physical stocks.

However, one of the drawbacks is that units can be thinly traded in the Australian market.

Mostly, money goes into wholesale and the fees are determined by the platforms. So the client may be charged 40 basis points for both index and non-index funds.

“You don’t get big upfront commissions, but then again, most funds don’t give that,” Darroch adds.

One growing niche is where Macquarie, Westpac and Citiwarrants have all issued structured products over streetTRACKS. ABN Amro warrants have also issued a new streetTRACKS 200 call warrant so investors can take advantage of a structured gearing product over the entire market.

Indexing fixed interest and property

One area that planners agree upon: local LPTs are probably better indexed than actively managed and fixed interest is probably best not because of the increasing role of corporate credit and the risks attached to that.

Matthews says: “We only have listed property trusts for Australia and it works well there [for indexing]. It’s quite a small sector and it’s been difficult for fund managers to outperform the index, which is about 18 per cent.

“It also applies to international fixed interest index and the weightings are determined by which government has the biggest debt. So you get an overweighting to the biggest debt and you’d have to question whether that’s the best way to go … there’s a question about effectiveness when it comes to regional spread.”

A place in the sun

DIY funds are a likely target for listed index funds; they’re more likely to want to beat the index so unlisted indexed funds tend to be overlooked.

But if funds are limited, Matthews says, then it may be a case of 50 per cent into index and then choosing actives at the edges, “but it comes down to what the planners are comfortable with”, he adds.

But while the returns should be the same, not all index managers are exactly the same, according to Navigator’s Stuart Fenech.

“In the eyes of the investor, the returns should be nearly identical. We would take into account MERs [management expense ratios] and their relationship with us on the platform,” he says.

“It’s the age old dilemma of index versus active — sometimes they get their positions right and sometimes not.”