The right mix

The right mix

With more market volatility expected, investors are scurrying for safety while setting their sights on active fund managers that promise minimal downside risk. However, experts suggest looking past the old passive/active debate and realising times like these require a combination of the two

IT HAS been a brutal 10 years for active fund managers, but many believe they are finally heading for a rebound.

The last decade saw $25.19 billion of investors' capital leave actively managed Australian equity funds, while $4.63 billion migrated to passive funds, according to Morningstar quarterly flows data.

The research house indicated, more recently, that the net inflow to index funds this March clocked in at $2.3 billion, compared with active managers which saw $3.9 billion leave their funds in the same month.

What is more, industry reforms and the David Murray-led Financial System Inquiry – which shined a light on the high costs in Australia's retirement savings sector last year – have encouraged a switch from active funds to low-fee investment strategies.

Morningstar's director, manager research, Tim Murphy, says this trend has been a long-term shift, showing no signs of slowing down.

"Not just in Australia, but all around the world you're seeing a structural shift of higher allocations to passive investing," Mr Murphy says.

"Notably, there has been an increased focus from many regulators around the world on fees, which has been particularly notable here with regulatory change in Australia with FOFA.

"So as a result, [there is] more focus on using lower-cost investments over high-cost as a general theme. So we certainly think that's a structural change that isn't going to reverse," he says.

That is not what active fund managers are thinking. They believe that with the anxiety-driven turbulence in the markets this year, and further volatility expected, their promises to beat the indices will once again get noticed by investors looking to protect their capital.

"I think because we are in a more volatile environment at the moment – combine that with the fact that investor horizons are shrinking because they're now getting older – a passive strategy is no longer optimal," says UBS Asset Management head of investment strategy, Tracey McNaughton.

"If you need to achieve your target returns – particularly when, actually, returns are difficult to come by – you need to be far more active in the management of it."

Even so, as the uncertain market environment reignites the 'passive versus active' debate, Mr Murphy says it is time to reframe the old argument. The conversation should revolve around investing into the "right" active and passive funds, he says, rather than one over the other.

"No one investment is right for everyone. It always comes back to the individual circumstances of the investor or client.

"We can talk about some aggregate numbers about passive funds attracting flow from active funds but that doesn't mean it's necessarily appropriate for everyone out there," Mr Murphy says.

"You can't make a generalisation that active is better than passive or passive is better than active."

Active managers pick 'winners'

It has, without doubt, been a shaky year. Investors are still grappling with fears of a hard landing in China while others are concerned about what will happen when the US Federal Reserve begins to increase interest rates, according to Jeffrey Johnson, Vanguard's head of investment strategy group, Asia Pacific.

"What could a rising interest rate environment mean for other economies globally? And in many cases, other economies globally are somewhat vulnerable right now and show signs of weaker growth and very low inflation," Mr Johnson says.

"What we've begun to see in markets is an uptick in volatility, an uptick in uncertainty and an uptick in general investor anxiety that is emanating from a couple of different things all at the same time."

While this may be worrisome for investors, it also presents an opportunity for active fund managers, says Nikko AM's head of global equity, William Low.

Mr Low believes certain companies and countries will start to feel the effects after quantitative easing (QE) by the US Federal Reserve expired last month. Because of this, investors should become more selective and side with active managers which are known for seeking out the companies more likely to flourish despite the changes, he says.

"We're in a diverging world of winners and losers. That is exactly what we're focused on when we pick 40 to 50 stock portfolios. We're trying to find the winners in this world that are going to survive," he says.

As a way to stay afloat, Mr Low recommends working with some of the many investment strategies today that tout discovering a formula for figuring out who the winners and losers are.

"No one really knows how this monetary experiment is going to evolve," he says.

"So having an investment team with a lot of experience and [one that] could potentially join the dots to work out who the winners and losers are, we think that's more likely to be a powerful strategy rather than an index strategy."

Ms McNaughton agrees. She predicts that investors are going to see lower returns in the future, prompting them to scout for strategies with more downside risk management.

"I think investors are going to be seeing more and more the negative returns out of what are fairly challenging markets. In a lower growth environment, there is less room for error and so downside risk management becomes more important," she says. "In order to have downside risk management, you need to be in active management."

However, whenever investors up their downside risk management, they are also enhancing potential losses should that active manager be wrong, Mr Johnson says.

"The conventional wisdom says that if markets are going to be more volatile, you need to have a more active approach.

"But what also happens when markets become more volatile, by taking a more active approach, you also open yourself up to the risk that the active manager could be wrong and make an incorrect move," he says.

"In a more volatile environment, potentially where the downside is greater, that can expose an investor to even greater losses."

State Street Global Advisors' Olivia Engel, head of active quantitative equities for the Asia Pacific, also disagrees that active investments are more defensive in a volatile environment.

"In fact, they might be more risky than the market and therefore suffer larger drawdowns," she says.
However, Ms Engel believes that if investors do decide to go active during volatile periods, they should pick a "truly active" manager.

"The reason I say that is because our active flagship strategy in Australian equities has provided a significant cushion against market drawdowns over the last six years when markets have been volatile," she says.

"But it couldn't have done that without being allowed to deviate significantly from the cap-weighted benchmark. Being truly active enabled us to minimise those drawdowns for the investors."

All about fees

Although the current environment may appear favourable for active fund managers, their associated high fees are still – and will continue to be – the biggest barrier to their success, Mr Murphy says.

"I think there is a general recognition that people are more and more fee-conscious and questioning the fees they are paying in their investments that they may not have historically," he says.

He adds that for advisers, FOFA has placed a "much greater scrutiny on the fees that are charged to an investor at every level of their investment".

This has affected Chris Bates, founding director of advice firm Canopy Private. The adviser says that new regulation is discouraging financial planners from considering active approaches for their clients.

"New FOFA laws make it harder to satisfy best interest duty when you're recommending something that's more expensive than where [the clients] are," he says.

"So that's forcing advisers to look at lower cost options, rather than just because they believe it's the best proposition."

Vanguard's Mr Johnson expects returns to be lower in the future, which could make fees an even more critical consideration for investors when considering investment strategies.

"Today, we would say that a realistic expectation for stock return going forward over the next 10 years is somewhere in the 7 to 8 per cent range. We would estimate that a realistic return on bonds over the next 10 years would be 3.5 per cent. Both of those numbers are lower than historical average returns on those asset classes," he says.

"What that means for investors is if your starting point is a lower return environment than we had in the past, anything that you can save in the form of paying lower fees increases your odds of reaching your long-term savings goals, whether it's retirement or saving for education or saving for a house.

"So a passive approach is a great way to lower your cost in today's environment and more fully capture the returns that that asset class affords."

Ms McNaughton, however, believes there are ways around this. She says choosing a single manager that can combine different sectors under one umbrella is a good way to bring down fees and still enjoy the benefits of active investing.

"It's so much harder now to choose a single sector and manager. That's one of the reasons we're seeing more and more flows to the multi-asset, multi-sector managers that can do multiple sectors under one single roof," she says.

"But also, from a risk management point of view, a single manager can see through every single aspect of the portfolio.

"You don't have to rely on some managers having good risk systems and other managers not having good risk systems.

"Being under a single umbrella, it has the benefits of keeping your costs down, your risk management tools are all centralised, and the manger itself can take advantage of diversification."

Smart beta: the middle ground

While Ms McNaughton believes a multi-sector manager could be the solution to the high-fee conundrum, Mr Murphy says there is another player in the industry that could potentially play that role.

Smart beta strategies – which alter indices to better reflect certain investment principles – represent a growing trend and are typically available at lower fees and considered to be an active approach, he says.

"I think you'll actually find a lot of the reasons why flows are increasing to passive are not necessarily because they are passive but it's because they are low cost. If you get a lower-cost active vehicle, that's likely to attract attention over time," he says.

"I think that's kind of the role that smart beta are looking to fill – because they have slightly higher fees than traditional passive but, generally speaking, are much lower fees than traditional active."

AXA Rosenberg's chief executive, Jeremy Baskin, describes his SmartBeta Equity Fund as the industry's "middle ground", as well as being able to incur lower volatility than a cap-weighted benchmark.

"The SmartBeta equity strategy offers a sensible middle ground between blind index tracking and alpha-oriented strategies, so [it] equips equity investors with a better chance of improving long-term investment success in a more cost-efficient way," he says.

"One example is by avoiding companies that exhibit 'unrewarded risk' while at the same time focusing on companies with strong earnings sustainability. A smart beta strategy can offer investors both the benefits of lower volatility while also improving long-term returns."

Meanwhile, Craig Hurt, AXA IM's director for Australia and New Zealand, says investors are becoming more comfortable with the concept of smart beta investing.

"The smart beta conversation has evolved from investors considering strategies that just focus on one risk premia to a blended, more sophisticated risk management approach," he says.

"The patterns of active returns for each smart beta strategy in the short term are generally imperfectly correlated and this means that smart beta strategies can be combined to target a desired risk and return outcome in a more diversified and targeted manner."

However, smart beta strategies are still too new, Mr Murphy says, and investors should proceed with caution. While those strategies might have done well in the past 10 years, whether there is any future efficacy to them is open to debate, he says.

"There is certainly a place for some [smart beta strategies]. Like anything, there are going to be some good and some bad. It's quite a phenomenon that's coming at the moment," Mr Murphy says.

"We would always encourage people to have a healthy degree of caution and strategy when assessing any newer thing like that, but it would be interesting over time [to see] whether some of those get the most market share."

Philippe Jordan believes they will. During the 2015 Australia Hedge Fund Forum in Sydney, the president of Capital Fund Management said he expects smart beta-type strategies to grow in popularity over the next 10 years.

"It's going to grow like weed. It's going to be very big," he said.

"I think it's going to eat up a big part of the inefficient part of the industry."

Picking the 'right' manager

Before the market reveals its stance on smart beta strategies, it is important to rethink the current debate surrounding passive and active funds, says Mr Murphy.

He believes the argument should be less about which strategy to side with and more about which manager is right for each circumstance and how they can work together in an investor's portfolio.

"Where does active make more sense than passive? That's a very sector-specific question," Mr Murphy says.

"In some segments [of the market], active management has a better track record and in others, active management has a poor track record.

"It really depends on the specific segment or specific market which you're talking about as to what constitutes the right decision."

In the Australian small-cap equities sector, for example, it would make little sense to have an in-depth passive approach because in the long term, a vast majority of active managers have "significantly" beaten the index, according to Mr Murphy.

"Now, that's obviously not true when you go into larger cap sectors, particularly in large developed markets like the US. When you look at the US for the large cap equity mutual fund space, the active manager underperforms pretty consistently through time," he says.

Canopy Private's Mr Bates says he also considers several factors before recommending active or passive strategies to his clients – for instance, whether his clients need a long-term or short-term approach or whether this is their first investing experience.

"For my younger clients, it's about staying invested for the long term and not trying to time markets," he says.
"I believe buying in and out of the market gives them the wrong premise of what I do as an adviser and it doesn't give them good habits on investing. That builds up behavioural biases and that can do more damage than good."

But active and passive can also peacefully coexist, says Mr Johnson, who recommends including both passive and active strategies in a portfolio as a way to build diversification. However, finding the right active manager is not easy and requires an investor to do some research, he says.

"First and foremost, we believe investors need to be focused on minimising the cost in their portfolio, but combining active and passive can be a great way to build diversification in a portfolio," Mr Johnson says.

"[This is] subject to the investor being able to locate an active manager that has a disciplined process, that has an experienced team, that looks like they can add value over time."

Ms Engel adds that investors need to make sure their active managers are not too correlated since this could create an index-like portfolio.

"Investors need to watch out when they're combining different active managers for redundancy in their portfolio," she says.

"When you have different strategies, active or passive, and you combine them together, you've got to understand how the different approaches will work together and form the overall portfolio.
"You don't want to have all offsetting positions because then that creates an index fund. So, you'd be paying higher fees for active strategies, and getting index returns as an outcome.

"It would have been better in that case to pay an index manager a lower fee to get the same result."
However, it's not just the active manager investors need to pay attention to and Ms McNaughton says being conscious of the benchmark is just as important.

"A lot of passive investors will invest in products and not really take into account what benchmark they're going into. The issue with that is that a benchmark is not necessarily a risk-free starting position," she says.

"You're taking risks when you invest into a product that has a benchmark so you need to be aware of what that benchmark is, what the constituencies of that benchmark are, and how the risks in that benchmark change – because they can change.

"So if you're just tying yourself to that single benchmark and not doing anything about it, then the unintended consequence is actually you're taking more risk."

Nevertheless, no matter what is happening in the market, investors should always refer to their long-term approach, Mr Murphy says.

"It obviously depends on the individual circumstances, but if we're talking about investing for a long-term strategy, not getting too caught up in market movements or making panicky reactions as a result is always important to keep in mind," he says.

"So we've obviously had some quite strong markets for a number of years now and then having one month of a bit of a drawdown shouldn't be a reason to drastically change your strategic allocation and portfolios."

The right mix
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