The adviser’s new go to trick

Jonathan Hock, Associate at Norton Rose Fulbright

Investors have always pooled their funds to reap the benefits of collective investing. The mutual fund industry, established in the 1960s, has grown from R600 000 to over R1.8 trillion total assets under management.

Exchange Traded Funds (ETFs), introduced to SA in 2000, may however be on the verge of upsetting that applecart.

Non-replicable
Mutual funds give investors access to levels of professional management and portfolio diversification which are not replicable on an individual scale.

In mutual funds, investors partake proportionally in the gains and losses of the fund by holding units of the fund. Mutual fund managers attempt to actively anticipate market movements, seeking to benefit from upward movements and smooth volatility through market cycles and generate a return above the market average.

ETFs are simply funds listed on an exchange which passively hold underlying securities in proportions determined by a market index. ETFs periodically rebalance (buy and sell) their holdings to ensure they continue to track the chosen index.

ETFs aim to replicate average market performance at a low cost rather than attempting to out-perform the market.

Proven predictor?
In mid-2016, investment research company Morningstar updated its ongoing research into the predictive power of expense ratios in relation to fund returns.

In line with their previous findings, the study concluded that costs are the most proven predictor of future fund returns. The higher the costs, the lower the likelihood of success in generating positive market returns for investors.

Fees matter when choosing investments and it is easy to see why. To justify higher fees, fund managers must consistently generate returns exceeding the market average or index-related return; itself no mean feat. All of this needs to be done while handicapped by the growth-dampening effect of the fees they seek to vindicate.

In other words, fund managers must not only beat the market, they must beat the market by a margin greater than the compounded value of the fees they charge. If fund managers cannot achieve this, investors may be better served in the long run by simply buying the market at a low cost.

Proving a point
To prove this point, nearly a decade ago, Warren Buffet bet a New York hedge fund U$D1 million that over ten years, his choice of a simple low-cost index fund would outperform the best of the hedge fund’s partners.

What was Buffet’s thesis? Despite the high intelligence, diligence and skill of fund managers, their IQ will not overcome the costs they impose on investors.

Buffet’s bet ends on 31 December 2017 and the Oracle of Omaha is all but assured a resounding victory over some of New York’s brightest investment experts.

Buffet, at times, criticises active fund managers saying that most will fail to out-perform the market average because fees never sleep.

Careful management
It ought to be noted that even a carefully and skilfully managed mutual fund may suffer less volatility through market cycles than a typical ETF. Active managers have the ability, at a cost, to react to market changes and smooth cyclical fluctuations.

Not all managers can successfully do this, almost none can do it all the time and it increases costs.

ETFs offer tax efficiency, liquidity, transparency of holdings and diversification at a relatively low cost.

In 2015, the Financial Planning Association’s Trends in Investing survey found that ETFs had for the first time since the report’s inception surpassed mutual funds as the preferred investment vehicle for financial advisers. The 2016 edition of the survey reached the same conclusion and also found that 46% of respondents plan to increase their use or recommendation of ETFs over the next 12 months.

While they have yet to be replaced by ETFs, present trends indicate that mutual funds will occupy a progressively smaller proportion of the investment market. Buffet, for one, views this as a good thing.