Page 1 of 15. Active versus Passive Investing Analysis of Multi-sector Fund Performance

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1 NZ T R E N D S Independent research and analysis Page 1 of 15 June 2015 Active versus Passive Investing Analysis of Multi-sector Fund Performance which takes into account their personal circumstances before making investment decisions. written permission from the author.

2 Page 2 of 15 Executive Summary This research considers the performance of index funds and actively managed funds in the main multi-sector fund categories over the 7 year period to 31 March Actively managed funds are defined as funds that are not pure index funds. The key finding of the analysis is that the average actively managed growth, balanced and conservative multi-sector funds have outperformed the corresponding passive fund average. Active managers produced better results during the Global Financial Crisis while asset allocation flexibility inherent in active multiasset funds appears to have been beneficial. The results are close and over longer time periods the performance advantage could shift cyclically. Although passively managed funds can claim to have a lower management fees (on average) they cannot claim performance superiority over the period under review. When tax was taken into account the advantage to active funds increased slightly. A key takeaway from an investor standpoint is that one should have a basic understanding of the relative merits (pros and cons) of both approaches. The decision between active and passive will pale in significance to the asset allocation decision which ideally should match the member s investment objective. As always an investor s own discipline to his or her chosen investment direction is crucial. The active-passive decision is largely irrelevant if investment selection is not aligned to objectives. While fees are vitally important they are not everything and members will be well-served to consider other factors rather than fees in isolation. Not all index-based fund options are low cost and high cost indexing is a poor strategy. Passive fund investors must hold realistic expectations about returns and should realise that after fees and tracking error index funds are likely to lag the gross index return. This principle will also apply at multiasset portfolio level. Members should give the issue its fair consideration but there is no need to obsess about the issue. Those who make the decision in favour of passive should be wary about doing so just because they dislike active. The active management universe is diverse and not all active managers are equal.

3 Page 3 of 15 Introduction Although the rest of the world has moved heavily into index funds in recent years, Australians and Kiwis have to a degree maintained their love affair with active management investing 1 The debate around the superiority of active or passive management is enduring and evolving. In terms of assets under management active is dominant but indexing or passive management is gaining market share in many investment and pensions markets around the world. Within the KiwiSaver industry passive management has a market share of assets of approximately 18% (at 31 March 2015). The participant base that seems fairly cost sensitive i.e. the demand side for low cost indexing appears strong. It is due to the supply side that active management dominates and only a few scheme providers offer index funds. The leading passive provider is ASB Group Investments with the ASB KiwiSaver Scheme the largest single scheme. Investment commentators are not short of opinions on which approach is better. Even legendary investors Warren Buffet and Peter Lynch have joined the debate with both endorsing the power of low cost, indexing. One method of testing which approach has outperformed over a particular period is by calculating the average performance of active and passive funds and comparing the results. This is the focus of this research report with an additional emphasis on multi-sector funds. While the active versus passive debate has tended to polarise managers, investors and consultants one must acknowledge that active and passive building blocks can co-exist within a multi-asset portfolio i.e. they are not mutual exclusive. The well-known core-satellite approach to portfolio construction follows this thesis combining alpha seeking portfolio building blocks (or satellites) with an index core. The core-satellite approach is commonly employed by institutional investors and investment consultants and is smart way of separating the market return or beta of a portfolio from the alpha seeking component. While the pitfalls of active management are heavily portrayed in academia and the media (and won t be repeated in this report) the pitfalls of indexing are largely unreported. Many index fund investors falsely believe they will receive the gross index return. This rarely occurs. After costs and tracking shortfalls sector index funds perennially underperform respective indices and these results will roll up for each asset class to create underperformance at a multi-asset portfolio level. Even the world s best known index tracker, Vanguard, manage index funds that consistently underperform the gross index return and that taking wafer thin fees and a mutual (or non-profit) business model into account. What is more important for investors and advisers is to grasp the pros and cons of each approach and make an informed and committed decision and then stick to it over the long haul.

4 Page 4 of 15 The relative pricing of active and passive funds is also crucial. If index funds are particularly cheap relative to active funds then indexing holds an overall advantage but if high quality active management is reasonably priced (relative to passive) then active will hold sway. The average fee advantage to passive funds in KiwiSaver multisector fund categories is shown below: Studies have shown that the index fund advantage is due to the cost advantage which tends to accumulate over time. Even though actively managed funds will beat the index over certain time periods, low cost index funds tend to creep up in the long-term rankings because it is not the same active funds that beat the index or index fund each interim period. The fact remains that you need to invest in an index fund in an attempt to obtain the index return and index funds have costs and tracking error. Investors will be well served to be open to both approaches during the investment planning phase and understand the pros and cons of both approaches. At the same time certain investor and personality types will gravitate towards a matching investment approach. Indexing has benefitted from the well-documented pitfalls Indexing Indexing is the essence of investing simplicity. Indexing provides a broad-based exposure to a market sector or sub-sector by tracking a recognized market index and generally charging a low fee. In some markets the low turnover inherent in indexing leads to tax advantages. In the traditional indexing model the index fund manager buys and holds the index securities in the same weighting as the index. While this might seems simple in theory, keeping the tracker fund aligned to the index requires skill when index constituents change or the tracker fund receives cash inflows or sells securities to fund withdrawals. Situations that result in the index fund not been perfectly aligned to the index will result in return differences, also known as tracking error. of active management and investors have left active as opposed to embracing passive. Indexing does a decent job of keeping investors focussed on the long-term and accepting of the returns the markets provide. If investors accept they will obtain the market return (slightly reduced by costs and frictions) then there is no need to partake in meaningless portfolio activity such as performance chasing and market timing. Many equity markets are in the process finding a better balance between active and passively managed assets and indexing s increasing share of US equity mutual fund assets is shown next:

5 Page 5 of 15 Active management Active management is a very broad-based term but in principle the fund or managers creates and manages a portfolio that deviates from the recognised index or benchmark in an attempt to produce returns above that of the notional index. Although this study and many others deal with averages not all active managers are equal and not all active managers are truly active. Because the index return is notional (does not represent an actual investment) and does not incur costs it is unbiased to Data Source: ICI Analyses shows indexing doing well in very strong or bull markets and research by Vanguard indicates that indexing outperformed in six of the last eight bull markets. That s a pretty strong upside capture from an indexing standpoint plus there tends to be more bull markets than bear markets. Finally, as mentioned previously indexing has not been embraced as enthusiastically in Australia and New Zealand relative to other developed markets. compare active management results against passive funds. This is the methodology used in the analysis for this report. At one level active management can be classified as benchmark cognisant or benchmark agnostic. A 'benchmark cognisant' manager is aware of the index composition and manages a portfolio that deliberately differs in weightings and holdings from the index. Benchmark agnostic managers use a clean slate basis and manage portfolios without reference to the index constituents and weightings. The following schematic is a useful guide to the spectrum of investment management methods. indexing benchmark cognisant active high conviction & concentrated Brinson, Hood and Beebower concluded that a portfolio s asset allocation is the primary determinant of portfolio return variability, with security selection and market timing playing minor roles. 2 enhanced/fundamental indexing & smart beta benchmark agnostic

6 Page 6 of 15 Before costs all investors as a group attain something similar to the representative index gross return. Because of management fees - which converts a zero sum activity into a negative sum activity - investors as a group must underperform the gross or no cost index return. This argument is often used against active managers and used to belittle the effort and expertise involved in the active management process. The reality is that after cost investing is a negative sum gain for both active and passive managers. However, very high active management fees can cause a heavy drain on performance that just cannot be overcome by skill. This in turn compromises the attainment of investor goals or the reason for investing in the first place. The difference between active and passive fund costs can dictate which approach has the upper hand. Then again investors don t invest in the average fund but in a specific fund and the specific fee comparison has the most relevance for investors. The dominance of active management in terms of assets suggests a strong belief (amongst providers) that professional investors can beat the index. Plus the active management business model is potentially more lucrative and consistent alpha generators can boost revenues via performance fees. The highly respected Charles D Ellis 3 argues that the equity markets have changed and that institutional investors cannot outperform as they did in the past. Professional investors used to win the game of investing at the expense of private or retail investors who were large players in the equity markets but not as sophisticated. Equity market structure has changed dramatically and institutional investors dominate these days. As a result institutions are competing against themselves in an ever difficult contest for excess return or alpha. In this modern equity market structure luck is also having a larger role in short-term investment results as the skill differential amongst fund managers has narrowed. What we find is that in just about every equity market exists a small group of dedicated firms and individuals who outperform the index and index funds on a consistent basis. While outperformance is perceived to be the domain of small boutiques, large fund managers such as Capital International, T Rowe Price and Wellington Management Company have excellent track records across a large number of mandates and a very large assetbase. The difficulty for investors is that they only benefit from these exceptional results if they identify the manager in advance of the good results and stick with them through the inevitable periods of short-term underperformance. This has proved to be very difficult for many individual investors, their financial advisers plus institutional investors and their investment consultants. The negative impact of emotional investing is highlighted in the annual Dalbar study 4 which compares index returns to investor returns. The investor return shortfall over most measurement periods is dramatic and the behavioural biases embedded in most investors means they do not share in an outstanding manager performance because money chases good performance and markets.

7 Page 7 of 15 Analysis The analysis section covers multi-sector funds only. The vast majority of KiwiSaver assets and members are invested in multi-sector funds or lifecycle programs using multi-sector funds. On the plus side it is a good feature that so many investors have diversified portfolios while on the other side it seems that the bias towards defensive multi-sector funds is not ideal given the long-term time horizons of the most KiwiSaver members. The analysis is based on before tax and after management fee returns. The fee advantage of index funds is thus built into the results. One argument is that if active and passive funds perform in line before costs then passive will win because lower costs are subtracted from the gross return. If active and passive perform in line after costs then active management has made up the cost shortfall (but no more). Tax has been left of the analysis but the tax differentials between active and passive funds are by no means inconsequential and are shown in the Appendix. KiwiSaver assets invested in multi-sector funds A good example of funds that appear the same but differ are KiwiSaver default funds. These funds are clones and are regulated to be a certain risk profile but when you drill down in the asset allocations there are slight differences in portfolio composition that will impact relative results (albeit at the margin). How asset allocation is managed can also differ across funds. Passive funds tend to practice disciplined or rule-based rebalancing - returning the actual portfolio to the target allocations at regular intervals. Active managers can practice tactical asset allocation but it must be noted that many New Zealand fund managers rarely stray too far from strategic asset allocations. A select few managers practice flexibility or opportunistic asset allocation while others work within ranges or bands for each asset class within a multi-sector fund. When flexible managers get it right the results can be outstanding (but this also means surprisingly weak results are a possibility). Two graphs are shown in each section that follows. The first graph shows the fee differential or the average passive fund TER less the average active fund TER. The second graph shows the annual active return for each Data Source: FMA A number of additional comments are crucial before the results are presented. First, multi-sector funds are rarely created equal in terms of asset allocation. Subtle differences occur in the structure of funds in the same fund category (even though they appear alike on the surface). separate 12 month period plus a line showing the cumulative return differential (or performance relative strength). The final point on the cumulative line shows the superior performer over the full 7 time period. The analysis is free of survivorship bias i.e. all funds (active or not) are included. Another note is that monthly member admin fees are also part of a member s total costs but are excluded from this analysis.

8 Page 8 of 15 Multi-sector Growth Fee Differential Discussion Currently about 26% of all KiwiSaver assets are invested in multi-sector growth funds. This figure has increased steadily since While passive funds possess a fairly sizeable fee advantage (of 0.66%) active funds have managed to overcome this hurdle. Actively managed funds achieved almost all of their outperformance during the 12 months to end March Annual Active Returns 2009 and have retained the overall advantage although the degree of outperformance has narrowed significantly. It is reasonable to say active and passively managed funds have performed pretty much in line for multi-sector growth funds. Growth funds tend to maintain a strong position in growth assets and as a result security selection within growth funds is more important than asset allocation. While active managers can hold more cash and bonds during or in anticipation of weak markets the disciplined rebalancing inherent in passive management means they Key Takeaways - Active funds have outperformed on a cumulative basis (albeit by a very slim margin) - Active funds performed better (or declined less) during the GFC while passive funds outperformed during the strong market rebound that followed - Subsequent returns have been comparable will participate fully in very strong markets. Equity markets spend more time going up i.e. there are more bull markets than bear markets over time. Nonetheless there is value in partially protecting capital during bear markets. Multi-sector growth funds are mandated to produce capital growth over the long-term and they participate to in the extreme equity market movements. Three passive funds were included in this analysis, with 2 of those funds still currently active. Thirty active funds were analysed.

9 Page 9 of 15 Multi-sector: Balanced Fee Differential Discussion Approximately 24% of all KiwiSaver assets are invested in multi-sector balanced funds. The relative performance trend in the first two years is similar to that of multi-sector growth funds. What is different for balanced funds is that active funds incrementally outperformed thereafter. Another popular way of looking at active versus passive performances is to consider the percent of active funds outperformed by the largest passive multi-sector balanced fund, in this case the ASB Balanced fund. Annual Active Returns The percentage of balanced funds outperformed by the ASB Balanced fund varies per year. This highlights the fact Key Takeaways - Active funds have outperformed on a cumulative basis by 5.8% (or 0.8% per annum) - Active funds declined less during the GFC while passive funds added value during the rebound - In subsequent periods active management resumed the upper hand that the relative performance of active and passive management moves in cycles. Thirty six active funds were analysed while this category only contained 3 passive funds, one which has closed recently due to a scheme closure.

10 Page 10 of 15 Multi-sector: Conservative Fee Differential Discussion Approximately 19% of all KiwiSaver assets are invested in multi-sector conservative funds. Within the Conservative fund category passive funds enjoy a fee advantage of 0.48%. As a general rule as multi-sector funds get more defensive the impact of security selection on relative returns reduces while the impact of asset allocation increases i.e. the security selection asset allocation relationship is dynamic. Annual Active Returns Active funds, on average, have more than made up for the fee shortfall and have posted an annual average performance advantage of 0.54%. While the attribution of the return advantage to active is difficult to decompose due to a lack of sector returns it is almost certain that active asset allocation or tactical asset allocation is playing a positive role. This fund category has the best passive fund Key Takeaways - Active conservative funds have outperformed on a cumulative basis by 3.8% - The relative performance trend is similar to that of the multi-sector balanced funds but less pronounced representation in the study with 5 funds. Another consideration for passive funds in this category is the wide variation in returns for these funds. This highlights that not all conservative multi-asset index funds are created equal. Investors must do their homework and investigate the various passive options as opposed to selection based on purely on a preference for passive.

11 Page 11 of 15 Multi-sector: IRD Default Fee Differential Discussion Approximately 19% of all KiwiSaver assets are invested in default funds. This figure has steadily reduced and was actually over 30% in TAA is not really part of the management of default funds and this means that active managers lose some flexibility Annual Active Returns in the portfolio management process. While asset allocation flexibility can be an overrated aspect of active multi-sector portfolio management it does appear to have played a contributing role in active management outperformance within other KiwiSaver multi-sector fund categories. As this is the one multi-sector category where passive wins there is an argument that the lack of TAA is not only the key factor here (where it is absent) but is the reason for the outperformance in the other categories (where it is present). As things stand costs have a major bearing on results in the Default fund category. Yet, this is a non-issue as most Key Takeaways - The single passive multi-sector Default fund included in this category (ASB Conservative) has outperformed the remaining active funds by 0.6% per annum, on average. - The results in this category indicate a steady advantage to passive after fees members in default funds have not actively selected the fund i.e. to get allocated to the lowest cost default fund is a matter of luck. For providers this should mean that in order to make your default offering more competitive, reduce the management fees, manage it on a passive basis or include low passive as a core.

12 Page 12 of 15 Single-sector funds General Discussion Due to the low number of single-sector funds in general and the absence of tracker funds in a number of asset classes or sectors it is difficult to perform the same analysis. Differences in currency hedging policy pose a problem for international equity fund analysis. An analysis of active and passive fund returns at sector level would be most useful in terms of providing security selection insight at multi-sector fund level. The table that follows shows the number of index funds for each sector fund category: Passive Funds Equity - Australasian 3 - International 2 - Australasia & International 0 Bonds - New Zealand 1 International 2 Property - Australasian 0 - International 0 - Australasia & International 1 Key sectors for multi-sector funds are international equities and international bonds and 2 funds exist in these sectors (but fund performance records are incomplete). As mentioned before the benefit of this information is that it will allow for a more robust analysis of relative performance at a multi-sector level. If sector funds within passive multi-sector index funds are performing in line with their active counterparts then we can infer that asset allocation is the main reason for active s outperformance and vice versa. Fees matter but are not everything In too many instances active management is overpriced while passive investing should always be synonymous with low costs. Whether that is the case with passive KiwiSaver multi-sector funds depends on where you draw the line on fees. Investors must make every effort to ensure that the index fund they are considering is low cost as high cost indexing is a very poor investment strategy. Index funds are cheaper than active funds, on average, yet active funds have outperformed after fees over the 7 year period. A natural reaction would be for index funds to reduce their management fees to make the funds more competitive. Ultimately the decision to invest exclusively on an active or passive basis is a trade-off. Individuals deal with tradeoffs in all aspects of life by way of personal preferences. Knowing yourself and your investing personality can help to make a sound decision. Some investors like the allure of managing their own portfolios or picking active funds and fund managers. Others prefer to set low costs as an investing priority or take a dim of the apparent underperformance profile of active management. For this group indexing makes sense. Knowing yourself and your investing personality can lead to conviction with long-term investment programs. This places the investor in a strong position to attain good outcomes.

13 Page 13 of 15 Realistic expectations for passive fund investors Warnings around the shortcomings of active equity management are fairly common but many market participants are not aware of the pitfalls of index investing no investment approach is infallible or works in all market environments. Indexing is often seen as an investment panacea that cannot fail but this is not true. 0.2% 0.0% -0.2% -0.4% -0.6% -0.8% -0.2% The world s best known and longest running index fund is the Vanguard 500 Index Fund, which tracks the Standard & Poor s 500 Index of large capitalisation companies listed in the United States. Established in 1976 the annual tracking error of this Fund has averaged minus 0.2% since inception i.e. it trails the index return by 0.2%, on average, -1.0% -1.2% -1.4% Relative Strength each year. Vanguard has steadily lowered the 0.98 management fee on the Fund over the years and the current TER for the Admiral Share class is only 5 basis points or 0.05%. As a result the process of underperformance is very slow. It is much faster for index funds with higher costs Very few (if any) index fund companies can compete with Vanguard s low fees and non-profit (or mutual) business structure. In the first graph to follow the annual tracking error for the Vanguard 500 Index Fund has declined over time partly due to lower fees and improved tracking skill. The systematic underperformance shown in the second graph (or cumulative performance) shows how even this super-efficient Fund will slowly but surely deviate further and further away from the gross index return over time Data source: Vanguard Investors expecting results perfectly in line with the chosen index will be disappointed and herein is the reality of passive management, namely systematic underperformance of the gross index return.

14 Page 14 of 15 As mentioned, tracking error for index funds is almost unavoidable and some of the market frictions are: Cash Flow Timing Cash Drag Brokerage Commissions Index Constituent Changes There is no mistaking that low cost indexing (in the Vanguard mould) is a powerful approach to investing but investors must do their homework and ensure that both components of successful passive management, namely low cost and good tracking ability, are in place. A sound grasp of the pros and cons of indexing will promote sound decision-making. All index funds are not created equal and tracking ability and costs should be evaluated on a caseby-case basis. Finally, be aware of the pitfalls of indexing. Appendix Net of fees and tax average returns for active and passive KiwiSaver multi-sector funds (for 7 years to end March 2015) This exercise was conducted on exactly the same basis and using the same fund universe as the analysis in the main body of the report. Return Advantage to Active Return Advantage to Active Tax Advantage to Active (before tax) (after tax *) Growth +0.12% +0.26% +0.05% Balanced Conservative Default -0.57% * Highest PIR In all cases where active held an advantage (over passive pre-tax) the advantage to active funds increased while the advantage to passive reduced in the case of default funds.

15 Page 15 of 15 Sources: 1. Money Management, Australia defying global index funds trend for now, 5 November Vanguard Investment Counselling & Research, Sources of Portfolio Performance: the enduring importance of asset allocation, July Charles D. Ellis, Winning the Losers Game, 6 th Edition, Dalbar, Quantitative Analysis of Investor Behaviour (QAIB), Contact NZ Trends is an occasional publication providing independent research, analysis and comment on the KiwiSaver industry. The newsletter is produced by Collin Nefdt, an independent KiwiSaver analyst. contacted at nz_trends@yahoo.co.nz He can be