Issue: December 2012 / February 2013
Editorials

ACTIVE MANAGEMENT

A considered retort

There’s a strong argument for active against passive management. John Kinsley, of Prudential Portfolio Managers, presents it.



Kinsley . . . baby in the bathwater

Much is being said about the effect of costs on retirement savings. These costs include asset management charges and advisory fees. A National Treasury discussion paper highlights them as principal concerns regarding retirement and investment products.

Whilst many legacy-type products have carried far too high a cost burden, major improvements have been made to many of the new investment products available today. My fear is that the pendulum will now swing from one extreme to the other, from excessive costs to an attempt at removing costs altogether. I do not believe that this will necessarily be in the interests of investors.

I tackle this debate from a financial-planning perspective and more particularly from the standpoint of a living annuity. This approach could equally be applied to the build-up of a retirement annuity or even a member-choice retirement fund.

Many of the new-generation products (such as unit-trust based retirement annuities) have helped to reduce costs and increase transparency. However, in order to drive down costs even further, there is a move to passive-type strategies such as index-trackers and exchange-traded funds.

Whilst these options definitely have a place in retirement planning, a move to passive simply to cut out active asset management fees would, in my view, be short-sighted. Passive strategies are not free; annual costs could be at least 0,5% of asset value.

The favouring of passive solutions is based on the argument that active managers do not outperform markets on a sustainable basis anyway. I am not here to defend my competitors, but the reality is that certain managers have produced excess returns (or “alpha”) over significant time periods. The key issue for me is not large chunks of alpha from time to time but rather regular, incremental alpha which can arise from active asset allocation and judicious stock selection.

It is here that tactical asset allocation plays a critical role. This is not simple market timing. It’s an approach that requires a robust understanding of valuations, patience and the discipline to hold a neutral position when it is justified.

Now let’s turn to our case study of Mr X. He has a R1m living annuity and wants to draw 5% per annum in real terms. In other words, he wants his 5% drawdown to grow in line with inflation, whilst the residual capital must also grow sufficiently to support that objective over time.

I will argue that there are certain steps that Mr X (and hopefully his advisor) must follow if he has any chance of success:

Mr X must identify the return requirement after inflation that he requires from his capital. This he has done i.e. inflation plus 5% p.a. over time.

He then needs to identify the mix of assets that will best achieve this return over time, based on long-term after-inflation returns. These long-run real returns will range from a minimum expectation from cash to a maximum expectation from equity as one takes on more risk.

The long-run equilibrium numbers that we use at Prudential range from 2,5% for cash to 8% for equity. (These equilibrium expectations are in fact only slightly below the actual 30-year returns for asset classes in SA as at end-July.) Through the use of optimisation models, the best mix of assets to achieve the target real return of 5% can then be determined, with or without constraints such as Regulation 28.


Long run equilibrium assumptions

It’s critical to recognise that these long-run returns represent the beta of the market – and are by definition before fees and before any alpha that a manager may be able to add. If Mr X therefore simply defaults to a static mix of passive funds over time, the mix is likely to underperform the target return by the extent of the costs of using those passive funds.

There is nothing wrong with this as long as Mr X is happy to adjust his return expectation by the amount of those fees. But he must remember that 0,5% p.a. can have a large compound effect over time.

The key to my argument is that, if Mr X is not prepared to reduce his return requirement, then he requires reasonable alpha over time to absorb reasonable asset management (and advisory) fees in order to leave him with the return expectation built into his plan. For this he needs an active manager.

My great concern is that, in an attempt to cut fees at all costs (pun intended), the authorities could end up “throwing out the baby with the bathwater”. This will not benefit investors in the long term.