Issue: December 2012 / February 2013
Editorials

PASSIVE INVESTMENT

In praise of proper counsel

Attempts to beat the market are basically futile, and investors hardly understand the impact of costs. Professionals will win by serving clients before themselves.



Ellis ...losers turned winners

Support for passive or index-tracking investment, encouraged by National Treasury because of its relative cost advantages, comes from an unlikely source. It was from the platform provided by Sanlam Investment Management, an active manager if ever there was, for the keynote address by internationally-renowned consultant Charles D Ellis.

But first, a rider: Ellis argues that investment professionals have falsely defined their mission to clients as “beating the market”. No, he says, they have allowed the values of their profession to be increasingly dominated by the economics of their business: “Investment counsellors can add far more to clients’ long-term returns (by gaining clients’ trust and addressing their needs) than portfolio managers can hope to produce.”

Unlike days gone by, he suggests that in today’s intensely competitive securities markets few active managers outperform the market by even 1% over the long term. Underperformance substantially exceeds outperformance. So profound have been changes over the past 50 years – the massively increased volume of trades, institutional dominance, commoditisation of instant information, computer models and globalisation, to name a few – that active investing has become a “loser’s game”.

The world’s largest and most active “prediction markets” have become increasingly efficient. It’s become harder and harder to beat the smart professionals who set the market prices. And it’s still harder to beat the market after costs and fees.

“That is why, among mutual funds, the approximate proportion net of fees typically falling behind the market averages has become 60% in any one year, 70% over 10 years and 80% over 20 years,” Ellis finds. “Nor do the data adjust for taxes, particularly the high taxes on short-term gains that come with the now normal 100% portfolio turnover.”

Most investors, he says, still don’t realise that investment management fees aren’t low. In fact, they’re high. He reckons that a fee of 0,5%, as a percentage of the client’s assets, is surely more than 5% of the client’s probable after-inflation annual return.

“Because investors can get virtually guaranteed market returns through index funds for less than 10 basis points (i.e. 0,1% as opposed to 0,5%), what they really buy is incremental returns. After 50 years of fee increases, overall investment management fees are now greater than risk-adjusted incremental returns. This means that investment managers now charge clients more than 100% of the benefits actually produced.”

The industry continues to sell beat-the-market performance that it cannot deliver, Ellis contends. Most investors have not yet caught onto the fact that they would be better off if they put most, if not all, of their investments into low-cost index funds or index-matching exchange-traded funds.

He’s also highly critical of how individual and institutional clients, such as pension funds, turn negative towards their investment managers after a few years of underperformance. When clients then switch to managers with a “hot” investment record – positioning themselves for another round of buy-high sell-low dissatisfaction – they obliterate roughly a third of their funds’ actual long-term returns.

Wryly, he observes: “This costly behaviour is encouraged by investment firms that, to increase sales, concentrate their advertising on funds clearly selected because their recent results – over selected time periods – make good results look even better. And some fund managers have several hundred different funds so that they will always have at least some documented winners.”

The crucial need for investment counselling, believes Ellis, is magnified by the shift from defined-benefit to defined-contribution retirement funds. How many beneficiaries don’t realise how much capital it will take to pay out a comfortable monthly amount, and how many of these will run out of funds in their old age?

“Our profession’s clients and practitioners would all benefit if we devoted less energy to attempting to ‘win’ the loser’s game of beating the market and more skill, knowledge and time to recognise market realities, understand themselves as investors, clarify their realistic objectives and then stay the course that is best for each of them,” he urges. “While doing right for our clients, we’ll be doing right for ourselves.”