It might surprise some, but in the early part of my career, I was an active investor.
I had my light bulb moment when I found out only a tiny number of professional investors consistently beat the market over the long run.
According to the S&P SPIVA Scorecard, 75% to 95% of active funds underperform their benchmark, depending on the country and timeframe. For example, over the last 15 years to December 2020, only 14% of Australian equity funds outperformed their benchmark.
The winning fund managers are always changing too, which is why you’ll have as much chance of picking a successful fund at random than if you do your research. In fact, even investment consultants who recommend active funds for a living are no better at picking winners. Despite this, active fund managers rarely say they’re wrong.
Active investing attracts incredibly smart people, but intelligence doesn’t count for much in today’s hyper competitive investment market. 95% of trading happens between very competent professionals – who are all trading against each other. Being on the wrong side of macroeconomic calls or factor tilts (i.e. growth or value) often has much more impact than the quality of bottom up stock analysis.
All these realisations led me to index investing. Evidence shows that investing into simple, low-cost index funds consistently puts you in the top quartile of investors. Mathematically it has to, since active funds make up over 95% of all trading and charge many times the fees of index funds.
There are so many upsides to index investing, yet most investors still believe they can grow their wealth by trying to uncover the next Warren Buffett. They could avoid the stress of this strategy, invest in the entire market – and beat at least 75% of others.
A critique of popular active funds in Australia
I was recently asked to give my views on five active funds on the Buy, Hold, Sell segment of the Livewire platform.
As the first guest to ever put an emphatic Sell on each and every one of them, some of the fund managers thought I was taking a pot shot at them. I wasn’t. This simply reflects my understanding that active investing is statistically a losers game.
To demonstrate this, I’ve critiqued three popular and highly regarded active funds:
WAM Capital (ASX: WAM)
Wilson Asset Management is an incredibly successful pioneer of Listed Investment Companies (LICs) in Australia, and the WAM Capital LIC (WAM) has been around since 1999.
Wilson has a large and loyal following of mum and dad investors, on whose behalf they campaigned against Labor’s franking credit policy in the last Federal Election.
Here are three reasons why I wouldn’t invest into WAM or recommend it to clients:
Fees are only calculated on current year performance
Performance fees are only calculated on current year performance. They don’t take into account underperformance in prior periods.
To illustrate, let’s say that the market benchmark All Ordinaries Accumulation Index is flat across a 2-year period. In the first year WAM’s portfolio declines 5% (from say $100 to $95) and no performance fee is paid. In the second year WAM’s portfolio increases in value from $95 to $100 to recover back to the benchmark level. WAM’s portfolio value has increased 5.3% in the second year which is an outperformance of 5.3% in that year against an unchanged benchmark. WAM receives a performance fee of 1.06% despite the index being flat over 2 years and WAM already receiving 2 years of 1% management fees over that period.
WAM reports ‘investment performance before expenses, fees and taxes’ on its website and promotional materials. This is inconsistent with industry best practice of reporting performance on an after-fee basis and does not reflect the actual experience of an investor in the LIC.
In order to compare to managed funds or other investments like ETFs, expenses have to be deducted from performance. After taking expenses into account, ASX fund statistics data shows that WAM has actually underperformed the All Ordinaries Accumulation index over three years, five years and seven years to 30 June 2021.
Trading at a premium
This LIC now trades at an 18% premium to its 30 June net tangible assets (NTA). This implies that investors have priced in significant future outperformance above the index return on a net of fee basis. Since the fund has not outperformed over the last seven years, a 14%-40% discount to NTA seems more appropriate.
How did I get to this 14%-40% discount? First, I take into account the future drag of WAM’s 1% base management fees. Then I add in the impact of a 20% performance fee which doesn’t take into account underperformance in the previous period.
Assuming the gross return for the All Ordinaries Accumulation Index over the long run is 10% p.a., an index ETF charging 0.1% will give you a net return of 9.9% p.a. If WAM is able to match the index on a pre-fee basis, it’s 1% p.a. fee would be expected to yield a long-term net return of 9% p.a.
Then there’s the 20% performance fee. If, over time, WAM’s portfolio performance tracks the index but outperforms and underperforms by 5% on a regular basis, there would be a long term performance fee drag averaging around 0.5% p.a. This is because there is no claw back of performance fees for previous or subsequent underperformance.
So – how can we value the total fee drag in today’s money? The first step is to recognise that the fees will be paid forever. The second step is to apply a discount rate to the fees.
You can choose your discount rate but as an indication, applying a 4% discount rate to an average future management fee of 1.5% into perpetuity gives a discount of 37.5%.
Looking at it another way, if an index ETF can give you a return of 10%-0.1% = 9.9% net of fees and an equivalent LIC has an expected return of 10%-1.5% = 8.5% p.a., then an appropriate discount for the future cashflows of the LIC would be 14%. If the long term average market return is lower, the LIC discount to NTA should become larger since fees eat into a larger portion of the overall market return.
This is why I believe LIC discounts to NTA are systemic, not cyclical, and these discounts are likely to become more apparent as investors price in lower long term market returns.
Magellan Global Fund (ASX: MGOC)
The brilliant Magellan grew from zero to $100 billion under management in around 10 years, due in large part to the impeccable timing of their launch.
They also pioneered the active ETF structure in Australia (and the world). Compared to the LIC structure, one of the big benefits of Magellan’s active ETF structure is that the fund actually trades close to its NTA. I also like that it reports performance after fees.
This fund is a great example of the relationship between sequencing and success. Perform poorly for the first five years and nobody will go near your fund ever again. Outperform for your first five years, and any subsequent period of underperformance will be forgiven.
Coincidentally, the story of the original Fidelity Magellan fund follows this pattern too. This article sums up why the average investor into even the best performing fund of all time can lose money over the long run because of sequencing and investor behaviour. It’s a great example of that demonstrates the need for good financial advice to keep investors on track.
There are two main reasons why I wouldn’t invest into Magellan Global or recommend it to clients:
Underperformance of a simple index fund
Large cap U.S. shares are one of the most efficient markets in the world. Thousands of highly qualified analysts and fund managers pore over data, and few funds can outperform all the other smarts in the industry. Additionally, overcoming a 1.35% fee hurdle is extremely hard.
This has certainly been apparent over the last five years where Magellan Global has underperformed a simple index fund holding the largest 100 companies in the world (ASX:IOO). My other concern with this fund is that it’s hard to know what percentage of its earlier outperformance was due to macro factors versus stock picking skills.
U.S. large caps and tech have outperformed over the last 10 years, but what will happen when the market macro thematic changes? Will Magellan be able to identify the next market theme or is it entrenched into a style of investing which has rewarded it over the last 10 years – but may not do so into the future?
The fund has underperformed its benchmark over one, three and five years according to its own reporting. You would have been much better off just owning the largest 100 companies in the world in an ETF like iShares Global ETF (ASX:IOO) which is the global fund we’ve recommended to clients since 2014.
The fund can choose to hold up to 20% in cash. Magellan takes the approach that it not only knows which shares to invest into, but it also believes that it knows when it should be invested in shares or holding cash instead.
It’s extremely difficult to know when to time markets, so the Magellan approach is concerning. Over the last year to 30 June 2020, Magellan’s cash stockpile and defensive share tilt has meant that it underperformed its benchmark by 16%.
The benchmark MSCI world index is up around 27% since July 2020 when Magellan outlined to The Australian newspaper why they were hoarding cash and bracing for a reversal. When will it decide that shares are the right place to be again? As markets rise this becomes an increasingly difficult decision for Magellan since returning to be fully invested will lock in significant underperformance. This could take many years to recoup.
Platinum International Fund
It’s a well regarded fund, but my reasons for advising against Platinum’s International Fund are simple.
One of the worst underperformers versus its benchmark over five years
If you wanted to be contrarian, now would be the time to invest with Platinum. After being the darling of the late 90s and early 2000s, the fund has had a shocking last 10 years. According to Morningstar data, it has been in the bottom quartile of performers over five years.
The fact that such a well-known and highly regarded fund can underperform by such a long way and for such a long time, is another reason why index investing is so appealing to me. The weight of retail mum and dad money went into Platinum towards the peak of its relative outperformance.
It would be interesting to learn what the average investor into Platinum’s fund has earned over the long-term on a money weighted basis and whether this follows the pattern of the Fidelity Magellan fund (mentioned earlier). The experience of many funds is that inflows peak around the same time as relative outperformance because people tend to mistakenly chase past winners.
Investors are clearly catching on, since Platinum manages around 20% less today than it did in 2013.
When would I invest into active funds?
There are three things I’d be looking for to get more interested in active funds.
Clear information advantage
The fund managers would need to be participating in markets where they have a clear information advantage over the majority of other market participants.
Investing, like poker, is a zero sum game. When 95% of trading in markets like Australian and U.S. shares and bonds occurs between professionals, it’s like sitting at a poker table with only poker sharks. It’s difficult to imagine that retail participation in equity or bond markets relative to institutional investors will increase to the point where institutional investors can once again ‘pick off retail’ like they did back in the 1970s.
Lower base management fees
Base management fees should reflect a fair split of fund managers ability to monetise their edge over other participants. Even in a world of higher retail market participation, fees for active managers would need to be at least half of what they are currently (or around 0.5%), so that some ‘edge’ was left over for the investors providing the capital.
Performance fees are paid over longer periods of time
Any performance fees are measured and paid over rolling five or 10 year periods, with a clawback. This makes it less likely that investors are paying for performance that’s due to nothing more than luck.
Why investors should stick to indexing
Of the above three mentioned funds, you could statistically expect one to outperform over the next five years (even after fees). One will perform awfully. And one will land somewhere in between.
However, in line with my earlier points, most active funds will underperform after fees, and there’s no evidence it’s possible to pick winning fund managers.
There is absolutely a place for active management in markets. Active managers help set prices and efficiently and allocate capital.
However, as an investor looking to build wealth, there’s little reason to pay for active management when you can access the wisdom of the crowd at a fraction of the price – and mathematically guarantee better relative returns.
Essentially, why gamble on active managers when the odds are stacked against you and there’s an easy alternative?
If you’re still not convinced about the merits of indexing, I’d recommend this evidence based critical look at the arguments against indexing.