How’s this for an alternative investment? Buy your clients an actively managed large-cap equity mutual fund.
While that is the definition of plain-vanilla investing, in a sense it is an alternative investment in a world where investors are increasingly drawn to butterscotch caramel ripple or munchy-crunchy mocha almond fudge brownie and the like.
That, at least, seemed the underlying premise of a sober-sounding session at Schwab Impact 2014 in Denver in which two American Funds execs grimly described how in the past seven years assets have flowed out of actively managed funds and have poured into passively managed index funds and smart beta products as well as hedge funds, high-yield bond funds, emerging markets and other investment exotica.
While these trends are undeniable, American Funds’ Martin Romo and Steve Deschenes brought some intriguing data to make the case that maybe the emerging consensus that relegates the “core” part of a portfolio to a passively managed index is just wrong.
The reasons investors are flocking to index funds, says Romo, likely has something to do with the difficulty in finding winning active managers and their poor aggregate track record, as well as passive funds’ low costs, not to mention the lower fiduciary and career risk for advisors who use them.
But Romo, whose American Funds have long been popular with advisors for their generally solid performance and relatively low costs, insists advisors can “expect more from the core,” referring to the key large-cap equity part of an investor’s portfolio.
What investors are assuming, Romo says, is that the most common core elements of a portfolio—U.S. equity, international equity and investment grade bonds—are easy to replicate through use of index funds, so why not use passive investments to lower costs? That can free investors to seek “home runs” through their hedge funds and other satellite investments.
But the American Funds exec argues that asummption gets things backward.
“Why accept merely average returns in the biggest part of your portfolio—the core? Do your clients look for merely average schools for their kids, average homes, average neighborhoods, average advisors?”
Instead, they should seek excess return while keeping costs low and risk low.
To that end, American Funds conducted a study whose implications run counter to the current indexing and ETF asset-flow momentum.
The study, which American Funds is making available to advisors who request it, acknowledges that many factors, such as portfolio turnover, fund expenses, manager tenure, manager ownership and incentive structure can enhance a fund’s results, but through empirical examination seeks to isolate the critical factors.
The American Funds study found (and Romo was pleased to note that an entirely separate 2014 Morningstar stewardship survey confirmed its findings) that a low expense ratio and manager ownership which aligns managers and investors were the two dominant traits for outperformance.
Romo’s colleague Deschenes went through the nuts and bolts of the study, which examined rolling 1-, 3-, 5- and 10-year returns for the 20 years from 1994 through 2013.
Looking at 2,466 funds over this period and eliminating the bottom three quartiles in terms of expense ratio left a tally of 509 lower-cost funds; the analysis performed a similar process of elimination in the category of manager ownership, and then looked at both lists to find 85 overlapping funds—that is, low-cost funds in which managers ate their own cooking, as it were.