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.
They repeated the process in the international funds sphere, yielding 20 top funds exhibiting these two traits.
The American Funds study then compared the various categories and found that fewer than a third of actively managed funds in general could beat index funds while something close to half of the active funds with lowest costs could do so. Meanwhile 71% of manager-ownership U.S. funds and 58% in the international domain beat the index funds.
But combining the two traits, they found that 100% of low-cost manager-ownership U.S. actively managed funds beat their passive rivals—93% in the international arena.
They found the same staggered pattern looking at five-year rolling returns and other time frames.
“Active management [alone] doesn’t add value, but the top two traits combined dramatically added value,” Deschenes said.
But active managers with the two key traits could add still more value in other areas, most particularly by limiting “downside capture,” in other words, by swooning downward to a lesser extent than the market in down markets, something that an index fund is mathematically compelled to do, he said.
“Customers dislike a loss twice as much as they appreciate a gain,” he said, noting that the best actively managed funds (combining the two key traits) captured 92% and 97% of the downside compared to 100% and 101% of the downside, for U.S. and international categories, respectively.
The American Funds study road-tested these findings by comparing an investor using a passive ETF core with their “screened active core,” that is the 85 U.S.and 20 international funds that are low-cost and management-owned.
Over 20 years, the ETF core delivered 5.69% average returns, with up and downside capture of about 100%, while the screened active fund added 178 basis points to that, for an average return of 7.47%, along with better upside and lower downside.
Looking at these winning actively managed funds, they observed that 100% of their own funds qualified on the dual (cost and management ownership) screens.
So they crunched the data for their own funds and found a 248 basis-point advantage, resulting in 8.17% average annual returns, along with a lower (hence, more favorable) downside capture of 87.6%, a key advantage for clients who don’t enjoy the ride down.
Martin Romo concluded the session with more client-specific scenarios.
Looking at a hypothetical 45-year-old’s accumulation portfolio, the American Funds study found the best actively managed fund did 31% better than the ETF portfolio, and the American Funds option did 44% better than the ETF core.
Then, looking at a 65-year-old investor withdrawing 5% a year until age 85, the study found the screened active core did 57% better and the American Funds portfolio 78% better than the ETF core.
Their conclusion is that active management—the right active management combining the identifiable traits of low cost and management ownership—can get investors more from their core, specifically that part of their portfolio that, unlike satellite positions, has the largest impact on their overall wealth.