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Getting serious on active versus passive: not as simple as it seems
by Greg Bright
We all know that index funds and smart-beta funds can, and maybe should, co-exist with active management. What we don’t know, yet, is how and to what extent this should happen. This report is based on the views of two well-respected analysts in the institutional market. APRA, with the rest of the industry, needs to take note.
David McMahon, current investment committee member, former asset consultant and fund trustee, and John Peterson, former researcher, fund manager and asset consultant, have become engaged in an interesting discussion on the issue of fund cost pressures and their implications in the active versus passive debate.
As reported last week, Peterson, of the Peterson Research Institute, looked at two similar investment options with AustralianSuper – one passive and one active. Over a relatively short timeframe of five years, the active one won out. David McMahon thought that the comparisons were not exactly like-for-like and he had slightly divergent views in the overall debate. Then APRA weighed in and said, contrary to our suggestion, that it did not pressure super funds towards adopting low-cost index funds to the long-term detriment of members (see Peterson’s separate letter to APRA).
While this all might sound a little messy, when you are talking about multiple asset classes, as necessarily is the case with MySuper default options, administered by APRA, you get questions concerning comparisons of like with like. Even slightly different asset classes, such as private debt versus public debt, can make a big difference in overall returns. As other research has shown, more commercial super funds use more indexed funds in their MySuper options than not-for-profit funds do.
As an example, when someone is trying to make comparisons in this space, David McMahon points out that the Australian Super active fund, the default option, has assets spread across eight different asset classes, including Australian and international shares, unlisted property, private equity, and infrastructure. The Australian Super indexed option, on the other hand, has only four public market asset classes, with no unlisted property, private equity or infrastructure, which together make up almost a quarter of the active fund.
He also says that the time period under question is important. For instance, the active option with AussieSuper really kicks in the fifth year of a five-year comparison. A four-year comparison is not so favourable to the active managers.
McMahon and Peterson agree on most things, though, in the active-versus-passive discussion. Most importantly, they agree that there is room for both investment strategies with big or small funds and that there should be some reward for manager skill, which means good active managers should get paid more.
Peterson says: “A component of the decision to minimise fees is to forego investments in asset classes that require manager skill. Part of what makes the analysis an ‘experiment’ is that the same investment process was used to construct both of the Australian Super options.”
McMahon says a better comparison for the AussieSuper balanced active option versus an indexed counterpart may be with the Vanguard diversified indexed version, which mixes seven asset classes. McMahon used this in a 50:50 mix of the Vanguard diversified index product and a high-growth fund for comparison, comparing it with Peterson’s initial AussieSuper table (below).
He says that the ultimate aim for a super fund is to construct portfolios with the highest risk-adjusted return net of fees. Tax is another complication, but this discussion is about fees, he notes.
Therefore, if a board has conviction that at least some active managers can beat the relevant index after fees and within risk constraints, then it is logical to appoint those active managers, regardless of fees. Peterson agrees.
Attempts by regulators to enforce lower management fees on funds regardless of expected net outcomes are misguided, they both say.
This assumes, of course, that the fund has the required governance and management structures to construct, implement and monitor such well-designed portfolios.
NOTE: my thanks to David McMahon and John Peterson for putting in the effort to engage in this discussion. It’s important. If anyone wants to liaise with them separately, please let me know on: [email protected]
