Passive investing for pension fund trustees

Transcription

1 Passive investing for pension fund trustees December 2012 WHITE PAPER For Professional Clients Only Evercore Pan-Asset is authorised and regulated by the Financial Services Authority 1

2 Why trustees want passive Does cost really matter when it comes to occupational pensions? That is a question that many trustees have been asking themselves in recent years as they face record funding deficits, weakened sponsors and disappointing investment markets. The launch of pensions autoenrolment in October 2012 has helped focus a spotlight on the importance of reducing investment management costs; many defined contribution schemes newly set up to cater for auto-enrolment are targeting annual fees of 0.5%. One of the main ways trustees are considering managing investment costs is through passive strategies, with good reason. Research by passive fund manager Vanguard* shows that for most asset classes the performance of active managers has been extremely disappointing. The proportion of active global, US and European fixed income managers who have beaten their benchmarks over the last 15 years is zero, for instance. The story is largely similar in equities, although not to the same degree; only 28% of global equity managers beat their benchmarks over the last five years. This is not uncommon; most active managers fail to beat their benchmark after fees over most time periods longer than one year. Executive summary Executive summary A portfolio of Exchange Traded Funds (ETFs) can be just as cost effective as equivalent A portfolios of of traditional Exchange index-tracking Traded Funds funds, (ETFs) but is just is more as cost liquid effective and can as contain equivalent a wider portfolios variety of of traditional asset classes. index-tracking funds, but is more liquid and can contain a wider variety of asset classes Passive fund performance in 2011 was very Passive different fund from performance that implied by in published 2011 was Total very different Expense from Ratios what (TER). is implied The weighted by published average Total Expense tracking difference Ratios (TER). in all The portfolios weighted considered average tracking was lower difference than their in overall portfolios TER. A considered portfolio of was ETFs lower had the than highest its overall weighted TER. A average portfolio TER of of ETFs 0.31% had but the one highest of the lowest weighted tracking average differences TER of 0.31% of the portfolios but one of at the 0.00%. lowest tracking differences at 0%. A diversified portfolio selected purely on grounds A of portfolio the lowest selected cost*** purely for pension grounds schemes of the would lowest consist cost*** of 58% for ETFs, pension 40% schemes index-tracking would funds consist and 2% of cash. 58% The ETFs, tracking 40% index-tracking difference of this funds and portfolio 2% cash. in 2011 The would tracking have difference been a positive of this portfolio 0.08% (ie in it 2011 would would have have just beaten been a its positive respective 0.08% basket (ie of indices) it would and have including just beaten all purchase its respective basket costs would of indices) have cost and including only 0.1% all in trading. its first year. Trustees keen to increase their allocation to passive strategies often turn to the large index-tracking pension fund ranges. These index-tracking funds have been established to cater specifically for occupational pension funds; they have grown very large and are generally considered to be the most cost effective option. But in the last few years a relatively new passive option has come to the fore; Exchange Traded Funds (ETFs). ETFs have been well used by pension funds in the US for many years, where they were first launched in In Europe the market has taken longer to build up strength, but has boomed in recent years, expanding from $10.7bn of assets under management in 2002 to $313bn at the end of October**. The recent growth of ETFs has meant that costs have come down substantially, making them more attractive than ever before. ETFs are passive funds that are traded on stock exchanges and available to all investors. For that reason many have considered them to be applicable to traders and retail investors but not pension funds which plan to hold them for long time periods. ETFs offer significant benefits however; they are extremely quick to buy or sell, are highly transparent and offer investors a much larger universe of asset classes and markets than are available in traditional index-tracking funds. But given the competitive fees that occupational pension trustees enjoy in institutional index-tracking funds, are ETFs worth considering? Table 1: Comparison of features between ETFs and Index-tracking funds Index-tracking funds Exchange Traded Funds How purchased Direct from provider Stock exchanges Notice period to buy or sell 1-5 working days None Holdings transparent? Partially Completely Trades at NAV? Yes Can vary 1. * Source Vanguard: The case for index fund investing for UK investors September ** Source BlackRock, ETFGI 3. *** Cost is defined in this study as tracking difference plus purchase costs, as explained in the Appendix. 2

3 The research project In a bid to answer this question, Evercore Pan-Asset embarked on a detailed research project during the summer of 2012 to compare the latest generation of ETFs with the index-tracking funds typically used by occupational pension funds in the UK. We analysed 223 European ETFs and the three leading ranges of index-tracking funds used by UK pension funds. Evercore Pan-Asset is one of the leading independent investors in passive funds, and we used our considerable experience of passive investing to drill down into all the costs incurred by investors. We took the asset allocation of our flagship Diversified Growth Strategy* (see pie chart below) and compared the cost of a 50 million portfolio made up of the lowest cost ETFs with portfolios made up of the index-tracking fund ranges used by UK pension funds. We discovered that while the published Total Expense Ratio of a portfolio of index-tracking funds is usually lower than an equivalent portfolio of ETFs, in 2011 the ETFs performed better than all but two portfolios considered, and proved cheaper in most instances in terms of trading costs incurred when buying ETFs or indextracking funds at the outset (such as broker commissions and spreads ). Taking account of their 2011 performance and additional costs, a portfolio of ETFs would have cost 0.24%, cheaper than all but one portfolio of index-tracking funds considered. Asset Allocation of Evercore Pan-Asset s Diversified Growth Strategy Source: Evercore Pan-Asset. Breakdown of EPA Diversified Growth Strategy based on PFS PanBalanced OEIC July 2012 By comparison the lowest cost portfolio of index-tracking funds (managed by Provider 'C' in this study) was 0.22% and the highest cost was 0.59% (managed by Provider 'A'). A wide variety of portfolios was considered (see Table 2 overleaf and Appendix) including portfolios consisting of just two 'consolidated' equity and bond index-tracking funds, and those in which index-tracking funds were substituted by ETFs where no direct equivalent was available (for example Chinese equities or Asian property). While one provider had better performance in 2011 and What is the difference between synthetic and physical ETFs? Physical ETFs operate very much like traditional indextracking funds. Underlying the fund is a basket of securities which mimics the make-up of the index that is being tracked in order to copy its performance. A synthetic ETF includes a swap contract; an agreement from a provider to pay you the difference between the index performance and the value of the shares it holds. one provider offered lower trading costs, the portfolio of ETFs delivered compelling all-round cost efficiency. It should be noted that the portfolios containing only index-tracking funds had a simplified asset allocation, with no direct allocation to US property, Asian property, Chinese equities or gold producers possible. The ETF portfolio was, therefore, also the most diversified, offering access to the widest range of alternative and traditional asset classes. We calculated that a portfolio blending the lowest cost index-tracking funds with ETFs was cheaper still at 0.1% overall cost. * EPA Diversified Growth Strategy; actual asset allocation as at July 2012 of PFS PanBalanced OEIC 3

4 Conclusion When choosing passive funds, trustees should now consider ETFs alongside traditional index-tracking funds and they should also factor in all costs when evaluating their options. Annual Management Charges or Total Expense Ratios (TERs) are incomplete guides to cost as they exclude trading costs which can be substantial, as this study demonstrates (including bid / offer spreads and commissions.) We believe that performance net of all costs is the best guide to investors as it represents the real return that they would experience. The performance of the portfolios of ETFs and index-tracking funds in this study deviates significantly from their TERs, even more so when trading costs are added. Liquidity should also be considered; some of the index-tracking funds considered can take seven working days to purchase or redeem units, whereas shares in ETFs can be traded almost instantly. However, selecting and buying ETFs requires action by occupational pension fund trustees to ensure proper support for the portfolio. If they do not already have one, trustees need to appoint a custodian and need a third-party to trade on their behalf, just as they would if they were buying individual shares. They would also need advice on selecting appropriate ETFs from what is a large and growing universe with many esoteric products in addition to the plain vanilla funds considered here. But by working with expert investment managers and consultants, ETFs now allow trustees to build sophisticated, liquid, diversified portfolios without incurring the risk or cost of active management, and without incurring any more fund or trading costs than they would do by using the limited range of traditional index-tracking funds typically relied on by pension funds. In light of this study, Evercore Pan-Asset retains the view that ETFs are predominantly the best way for us to build and manage diversified portfolios for pension fund trustees, allowing us to deliver sophisticated, dynamic strategies at twothirds of the cost of leading off-the-shelf diversified growth funds. While a small number of index-tracking funds do well in this study, we believe that overall ETFs are the most attractive option, combining low cost with high liquidity so allowing us to exit markets quickly in times of stress as we did in the summer of 2011 and so enabling us to perform an important risk management function for our pension fund clients. Table 2: Summary of Results Provider A (equities and bonds) Portfolio of index-tracking funds (weekly dealing) Provider B (equities and bonds) Portfolio of index-tracking funds (daily dealing) Provider C (equities and bonds) Portfolio of index-tracking funds (daily dealing) Performance difference versus indices in 2011 % Total cost including purchase costs % Does cost really matter? Just like interest, costs compound over time which means that small annual percentage costs can really mount up. A 50 million pension fund portfolio enjoying gross returns of 6% a year but paying 0.5% in annual costs will have spent 14 million in fees after 20 years, leaving the trustees with 9% less than they would have had otherwise. Every basis point counts, and anything trustees can do reduce annual costs will have a significant impact over the long term. With the average defined benefit scheme facing an actuarial deficit of 18%* according to the Pension Protection Fund, saving money can really help tackle shortfalls in funding. Want to know more? Portfolio of ETFs Mixed portfolio of the lowest cost ETFs and index-tracking funds For more information about Evercore Pan-Asset s passive fund research and Diversified Growth Strategies, contact: Bob.Campion@Pan- Asset.co.uk or call Bob on * Source: Pension Protection Fund s PPF 7800 Index, October 2012 update 4

5 Appendix A range of portfolios have been considered as part of this study. A diversified portfolio of ETFs is compared on a TER and performance basis net of fees and initial costs with the following portfolios of weekly and daily dealing index-tracking funds from three leading providers: A portfolio of two consolidated funds (49% global equity, 49% UK corporate bond, 2% cash) A portfolio of index-tracking funds only, amending the asset allocation where needed if equivalent index-tracking funds are not available (eg China equities, Asian property) A portfolio of index-tracking funds using an equivalent fund where available, substituting an ETF where it is not Table 3 (below) details the make-up of a portfolio containing the lowest cost funds across leading providers of index-tracking funds and ETFs. Table 4 (overleaf) details the full analysis of all portfolios considered in this study. Table 3: Components of the lowest cost portfolio Performance difference versus indices in 2011 %* Purchase costs (spreads / commissions) % Total cost including purchase costs %** Provider C Corporate Bond Index Fund Corporate Bond ex-financials ETF Emerging Markets Government Bond ETF FTSE 100 (UK Equities) ETF S&P 500 (US Equities) ETF Provider B Asia Equity Index Fund MSCI China (Chinese Equities) ETF Provider C Emerging Markets Equity Index Fund Gold Producers ETF US Property ETF Asia Property ETF Provider B Global Property Index Fund Total * Full year tracking difference in 2011 is used, except for those funds launched during 2011 where performance since inception, first 12 months performance or TER is used instead 2. ** Bold italics indicates a negative cost, ie a positive overall return versus the index after all costs paid How is cost calculated? In this White Paper, the cost of passive funds is measured as the performance of a fund versus the index it was tracking in 2011, known as the tracking difference. For instance, if a passive UK equity fund returned +1.3% and the FTSE All Share index it tracks returned +1.5% over the same time period, the tracking difference would be -0.2%. This is the cost in performance terms that the trustees would have incurred. In addition, the investor would have suffered additional costs upon the purchase of the fund, in the form of spreads and/or broker commissions. This trading cost is estimated based on data supplied by the fund provider and from brokers in the case of ETFs, and includes an allowance for in specie transfers (ie crossing ) where this is possible for index-tracking funds. If the purchase cost of the UK equity fund is 0.1%, this is added to the tracking difference to determine the overall cost to the trustees; 0.3% in this example. The overall cost of a portfolio is calculated as the weighted average cost of its underlying funds. Purchase costs are one off costs but redemption costs are also incurred when exiting a fund, again through spreads and/or broker commissions. Typically these redemption costs would be broadly similar to purchase costs when redeeming units or shares upon exiting a fund, but these costs have not been included in this White Paper. 5

6 Table 4: The full analysis comparing portfolios of indextracking funds and ETFs Performance difference versus indices in 2011 %**** Purchase costs (spreads / commissions) % Total cost including purchase costs % ***** Weighted average Total Expense Ratio % Provider A* portfolios (weekly dealing) Weekly dealing fund portfolio, with ETFs where no equivalent available Weekly dealing funds only portfolio (daily dealing) Daily dealing fund portfolio, with ETFs where no equivalent available Daily dealing funds only portfolio Provider B portfolios Daily dealing fund portfolio, with ETFs where no equiv Daily dealing funds only portfolio Provider C portfolios Daily dealing fund portfolio, with ETFs where no equiv** Daily dealing funds only portfolio ** ETF portfolio *** Mixed portfolio of the lowest cost ETFs and index-tracking funds * Discounted to allow for crossing in weekly series for Provider A funds only. Provider C and Provider B are average crossing across all their pension funds where available. No crossing is accounted for in ETFs. 2. ** Provider B Property Fund included in these portfolios as no alternative at Provider C 3. *** Figures assume ETFs are bought on the secondary market and that broker commissions of 0.08% are incurred on purchasing ETFs. 4. **** Full year tracking difference in 2011 is used, except for those funds launched during 2011 where performance since inception, first 12 months performance or TER is used instead. 5. ***** Figures may not sum due to rounding 6

7 About Us Evercore Pan-Asset is a specialist manager of diversified growth strategies. Our portfolios invest in a wide range of global assets, including equities, bonds and alternative asset classes such as property, private equity, commodities and infrastructure. While we are dynamic managers, we like to keep it simple when it comes to executing our asset allocation decisions, so we access these markets using passive funds which track markets at low cost. The members of our Investment Committee have a combined investment experience of over 120 years which means the portfolios we manage for pension fund trustees are in expert hands. For more information about Evercore Pan-Asset s Diversified Growth Strategies, contact Bob.Campion@Pan-Asset.co.uk For Professional Clients Only Evercore Pan-Asset is authorised and regulated by the Financial Services Authority 7