The Case for a Passive Fund Premium

Transcription

1 September 2014 White Paper The Case for a Passive Fund Premium Should passive funds be expected to outperform? For professional investors only

2 Contents Background p2 Executive Summary p3-4 General Findings p5-6 Data Analysis p7-9 The Charles Stanley Pan Asset approach p10 About the authors Bob Campion Head of Institutional Business and Business Development Bob is a pensions specialist who has worked with trustees and advisers for more than a decade. Before joining Charles Stanley Pan Asset, Bob spent six years as a pension trustee and was an award-winning journalist and publisher. A regular contributor to professional newspapers and magazines, including the Financial Times and Money Management, he launched Engaged Investor and Pensions Insight and now leads Charles Stanley Pan Asset s pensions business and overall marketing programme. He holds the IMC qualification. Lynn Hutchinson Assistant Director Lynn joined Cantrade in 1992 which subsequently became Sarasin Chiswell. She was responsible for the investment administration of pension funds, corporate, private client and charity portfolios, including reporting, dealing and investment strategy implementation. She holds the Investment Management Certificate qualification and leads Charles Stanley Pan Asset s passive fund research programme.

3 Background In 2013, Charles Stanley Pan Asset published The Governance Revolution, a white paper presenting the case for a new investment process for UK defined benefit pension schemes, one that focuses on the active management of asset allocation, rather than selection of underlying securities. Our 2014 white paper The Passive Fund Premium brings up to date the findings of The Governance Revolution. It repeats our analysis of single asset class active and passive fund performance and considers the case for a passive fund-only portfolio for large DB investors. While The Governance Revolution looked at the benefits of a passive-only approach for relatively small DB schemes (using a 50m scheme as the case study), The Passive Fund Premium considers the same question for much larger schemes, using 500m as an example. It is intended that this research may support the decision-making of Local Government Pension Schemes (LGPS) during a period in which they are deliberating whether to adopt a passive-only approach to investing in listed asset classes. Methodology in brief Charles Stanley Pan Asset used an independent database of actively managed single asset class funds available to UK pension schemes to calculate the median relative returns in each case. Relative returns are defined as the difference between the total net return during the period and the total return of the index each fund is benchmarked to. By this process a relative return for each fund is calculated and the median relative return is presented here. This data is then compared with the relative return of a passive fund monitored by Charles Stanley Pan Asset s research team in each time period. The time periods used are 1, 3 and 5 years to the end of April In each case standard fees as would apply to institutional investors are applied to calculate net returns. These findings are then complemented by illustrating the cost of an entirely passive portfolio for a large 500m defined benefit pension scheme. The Governance Revolution, 2013, Charles Stanley Pan Asset 2

4 The Case for a Passive Fund Premium Executive Summary John Redwood, Chairman of the Investment Committee, Charles Stanley Pan Asset Our research and that of independent academics shows that pension funds draw most of their positive returns from the big picture decisions they make about how much to have in shares or bonds or property. These asset allocation decisions cannot easily be indexed and cannot be avoided. Past experience shows it is concentrating on these that makes the big differences to risk and rewards. That is why we concentrate on these decisions and recommend trustees do the same. When it comes to implementing a decision to have a specified proportion of a portfolio in bonds, or UK shares, or US property, the trustees and their investment managers have a choice. Do you pay extra to have specialists choosing the shares and trying to beat the index? Or do you go for a cheaper option, of simply trying to match the index? Our latest research confirms that in recent years pension funds on average have performed better if they decide to invest through index trackers rather than trying to outwit the indices. It is important to note that in both last year s report and this year there has been a substantial advantage for those choosing index trackers. We recognise that the future may be different to the past, and not all past periods will be the same. However, it is always the case that actively managed funds on average charge considerably more than passive funds. It will always be the case that it is difficult to beat an index by more than the extra fees, and in many cases difficult to beat one at all. The index has two big advantages. It incurs few transaction costs. It is Darwinian. It periodically drops shares or bonds that have performed badly, usually managing to avoid the disaster of holding something that goes bust and loses you all the money. Active managers struggle to keep up with these two winning features of index investing. It is not unusual for investment advisers working with institutional investors such as pension funds to include alpha in their projections of future returns or in their analysis of historic performance. Alpha is the word used by the investment industry to describe the returns that are attributable to the skills of the portfolio manager, rather than the general performance of the market which is denoted beta. Well established formulae, such as Jenson s Alpha part of the Capital Asset Pricing Model (CAPM) and first used in 1968 have attempted to calculate the alpha or abnormal returns which skilful managers are able to achieve: returns above that of the market. In order to take account of alpha in their models, advisers often include an allowance for outperformance by active fund managers who are attempting to beat their benchmark and so generate alpha for their clients. This assumption is often referred to as an active fund premium, typically adding one to two percent per annum to projected market returns. However, studies have suggested that abnormal returns in recent years have, in fact, been negative. In one study, The Case for Index Fund Investing for UK Investors, published by US investment manager Vanguard in March 2014, found that the majority of investment managers in most asset classes underperformed their benchmark. The longer the period considered, the more managers fail to beat their benchmark. Studies repeating this analysis over different time periods have reached the same conclusion. These managers are generating negative alpha. Using this most recent set of data provided by Vanguard, Charles Stanley Pan Asset calculates that the chances of choosing 11 managers one in each of the asset classes considered by Vanguard s study which all outperformed their benchmark over five years is approximately 0.01%. The chance of less than half of these managers beating their benchmark is 92%. The question for long-term investors is whether, net of fees, a portfolio of passive funds would outperform a portfolio of active funds and if so, by how much. In other words, if passive funds have performed better than active managers, rather than assuming a premium for active fund managers, would it not be more logical to assume a Passive Fund Premium? The conclusion of this study, built upon the foundations laid by our 2013 study The Governance Revolution, is that passive funds do indeed perform better than active funds on average. Across 14 listed asset classes studied, the outperformance of passive funds (the Passive Fund Premium) over 5 years is approximately 4.7%, or 0.9% a year. Further research is required to establish a long term figure across different time periods, but our findings so far support the use of passive funds in all listed asset classes. 3

5 Key findings Over five years to the end of April 2014, passive funds in 14 liquid asset classes have outperformed median active funds by 4.7% on average The same analysis to the end of June 2013 calculated an outperformance of 6.5%. It is suggested that a Passive Fund Premium may exist: the additional return to be expected from a portfolio of passive funds over an equivalent portfolio of active funds While further research is needed to establish the frequency and the size of the Passive Fund Premium over multiple time periods, these studies by Charles Stanley Pan Asset give weight to the evidence that passive funds are not only cheaper than active funds, they also perform better on average net of costs These findings complement research* conducted which suggest the Local Government Pension Schemes (LGPS) could save 420m a year by replacing active managers with passive managers across 85bn of liquid assets. Our findings suggest the improvement in performance net of cost could be slightly higher than this: 441m a year. The total performance improvement to the LGPS could be worth 28bn over 20 years Charles Stanley Pan Asset strongly recommends that the LGPS use passive funds to invest in all listed asset classes, as outlined in our response to the DCLG formal consultation paper The estimated cost of a fully passive portfolio for a 500m investor in terms of ongoing charges is 0.20%. This portfolio is equally weighted across all asset classes. The recent cost of this portfolio in terms of tracking difference has been 0.05% *Source: Hymans Robertson Local Government Pension Scheme structure analysis Impact on large pension schemes These findings come at a time when all pension funds that form part of the Local Government Pension Schemes (LGPS) are in the process of reviewing their governance arrangements. Following a review commissioned by the Department for Communities and Local Government (DCLG), investment consultant Hymans Robertson has recommended that LGPS members consider replacing all 85bn of investments currently placed with active managers in favour of passive managers. Hymans Robertson has calculated that the cost savings of the switch would be worth 420m a year. Our research into the Passive Fund Premium supports this recommendation. Even taking account of the significant fee discounts that large investors are able to negotiate, we have calculated that performance improvements of 441m a year would be gained from switching to passive funds, taking advantage of the Passive Fund Premium over the last five years. In other words, every pound saved in costs is an improvement in performance as well. There is no reason to expect a loss in performance through making this cost saving; quite the contrary. Every pound saved in costs is an improvement in performance 4

6 The Case for a Passive Fund Premium General findings Comparing the performance of active and passive funds across 14 asset classes over 1, 3, and 5 years Charles Stanley Pan Asset found that in most instances passive funds outperformed active funds, sometimes by a significant margin. Over five years in all but two instances UK equities and Japanese equities passive funds outperformed the active median. While the scale of this outperformance was often less than 4%, the difference in one instance, Emerging Market Bonds, was 12%. On average, passive funds outperformed active funds by 4.73%. The relative performance of active funds improved in some asset classes compared with our findings in 2013, most notably for UK equities where active funds outperformed passive over all three time periods. Overall the average margin of outperformance between passive and active funds fell from the level in 2013 when it was calculated to be 6.5%. Further research over different time periods is required to calculate an average margin over time, but based on research so far, Charles Stanley Pan Asset proposes the existence of a Passive Fund Premium: the additional return over active funds that investors in passive funds should expect. This runs counter to many of the models adopted by pension fund consultants and investment managers which assume additional returns should come from active manager risk - alpha - compared with the market beta. While passive funds cannot claim to capture all the return of the markets they track, they appear to capture significantly more than active funds. Implications for large schemes A 4.73% additional return over five years would be worth 24m to a 500m scheme; equivalent to 0.93% or 4.6m additional return per year. A significant proportion of this additional return is due to the high cost of investing in actively managed funds. Comparing the total expense ratio or ongoing charge of active and passive funds, assuming standard institutional annual management fees, we find a 0.68% difference between the annual cost of a portfolio of active and passive funds, equally weighted across the 14 asset classes studied. This suggests that, over this time period, active funds underperformed passive funds by 0.25% due to poor decision making and 0.68% due to higher costs. Large pension scheme investors are typically able to negotiate fee reductions on both passive and active funds. Given that fees on passive funds start at a much lower level, large schemes may be able to reduce the Passive Fund Premium. For example, annual management fees account for 83% of the total cost of active funds considered in this research. Independent research * suggests that a 500m pension fund may be able to negotiate discounts of 25% on standard institutional annual management fees for actively managed funds. Further research by Charles Stanley Pan Asset suggests that discounts of up to 10% may be possible for large investors such as this on annual management fees for passive funds, where pricing is much tighter. Were a 500m scheme able to negotiate these discounts in full, the difference in total annual cost between a portfolio of active funds and a passive portfolio would reduce to 0.51% a year. However, even taking account of this cost saving the difference is significant. Following the methodology outlined above, active funds running costs 0.51% higher than passive funds, would have underperformed passive funds by 0.76% a year (assuming a 0.25% underperformance due to poor decision making). This performance difference of 0.76% would be worth 3.8m a year to a 500m pension scheme after fee discounts. Over long periods of time, a 500m pension scheme experiencing investment growth would find that this performance difference is accentuated. Below is a demonstration of the impact of improving performance by 0.76% a year for a 500m scheme growing annually by 6%. Over 20 years the 0.76% increase in performance is worth 246m or 49% of the fund s starting value. For a 500m investment Difference in fund size over period Difference as % of original fund size 5 years 24m 5% 10 years 66m 13% 20 years 246m 49% Source: Charles Stanley Pan Asset The differential between a passive and active portfolio would be increased further if monitoring and consultancy costs could be cut as a result of no longer requiring the significant research costs and resources that are applied to the monitoring of active fund managers. These findings support research conducted by consultants Hymans Robertson on behalf of the Department for Communities and Local Government which suggest that the Local Government Pension Schemes (LGPS) stand to save 420m a year through moving from active to passive fund management on 85bn of its assets ** through reductions in annual 5 *Source: LCP Investment Management Fees Survey 2013 ** Source: Hymans Robertson, Local Government Pension Scheme Structure Analysis 2014

7 management fees and transaction costs. According to the report by Hymans Robertson, the LGPS could see annual fees on its actively managed assets fall by 0.27% through switching to passive. Using the methodology above, Charles Stanley Pan Asset estimates that the performance increase or Passive Fund Premium that the LGPS would have experienced by moving from active to passive fund management in the 14 liquid asset classes considered over the last five years would have been worth 441m or 0.52% a year. Assuming LGPS funds grow by 6% a year and the Passive Fund Premium remains the same, the potential improvements in performance over long time periods into the future are significantly larger, as the table (right) demonstrates. For an 85bn investment Difference in fund size over period Difference as % of original fund size 5 years 3bn 3% 10 years 8bn 9% 20 years 28bn 33% Source: Charles Stanley Pan Asset LGPS members should not be concerned that a move from active to passive fund management in liquid asset classes is likely to reduce performance. The research undertaken by Charles Stanley Pan Asset demonstrates that performance would have been at least as much as the savings made over the last five years. Our studies suggest the performance enhancement over the last five years could have been slightly higher than the saving on fees and costs. A fully passive portfolio - for large DB schemes In order to illustrate the cost of a portfolio of passive funds, Charles Stanley Pan Asset has sourced funds from its current recommended list across all the liquid asset classes studied in this report. These are the costs that a 500m pension scheme would be able to command in a diversified portfolio. Larger investors (for instance 1bn or more of investible assets) may be able to negotiate significantly larger discounts in some asset classes. Due to the rapid expansion in the market for passive funds, some vehicles used in this illustration have been launched recently and may have relatively short track records. All the funds included have passed Charles Stanley Pan Asset s rigorous due diligence process. For more information about Charles Stanley Pan Asset s passive fund research, contact Bob.Campion@Charles-Stanley.co.uk. Asset class Ongoing charge % Six Months Tracking Difference* UK corporate bonds Global bonds Index-linked gilts All gilts Emerging Market Bonds US equities UK equities Japan equities Europe Ex-UK equities Asia Pacific Ex-Japan Emerging Market UK Property Global Property Commodities Equally weighted average *Year to date 2014 (Jan to end June) Source: Charles Stanley Pan Asset The table below left outlines the expected cost in terms of ongoing charges (annual management fee plus additional fund expenses) of a 100% passive portfolio, based on discounts that a 500m pension scheme would be able to command. The funds are a combination of pension scheme-only life funds, other unit trusts and Exchange Traded Funds, taken from Charles Stanley Pan Asset s recommended list of passive funds. When monitoring passive funds, one of the key metrics which Charles Stanley Pan Asset follows is the Tracking Difference which is the relative performance (net return minus the index return) of the fund. The Ongoing Charge is a useful guide to the running costs to expect in a fund but it is not the real cost an investor pays. The real cost is the Tracking Difference. Particularly good passive funds will have a lower Tracking Difference than their Ongoing Charge. As the table illustrates, the running cost of this portfolio of passive funds is low: 0.20%. But the actual cost in terms of the Tracking Difference is lower still: just 0.05% for the first half 2014, implying the total cost for the year would be 0.10% if this performance is maintained. This is an extremely efficient portfolio. 6

8 The Case for a Passive Fund Premium Data Analysis Methodology in detail Charles Stanley Pan Asset s research team studied a universe of actively managed funds across 14 asset classes sourced from independent database FE Analytics. All funds were available to UK pension funds. Only active funds with 5 year track records were considered. Total return performance net of fees for institutional share classes in sterling for each of the 554 actively managed funds was considered over 1, 3, and 5 years and compared to the equivalent total return of the benchmark tracked by each active fund. This figure is the fund s relative return. In total more than 60 different indices were used across the 14 asset classes. The relative returns of each of the 554 active funds researched was used to calculate a median relative return in each asset class. This relative return was compared to the relative return of a passive fund monitored by Charles Stanley Pan Asset s in-house passive fund research team, which tracks more than 300 passive funds across more than 30 data points. Passive funds used in the study include standard institutional class passive funds, pension-fund only life funds and single share class Exchange Traded Funds. The relative return of the passive funds was calculated in an identical manner to that used for active funds. By comparing the relative return of the median active fund and the passive fund in each asset class, Charles Stanley Pan Asset has calculated the Passive Fund Premium (or Discount); ie the return above that of active funds in each case, and overall. The findings of this study are then compared below to those in The Governance Revolution in 2013, which followed the same methodology. Passive Fund Premium over five years (2014 & 2013 datasets) analysis 2013 analysis 15 % Average Average Relative Performance Overall Emerging Market Bonds Global Property Global Bonds US UK Property Asia Pacific Ex-japan All Gilts Index- Linked Gilts Emerging Market UK Corporate Bonds Commodities Europe Ex-UK UK Japan Source: FE Analytics / Charles Stanley Pan Asset The table above illustrates the Passive Fund Premium in each asset class, comparing data covering the five years to June 2013 (light blue) with five years to April 2014 (dark purple). While the premium has reduced in some asset classes with the more recent data set including US equities, UK equities and Japanese equities in others it has increased, notably Global and Emerging Market Bonds. The average has fallen from 6.5% to 4.7%. 7

9 Relative 5-year returns (%) Average UK Property Emerging Market Bonds Global Property Commodities Emerging Market UK Corporate Bonds Japan 2.95 US All Gilts Index-Llinked Gilts UK Asia Pacific Ex-Japan Europe Ex-UK Global Bonds Passive Fund Active Funds Source: FE Analytics / Charles Stanley Pan Asset The table above depicts the relative returns of active and passive funds in each asset class over 5 years. On average, passive funds underperformed their index by 1.9%, active funds by 6.6%, to the end of April Relative returns over five years of the full universe of 568 funds % 0-50 Median active fund -3% Median passive fund -0.6% Passive funds Active funds -100 Source: FE Analytics / Charles Stanley Pan Asset The table above depicts the relative returns over five years of the full universe of 568 funds included in this research. The active funds are in purple, the passive funds in green. The majority of passive funds are within the range of 0.67% to -4.75% with the median at -0.6%. The best performing active fund is 121%, the worst -84%, with the median significantly below zero at -3.04%. 8

10 Relative performance Active: median performance of all actively managed funds in this sector in GBP, institutional share class, to 30/4/2014 Passive: performance of a typical passive fund monitored by Charles Stanley Pan Asset, total return net of institutional fees, to 30/4/ year 3 year 5 year Uk Corporate Bonds Passive Active Difference Global Bonds Passive Active Difference Index-Linked Gilts Passive Active Difference All Gilts Passive Active Difference Emerging Market Bonds Passive Active Difference US Passive Active Difference UK Passive Active Difference Japan Passive Active Difference Europe Ex Uk Passive Active Difference Asia Pacific Ex-Japan Passive Active Difference Emerging Market Passive Active Difference UK Property Passive Active Difference Global Property Passive Active Difference Commodities Passive Active Difference Average relative performance Passive Active Difference

11 The Charles Stanley Pan Asset approach As a fiduciary and multi-asset investment manager working with defined benefit pension schemes in the UK since 2009, Charles Stanley Pan Asset has always preferred to use passive funds to access individual asset classes rather than actively managed funds. Most Charles Stanley Pan Asset client portfolios invest 100 per cent in passive funds across all global asset classes. The findings of this study demonstrate why this principle is so important. As a fiduciary manager investing across all asset classes, Charles Stanley Pan Asset is able to construct highly diversified portfolios of growth (return-seeking) and defensive (matching) assets at significantly lower cost than is possible using active funds. As this study demonstrates, lower costs typically deliver higher returns. By combining our market-leading expertise in passive fund research and selection with the dynamic asset allocation skills of Charles Stanley Pan Asset s investment committee (which has a combined experience of more than 115 years) clients benefit from highly efficient portfolio construction and robust risk management. The results have been a significant performance improvement compared with the returns to be gained from a static portfolio of active funds or that of other dynamic multi-asset strategies which run higher costs through the use of active funds, as the chart below demonstrates. Performance of a typical Charles Stanley Pan Asset dynamically managed passive fiduciary portfolio compared with a peer group of multi-asset funds used by UK-based defined benefit pension schemes Fiduciary Portfolio DGF Peer Group 10

12 Cutting Risk. Cutting cost. Keeping it Simple To find out more, or discuss how we might be able to help please contact: Bob Campion +44 (0) Visit our dedicated pensions microsite: Charles Stanley Pan Asset Capital Management Limited 131 Finsbury Pavement, London EC2A 1NT Tel Fax Twitter: Follow Disclaimer: This document is provided for information and discussion purposes only and does not constitute an offer to sell or a solicitation of an offer to purchase any security or any other investment or product. This document is intended for authorised recipients only and must be held strictly confidential. This document may not be reproduced or distributed in any format without the express written approval of Charles Stanley Pan Asset Capital Management Limited. The value of investments and the income from them can go down as well as up and you may not recover the amount of your original investment. Past performance is not necessarily a good indication of likely future performance. Charles Stanley Pan Asset Capital Management Limited is authorised and regulated by the Financial Conduct Authority.