A differentiated approach to asset allocation and product selection
Travis Morien
Compass Planners Pty Ltd
http://www.travismorien.com
Tribeca Targeting High Net Worth Investors Conference25th and 26th October 2004, Four Seasons Hotel Sydney
Active vs. passive investing
Pictures by Vanguard Investments
“Properly measured, the average actively managed dollar must under-perform the average passively managed dollar, net of costs”
(Bill Sharpe)
Pre-fees:
-4% +4%
Distribution of Manager Returns vs. Benchmark
Source: “Arithmetic of Active Management”, Financial Analyst Journal, Jan 91.
Average = 0% Average = -1%
-5% +3%
Post-fees:
Good Managers
Percentage of active funds underperforming their benchmark index after fees in the 5 years to 31 March 2004
51.0% 52.0%75.0% 76.0%
100.0%
0%20%40%60%80%
100%
Aus shares Intl shares Aus listedproperty
Aus bonds Aus cash
Underperforming OutperformingSource: Mercer/Morningstar IDPS Survey
Number of Australian Share managers outperforming the S&PASX300 Index, post fees (12 months to 31 July) and value minus growth returns
12 18 22 3354
28 21 28
10 7 8 12 16 5
43 56 58
35
-80
-60
-40
-20
0
20
40
60
1996 1997 1998 1999 2000 2001 2002 2003 2004
Above Index Below Index
Top chart source: Mercer/Morningstar IDPS Survey Bottom chart source: Dimensional Fund Advisors
Citigroup BMI Value - Citigroup BMI Growth
-15-10
-505
10152025
Value outperforms
Growth outperforms
Every US large cap fund with a 15 year history vs the S&P500 and CRSP 1-10 indexes. 15 Years ending 31 December 2001 (285 Funds)
Graphic by Dimensional Fund Advisors
3 years 5 years 7 years
Australian shares 0.77% 0.25% 0.41%Global shares 0.79% 0.39% 0.66%Fixed interest 0.09% 0.20% 0.19%Balanced pooled funds 0.52% 0.22% 0.20%
Source: Russel Investment Group, periods ending 30 June 2004, “Insights” IN107.
Survivorship bias: amount median prices are overstated per year
Source: PM Capital
"Investors continue to sour on stocks. So far this year, investors have made net withdrawals of $11.3 billion from their stock mutual funds
according—including a hefty $3.7 billion just last week—according to AMG Data Services.” Source: Gregory Zuckerman, "Investors Rush to
Buy Bonds, Fleeing Stocks," Wall Street Journal, March 11, 2003
S&P500 index 2000 - 2003
750850950
105011501250135014501550
1/01
/00
1/04
/00
1/07
/00
1/10
/00
1/01
/01
1/04
/01
1/07
/01
1/10
/01
1/01
/02
1/04
/02
1/07
/02
1/10
/02
1/01
/03
1/04
/03
1/07
/03
1/10
/03
S&P500 data source: http://finance.yahoo.com
Annual returns of “buy and hold” index vs actual annual returns enjoyed by US mutual fund investors
from 1984 to 2002
12.22%
2.57%
11.70%
4.24%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
US Stocks US Bonds
Index Mutual fund investor
Source: DALBAR, Inc. Media release of 2003 update of “Quantitative Analysis of Investor Behaviour” study.
The diverse world of passive investing
• Traditional index funds (BGI, Vanguard) • Enhanced index funds (BGI, Macquarie)• Exchange traded funds (Streettracks)• “Style indexed” funds (Vanguard ASHY)• Asset class funds (Dimensional)
Beating the market - passively
Fama and French’s Three Factor Model
Graphic by Dimensional Fund Advisors
11.99%
10.37%9.60%
14.92%
13.26%
9.56%
0.00%2.00%4.00%6.00%8.00%
10.00%12.00%14.00%16.00%
Large Small
Value Neutral Growth
Fama/French indexes on the US marketAnnualised returns July 1926 – August 2004
Source: Dimensional Fund AdvisorsFigures do not include fees, taxes or other costs and past performance may not be indicative of future results.
10 year rolling returns US large cap value, neutral and growth, July 1926 to August 2004
-15.00%-10.00%
-5.00%0.00%5.00%
10.00%15.00%20.00%25.00%30.00%
Jul-3
6
Jul-4
2
Jul-4
8
Jul-5
4
Jul-6
0
Jul-6
6
Jul-7
2
Jul-7
8
Jul-8
4
Jul-9
0
Jul-9
6
Jul-0
2
F/F Lrg Val F/F Lrg Ntl F/F Lrg Gro
10 year rolling returns US small cap value, neutral and growth, July 1926 to August 2004
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%Ju
l-36
Jul-4
2
Jul-4
8
Jul-5
4
Jul-6
0
Jul-6
6
Jul-7
2
Jul-7
8
Jul-8
4
Jul-9
0
Jul-9
6
Jul-0
2
F/F Sml Val F/F Sml Ntl F/F Sml Gro
Historical drawdown US large caps
0.00%
20.00%
40.00%
60.00%
80.00%
100.00%
Jul-2
6
Jul-3
2
Jul-3
8
Jul-4
4
Jul-5
0
Jul-5
6
Jul-6
2
Jul-6
8
Jul-7
4
Jul-8
0
Jul-8
6
Jul-9
2
Jul-9
8
Jul-0
4
F/F Lrg Val F/F Lrg Ntl F/F Lrg Gro
Historical drawdown US small caps
0.00%
20.00%
40.00%
60.00%
80.00%
100.00%
Jul-2
6
Jul-3
3
Jul-4
0
Jul-4
7
Jul-5
4
Jul-6
1
Jul-6
8
Jul-7
5
Jul-8
2
Jul-8
9
Jul-9
6
Jul-0
3
F/F Sml Val F/F Sml Ntl F/F Sml Gro
GROWTH OF DOLLAR (LOG PLOT)
Global Value Gross A$
Global Lge Gross A$
Global Small Gross A$
Valu
e of
Dol
lar
Time Periods: 1/80 to 9/04
0.1
1
10
100
12/79 1/83 2/86 3/89 4/92 5/95 6/98 7/01 8/04 9/07
Source: Dimensional Fund Advisors
Global value 17.75%pa
Global small 16.06%pa
Global large 13.78%pa
Figures do not include fees, taxes or other costs and past performance may not be indicative of future results.
GROWTH OF DOLLAR (LOG PLOT)
Aust Value Gross A$
Aust Large Gross A$
Aust Small Gross A$
Valu
e of
Dol
lar
Time Periods: 1/80 to 9/04
0.1
1
10
100
12/79 1/83 2/86 3/89 4/92 5/95 6/98 7/01 8/04 9/07
Source: Dimensional Fund Advisors
Australian value 19.97%pa
Australian large 13.02%pa
Australian small 12.06%pa
Figures do not include fees, taxes or other costs and past performance may not be indicative of future results.
Industry follows academia
GROWTH OF DOLLAR (LOG PLOT)
MSCI World Index A$
MSCI Emerg Mkts Free A$
Valu
e of
Dol
lar
Time Periods: 1/88 to 9/04
0.3
8
1
12/87 1/90 2/92 3/94 4/96 5/98 6/00 7/02 8/04 9/06
Emerging markets vs. MSCI world
7.00%
8.00%
9.00%
10.00%
11.00%
12.00%
13.00%
4.00% 4.50% 5.00% 5.50% 6.00% 6.50% 7.00%
Monthly standard deviation
Annu
alis
ed re
turn
0%
10%
100%
50%
20%
30%
40%
60%
70%80%
90%
Adding emerging markets to an international shares portfolio
MSCI World Index + MSCI Emerging Markets Free Index, January 1988 to September 2004
Percentage emerging markets
Choosing active funds
What do we want from active funds?
• Active funds potentially can have higher performance
• Passive funds are not available for all asset classes
• Perhaps something very different to the index for diversification
Core/Satellite Approach
Sector Index Funds: Tailor strategic allocation Increase index core where
confidence in active is low
Active “Satellite” Index Core
Property
Fixed Interest
Cash
Australian Shares
International Shares
Graphic by Vanguard Investments
80% x 0.286%pa + 20% x 6.356%pa = 1.5%pa
Wholesale index MER + aggressive fund MER = low tracking error MER
The cost of active management from a low tracking error manager
1.0%
3.0%
5.0%
7.0%
9.0%
11.0%
13.0%
Nov 1987 Feb 1989 May 1990 Aug 1991 Nov 1992 Feb 1994 May 1995 Aug 1996 Nov 1997 Feb 1999 May 2000 Aug 2001 Nov 2002 Feb 2004
Tra
ckin
g E
rror
(%pa
)
1 Year Rolling Tracking Error
Tracking Error in Australian Shares Specialist from Nov 1987 to Aug 2004Median versus ASX-300 (before tax and before fees)
Median
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
Feb 1986 Jun 1987 Oct 1988 Feb 1990 Jun 1991 Oct 1992 Feb 1994 Jun 1995 Oct 1996 Feb 1998 Jun 1999 Oct 2000 Feb 2002 Jun 2003
Tra
ckin
g E
rror
(%pa
)
1 Year Rolling Tracking Error
Tracking Error in Overseas Shares Specialist from Feb 1986 to Aug 2004Median versus MSCI (before tax and before fees)
Median
“The whole concept of dividing it up into "value" and "growth" strikes me as twaddle. It's convenient for a bunch of pension fund consultants to get fees prattling about and a way for one advisor to distinguish himself from another. But, to me, all intelligent investing is value investing.”
Charlie Munger
Growth ValueValue
Perpetual, MBA, Dimensional
GARP
BT, ING
Relative Value
Lazard
Growth
Colonial FS, Credit Suisse
Neutral
UBS
Indexed
Vanguard
The Style Universe
Graphic by Vanguard Investments
Tax efficiency• Income/growth and franking credits• Turnover• Tax loss selling• Hold range• Short vs. long term CG realisations• Tax liability on existing portfolio• Consider your turnover as well, how often will you
switch an active manager compared to a passive one.
Vanguard is now reporting after tax returns, Morningstar will start tracking them from next year.
Capacity issues
• Market size (large cap vs. small, domestic vs. international)
• Portfolio turnover• Contrarian vs. momentum• Active positions/index weightings (tracking
error)• Large size offset by possible new
opportunities and market clout.
Why does turnover matter?
• Ruins tax efficiency• Increases brokerage and market impact
costs, making it increasingly difficult to outperform as the portfolio gets larger.
• According to a US researcher, the Plexus Group, managed funds incur costs of around 0.8% on each side of a transaction. It costs about 1.6% round trip to buy and sell a stock.
Key person risk
• Skill vs. process• Incentive structure• Institution vs. boutique• Staff equity ownership• Eating their own cooking
Suggestion for picking active funds1. Avoid “index huggers” that charge a full active MER.
Funds with concentrated high conviction portfolios may actually represent better value on a price per active position basis.
2. Avoid tax inefficient funds for investors on high tax rates. The tax inefficiency penalty can cost several percentage points per year. If you must use inefficient funds, use super.
3. Avoid “growth at an unreasonable price” funds and funds with excessive turnover. Seek out funds with a value philosophy, but not necessarily funds pigeonholed into a “value” classification.
4. Look for fund managers with a performance culture rather than a FUM gathering culture that adequately reward their key staff.
Asset allocation and risk management
"The essence of risk management lies in maximising the areas where we have some control over the outcome while minimising the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us."
Peter Bernstein
Bernstein, P. L. Against the Gods: The Remarkable Story of Risk. Wiley;
New Ed edition (1998)
“The determining question in structuring a portfolio is the consequence of loss; this is far more important than the chance of loss."
Peter Bernstein
Bernstein, P. L. Management of Individual Portfolios. The Financial Analysts Handbook; Levine, S. Ed.; Dow Jones Irwin Inc: Homewood Il, 1975.
• Risk is the probability of not having sufficient cash with which to buy something important.
• Risk is a function of a portfolio's assets and its liabilities, in particular the cash flow between the two over time.
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
$8,000D
ec-1
979
Dec
-198
0D
ec-1
981
Dec
-198
2D
ec-1
983
Dec
-198
4D
ec-1
985
Dec
-198
6D
ec-1
987
Dec
-198
8D
ec-1
989
Dec
-199
0D
ec-1
991
Dec
-199
2D
ec-1
993
Dec
-199
4D
ec-1
995
Dec
-199
6D
ec-1
997
Dec
-199
8D
ec-1
999
Dec
-200
0D
ec-2
001
Dec
-200
2D
ec-2
003
Capi
tal v
alue
$0.00
$50.00
$100.00
$150.00
$200.00
$250.00
$300.00
Annu
al in
com
e
Shares capital Cash capital Dividends Cash interest CPI Inflation
Source: Reserve Bank of Australia
Dividends vs. interest, ASX200 index vs. treasury bills
Income planning for pensions• Dividends are fairly reliable for diversified
portfolios• We can’t eliminate capital volatility but we can
make it less relevant through portfolio structuring.• Fund near term capital withdrawals with cash, if
you aren’t drawing down on shares then share market volatility is sidestepped.
• This turns asset allocation into a mere budgeting exercise! Put aside enough cash to cover the dividend shortfalls and you’ll reduce your need to sell shares.
Evolving asset allocation during the accumulation phase
$0.00
$200,000.00
$400,000.00
$600,000.00
$800,000.00
$1,000,000.00
$1,200,000.00
0 1 2 3 4 5 6 7 8 910 11 12 13 14 15 16 17 18 19 20
Growth assets Medium risk assets Low risk assets
Three dimensions of risk profiling
• Tolerance of loss • Timing of cash flows (time frame)• Tolerance of tracking error,
unconventionality and complexity
GROWTH OF DOLLAR (LOG PLOT)
Large Portfolio
Tilted Portfolio
Valu
e of
Dol
lar
Time Periods: 1/80 to 9/04
1
10
100
12/79 1/83 2/86 3/89 4/92 5/95 6/98 7/01 8/04 9/07
Large Tilted
Annualised Return %pa
14.01 16.36
Total Cumulative Return %
2468 4150
Monthly Standard Deviation %
4.19 3.92
Monthly Average Return %
1.19 1.35
Annualised Standard Deviation %
14.50 13.59
20% Australian large
20% Australian value
10% Australian small
20% global large
20% global value
10% global small
50% Australian large
50% global large
Source: Dimensional Fund Advisors
Portfolio drawdown (maximum loss)
Source: Dimensional Fund Advisors
0.00%5.00%
10.00%15.00%20.00%25.00%30.00%35.00%
Jan-
80
Jan-
82
Jan-
84
Jan-
86
Jan-
88
Jan-
90
Jan-
92
Jan-
94
Jan-
96
Jan-
98
Jan-
00
Jan-
02
Jan-
04
Large Tilted
Disclaimer:This article contains the opinions of the author but not necessarily the author’s employer or any of the individuals or companies mentioned in this presentation, and do not represent a personal recommendation of any particular security, strategy or investment product. The author's opinions are subject to change without notice.
Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
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