Download Enhanced practice management

Enhanced practice management:
The case for combining active
and passive strategies
IRA insights
n O
ne implication of the
Vanguard research note | April 2014
n T
his “client risk” exists
transition toward a fee-based
practice model is that “client
risk” (for an advisor’s practice)
may increase if clients decide
to pull assets or terminate
a relationship because
of a mutual fund’s
underperformance versus
common market indexes.
because it is often shortto intermediate-term
performance that can make
or break an account, even
if the client is positioned
as a long-term investor.
For advisors who have elected to use active management,
either on their own via security selection or through
professionally managed funds, one hurdle is that
outperformance is difficult to achieve (Philips etal., 2014).
Figure 1 demonstrates two challenges of picking actively
managed funds. First, in each five-year period that we
evaluated, the median fund underperformed its prospectus
benchmark by more than 50 basis points (bps) annually.
Looked at in a different way, in each period, more than
50% of the funds failed to deliver on their objective
n Mitigation
of this client risk
is a frequently overlooked
benefit of adding broadbased passively managed
investments—that is, index
funds or exchange-traded
funds (ETFs)—to a portfolio
primarily comprising actively
managed funds.
of outper­formance. Second, the performance spread
between the top 5% and bottom 5% of funds was
more than 8 percentage points annually. This degree
of dispersion can lead to client risk, as we discuss on
the next page.
Complicating this is that over the full ten-year period,
nearly 45% of all funds that were alive on January 1,
2004, were liquidated or merged at some point before
December 31, 2013.
Figure 1. Advisors and their clients face a wide distribution of potential outcomes when using active management
6%
4.68%
4
3.56%
95th percentile
2
0
–0.52%
–0.69%
Median
–2
–4
–6
Key:
–4.75%
–4.51%
5th percentile
2004–2008
2009–2013
Notes: Chart includes all diversified active U.S. equity funds. Excess returns are measured relative to a fund’s stated benchmark. Results in each period reflect only those funds that survived
the full five years.
Sources: The Vanguard Group, Inc. (“Vanguard’) and Morningstar, Inc.
Indexing can help alleviate this asymmetry by truncating
the risk of unwise investor behaviour and negative
feedback loops for the advisor’s practice.
As Figure 2 shows, the risk to an advisor’s practice
when using active funds exclusively is that in volatile
markets and uncertain times, underperformance can
lead to an elevated risk of clients leaving one’s practice.
We submit that this risk is larger than can be offset
by positive client referrals during the good times.
Moreover, adding a slice of passively managed funds
or ETFs can help free up resources typically spent on
manager research and oversight. These resources can
then be redirected toward improving relationships with
existing clients or attracting new clients.
That is, although the upside of outperformance may
be a marginally greater share of wallet or referrals,
underperformance can lead to a client’s questioning
of the strategy or withdrawing of assets—plus
nonexistent referrals.
Figure 2. Adding passive funds to a portfolio can shrink performance distribution around the market,
reducing flight risk: A theoretical example
Reduced risk of losing clients:
Portfolio comprises both
active and passive funds.
Benchmark/market return
Benchmark/
market return
Elevated risk of losing clients:
Portfolio comprises active funds only.
Portfolio’s periodic returns
Source: Vanguard.
2
Also, only 24% (289) of the funds that were top performers
over the first five years even managed to outperform over
the next five years, while a sparse 7.5% (90) turned in
what we would call “significant” results of more than
2% annual outperformance.
Figures 3a and 3b demonstrate the implications of
dispersion among fund performance and the cyclicality
of outperformance. For this example, we ranked all funds
over the first five-year period shown in Figure 1, then
selected the top 20% of funds. We then tracked the
performance of those top funds over the next five-year
period (ended 2013). Figure 3a shows the results of that
exercise. It is interesting that although these funds were
the top performers over the first period, their performance
did not persist, and instead formed a distribution similar
to our theoretical example in Figure 2.
On the other hand, 33% (395 funds—see Figure 3a)
realized “significant” underperformance of –2% or more
annually, while another 169 funds were liquidated/
merged at some point between 2009 and 2013.1
Figure 3. From theory to practice
a. Distribution of excess returns over five years ended 2013 for funds that ranked in top quintile as of 2008
400
Number of funds
350
300
395 funds
250
200
150
100
>10
9 to 10
8 to 9
7 to 8
6 to 7
5 to 6
4 to 5
3 to 4
2 to 3
1 to 2
0 to 1
–1 to –0
–2 to –1
–3 to –2
–4 to –3
–5 to –4
–6 to –5
–7 to –6
–8 to –7
–9 to –8
–10 to –9
<–10
0
Dead
50
Annualized excess returns (%) versus stated benchmark
b. Same distribution but adding 50% allocation to each fund’s style benchmark (10-bp annual haircut to benchmark returns)
400
Number of funds
350
300
161 funds
250
200
150
100
>10
9 to 10
8 to 9
7 to 8
6 to 7
5 to 6
4 to 5
3 to 4
2 to 3
1 to 2
0 to 1
–1 to –0
–2 to –1
–3 to –2
–4 to –3
–5 to –4
–6 to –5
–7 to –6
–8 to –7
–9 to –8
–10 to –9
<–10
0
Dead
50
Annualized excess returns (%) versus stated benchmark
Notes: Figure 3a includes all diversified U.S. equity funds that ranked in the top quintile for the five years ended 2008. Figure 3b includes the same funds as Figure 3a, but combines each
fund with a passive index matching the fund’s investment style in a 50/50 ratio. To reflect implementation expenses, the index returns are reduced by 10 bps annually. Excess returns are
measured relative to a fund’s stated benchmark. Data reflect excess returns over the period 2009–2013 for the 1,205 funds in the top quintile from 2004 through 2008.
Sources: Vanguard and Morningstar, Inc.
1 For more on the performance of funds that were merged or liquidated, see Schlanger and Philips (2013).
3
The impact on a portfolio of adding a diversified passive
index fund or ETF is notable. Figure 3b uses the same
funds as Figure 3a, but adds a 50% allocation to a
benchmark matching the funds’ investment style.
To reflect implementation expenses, we reduced the
benchmark returns by 10 bps annually. Practically
speaking, similar results can be achieved by using a
broad-market index fund to help control relative risk
in the aggregate portfolio.
Mitigating such significant underperformance can be
critical to successful long-term client relationships.
The advisor who uses passively managed products
may be better able to shift client conversations from the
sometimes difficult topic of investment performance to
estate and family wealth planning, which are not subject
to the risks of the market. These services can be a more
reliable base upon which to build an enduring practice.
First, as would be expected, the active/passive portfolio
produced lower positive excess returns (22% of funds,
or 265 funds, continued to outperform).
References
However, perhaps more important, the active/passive
portfolio also reduced relative downside risk. The number
of significant underperformers was reduced to 161, or
13% of the available funds (versus 33% for the primarily
active portfolio in Figure 3a).
Philips, Christopher B., Francis M. Kinniry Jr., Todd Schlanger,
and Joshua M. Hirt, 2014. The Case for Index-Fund Investing.
Valley Forge, Pa.: The Vanguard Group.
Schlanger, Todd, and Christopher B. Philips, 2013. The Mutual
Fund Graveyard: An Analysis of Dead Funds. Valley Forge Pa.:
The Vanguard Group.
Connect with Vanguard™ > vanguardcanada.ca
Vanguard research authors
Christopher B. Philips, CFA
Francis M. Kinniry Jr., CFA
Todd Schlanger, CFA
Vanguard Investments Canada Inc. issues this report to Financial Advisors and Institutional Investors for informational and educational
purposes only. This report does not necessarily represent any product or service by Vanguard Investments Canada Inc. It should be noted that
certain information is written in the context of the U.S. market and contain data and analysis specific to the U.S. This document was originally
published by Vanguard Investment Strategy Group (“ISG”)—a business unit of The Vanguard Group, Inc. in November 2013. ISG publishes
proprietary research on a variety of investment, economic and portfolio management issues. The first date of use by Vanguard Investments
Canada Inc. is May 2014.
Commissions, management fees and expenses all may be associated with the Vanguard
ETFs™. This offering is made only by prospectus. Investment objectives, risks, fees,
expenses, and other important information are contained in the prospectus; read it
before investing. Copies are available at www.vanguardcanada.ca. ETFs are not
guaranteed, their values change frequently, and past performance may not be repeated.
The views and opinions of the individual strategists are as of the original publication date, are subject to change and may not necessarily
represent the views of The Vanguard Group Inc.’s portfolio management teams and/or Vanguard Investments Canada Inc. While this
information has been compiled from sources believed to be reliable, Vanguard Investments Canada Inc. does not guarantee the accuracy,
completeness, timeliness or reliability of this information or any results from its use.
No implied or express recommendation, offer, or solicitation to buy or sell any ETFs or to adopt any particular investment or portfolio strategy is
made in this material. This report is not investment and/or tax advice and it is not tailored to the needs or circumstances of individual investors.
The case studies and examples in this report are summarized for illustrative purposes only. These case studies and examples do not depict
actual performance, are calculated with the benefit of hindsight, and may not take into account material quantitative and qualitative factors
that would impact an investor’s investment decisions. The performance of a fund group average is not an exact representation of any particular
investment as you cannot invest directly in a fund group average. The performance of the fund group average reflects the reinvestment of
distributions and dividends but does not take into account sales, redemption, distribution or optional charges or income taxes payable by
any unitholder that would have reduced returns.
The information contained in this publication does not constitute an offer or solicitation and may not be treated as an offer or solicitation in
any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation,
or if the person making the offer or solicitation is not qualified to do so.
© 2014 Vanguard Investments Canada Inc.
All rights reserved
ICREPMC 042014