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XII No.11 - Sunday June 2 - Saturday June 15, 2013


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Graham Macdonald, MBE MBMG International Ltd.
Nominated for the Lorenzo Natali Prize

 

Passive V Active - Which is healthy for you? Part 1

Traditionally, investors have appointed investment managers to (actively) manage their exposure to asset classes - their asset allocation - and individual assets within each asset class - asset selection. Fund managers charge a fee for their service of constructing portfolios for their investors - either at the asset class or individual asset level, or both. In return for this they try to outperform their benchmarks. In the case of asset selection it would be something like the FTSE, MSCI or S&P500. They do this by identifying assets (shares in this case) that will outperform the combination of assets that make up the benchmark. Fund managers’ value proposition is that their skill in selecting assets (or asset classes) produces sufficient out-performance against the relevant benchmark to justify their fee.
Passive products differ from active products in two key ways. Firstly, individual assets are selected on a mechanical basis; and secondly their fees are significantly lower. The first generation of passive products was designed to replicate the returns of benchmarks such as the aforementioned. The range of these products has been broadened to include index tracking funds covering specialised indices that concentrate on a particular sector, e.g. commodities or technology, etc.
Other, more recent versions try to improve on this in systematic (i.e. mechanical) ways. Some use different measures to market capitalisation (the way the FTSE, etc., is constructed) to build their portfolios. The latest evolution in the passive space includes the so-called ‘Smart Beta’ products. They use pre-determined (i.e. mechanical) investment strategies to give investors consistent exposure to a particular investment style or outcome. Examples include value and momentum style portfolios and risk managed portfolios such as the minimum volatility (min-vol) product. These products all construct their portfolios using a fixed methodology or set of rules.
The ‘style’ funds such as value and momentum products systematically identify the presence of these ‘factors’ and construct portfolios of equities which embody them. In the case of the min-vol portfolios, they are constructed in such a way as to minimise the volatility of the returns of the portfolio using average historical returns and variance/co-variance matrices. As with all passive products the fees are low as the ‘recipe’ is fixed and the portfolio manager merely oversees its application.
Passive products have been around for a while in their various guises but it is only recently that they are getting more widely used in the many more markets. Why the delay? We believe that most investors tend to view them as direct alternatives, or substitutes, to the traditional active funds. If it is framed in this way, the debate immediately becomes one of ‘either/or’ - in other words: which approach is better than the other?
Comparisons are most often then made between the lower fees of the passive funds vs. the (often temporary) out-performance of the active managers. Somehow the idea of buying consistently average performance is not that exciting - even when it’s very cheap! However, as customers become more familiar with the concept of passive products and their relative advantages they are beginning to choose them more often. The relatively low returns environment offshore has also pushed investors there into using the cheaper passive investments to save on the negative impact of costs on their (already low) returns.
A more productive perspective is to view these two investment approaches as complementary to other - they can both play different, but equally important, roles in a portfolio. Passive products allow us to get very precisely targeted, consistent exposures to asset classes and investment strategies at a relatively cheap price.
We value this highly, given the importance of asset allocation in our investment process. The more recent developments in this field, such as the Smart-Beta products, allow us to get consistent exposure to investment strategies that were previously only available via active managers (e.g. value, momentum or high yielding equities). Furthermore we had to hope that active managers would implement these strategies consistently - in other words, there was no style drift. Now we can be certain of this outcome if we go the Smart-Beta route.
To be continued…

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]


How to choose a fund - Part 5

One of the most confusing parts to funds can be the charges you pay and who you are paying that money to. There is also the issue that not all funds or advisers charge the same. Obviously though, whatever the cost these charges are going to affect the overall performance of the fund so they must be accounted for when calculating what your risk/reward ratio is.
As stated above, charges come in many guises. Let’s look at some of the more common ones:
- Annual Management Charge (AMC): This is charged to cover ongoing costs, such as up to date analysis, and will be deducted from your investment either annually or quarterly.
- Initial Charge: This is a one off cost charged by many funds as an ‘entry’ fee. The purpose is to cover set-up costs and can apply to both open and closed end funds although Exchange Traded Funds do not use them.
- Administration Fee: This will also be charged on a regular basis and is self-explanatory.
- Policy Fee: Is another word for administration charge and usually only refers to policies which have regular payments.
- Investment Administration Charge: Will be charged on a percentage basis for regular premiums and as a one off for lump sums. This is when any buy/sell/fund switches are done.
- Early Surrender: Can be applied if the policy is closed in toto before an agreed period of time which should have been explained to you before you started any investment.
- Performance Charge: If a fund reaches a pre-agreed percentage gain then any further gains can be subject to a performance fee.
- Adviser Fee: Your financial adviser will also charge a fee if you wish him or her to actively manage your portfolio.
So what now? You have done all your due diligence, you have selected the funds appropriate to your risk reward ratio and you want to start investing. How? Well, you can either invest directly into funds or use a life company as an umbrella. As with all things, there are pros and cons to both.
If you are only looking for short term gains with the funds you invest in then do not bother with life companies as the charging structure over the short term can be prohibitive and you may well have to pay early surrender charges. However, if you are looking beyond five years, and preferably longer, then some life companies’ products can help a lot as you will be buying at institutional rates and not retail ones. Also, your charges, after a certain period of time, make the overall cost of running the portfolio considerably cheaper than investing directly over the same period of time.
Caveat emptor though! Some life companies will charge high annual management costs in perpetuity. Over 20 to 30 years this can add up to be a lot of money. Others though will not and after anything between five and ten years will drop their charges to very little at all.
There are other benefits to a life company. For a start, the ease of administration as you only have to refer to one place to see how you are performing and not a load different places. Also, if you want to buy a new fund then you ‘borrow’ from the life company so you can buy when you want and not have to wait, like you would with dealing directly, until the original fund was sold. Once the original fund has been sold then the life company can be repaid. This also applies to investment trusts, ETFs, direct stocks and shares - all of which can be included in a life company Personal Portfolio Bond.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]

 


 
HEADLINES [click on headline to view story]

Passive V Active - Which is healthy for you? Part 1

How to choose a fund - Part 5
 

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