It has been known for decades that active fund managers general underperform their benchmarks. Eugene Fama penned the Efficient Market Hypothesis in the 60’s proving this and there has been numerous others who have throughout the years. In very recent times, Warren Buffet made waves this weekend with his harsh criticism of Wall Street and how investors have paid more than $100 billion needlessly in fees over the year. Also, every six months S&P publishes their SPIVA report which shows this happening in practice – ‘over the five-year period, 91.91% of US large-cap (active) managers…lagged their respective benchmarks’.
After decades of poor performance and high fees, investors are finally voting with their feet and moving to lower cost and more passive. Notably, three fund companies have seen their assets under management swell in the past 5 years and have recorded positive fund inflows in each of those years. These companies of course are Blackrock (iShares), Vanguard and Dimensional Fund Advisors who are all providers of low cost, tax efficient ‘asset class’ funds. This does not mean that Vanguard index funds or iShares ETF will perform exactly in line with their benchmark and we don’t expect them to. We would expect these investments to perform in line with their benchmark, minus their Total Expenses Ratio, the Reconstitution Effect and other trading cost/friction such as bid/offer spreads that are typical in index funds and ETFs. These costs tend to be higher in emerging markets than in developed markets and you see it show up in the figures.
For example, for the five years ending December 31, 2016 the iShare MSCI Emerging Market Index which has a TER of 0.72% was up 0.48% annually underperforming its index by 0.80% annually – almost exactly as expected. Vanguard FTSE Emerging Market ETF was up 1.45% annually and unperformed its (different) benchmark by 0.16% annually – its TER is 0.15%. So, as you can see, it is hard, maybe impossible to always achieve benchmark returns because there are costs to run and manage Asset Class funds.
At MASECO we have been investing in Asset Class funds for all equity investments and some fixed income investments since our inception in 2008. In fixed income, however, the record of active managers in some asset classes has been enviable. For example, we have been investing client assets in the Templeton Global Bond fund since our time at Citigroup. As our long-term investors know, this fund is volatile but also outperforms the Citigroup World Government Bond Index on a 1, 3, 5 and 10-year time frame. Why is this? Simply put, we believe that owning some bond indices may be detrimental to your health. Most of the original government bond indices were created by the big bonds houses as a way to help their brokers sell bonds (more on this another time). The Barclays index was originally the Lehman index, the JPM index originally was the Bear Stearns index and the Citigroup index was the Salomon Brothers index. By definition these indices are market weighted which means if you invest in them, you are buying the most heavily indebted countries in the world. At the moment, this means the US, European countries, Japan and other indebted countries. These countries pay close to zero interest, have increasing debt burdens and have falling credit ratings. As a bond investor why not invest in countries that pay (a little) interest and have manageable debt burdens? This is what Templeton has done and why more that 40% of Global Income funds have outperformed their benchmark.
The final area we have allocated client’s portfolios to over time has been hedge funds in alternative credit (Nolex and the MASECO ACF). Returns have been generous over the past few years and correlation very low with stocks and bonds. Fees, however, have been higher in these investments than any other investments we have made, but I don’t think it is fair to compare alternative credit lender fees with hedge fund manager fees. In alternative credit, the vast majority of the underlying investments are underwritten loans where the ‘manager’ is the underwriter. These are lending businesses that are structured as hedge funds because that is how investors like to invest. Like a bank, most of the underlying ‘managers’ take part of the spread on the capital we invest with them. I believe it is fair for a lender to receive 2,3 or 4% of the invested capital because, unlike running a hedge fund, finding borrowers and underwriting loans is expensive. As the number of loans increases, the more it costs the alternative lender to find, underwrite and service these loans. In a hedge fund, it doesn’t cost a hedge fund manager substantially more if he manages $1 billion in assets or $10 billion.
So, what should an investor do? They should:
>>Focus on their Asset Allocation strategy. This is where the vast majority of the variability of a portfolio’s return comes from.
>>Diversify their portfolio as one of the best way to lose money is in concentrated positions. Many wealth families have seen their fortunes wiped out over the course of two generations due to highly concentrated investments that didn’t work out.
>>Stay disciplined and rebalance when the markets are volatile. Volatility is the friend of the disciplined investor.
>>Be tax efficient as much as possible without hurting your investment portfolio, especially diversification.
>>Like Buffet says, don’t pay mutual fund managers fees needlessly for additional performance they probably will not achieve.
 SPIVA Reports and CRSP from University of Chicago
 Source: Mid-year 2016 SPIVA U.S Scorecard: https://us.spindices.com/documents/spiva/spiva-us-mid-year-2016.pdf
 An asset class fund could be an ETF, index fund or diversified low cost fund that provides an investor with exposure to a specific asset class.
 The total expense ratio, or TER, is a measure of the total cost of a fund to the investor.
 A reevaluation of a market index that involves adding and removing stocks and re-ranking existing stocks so that the index mirrors current market capitalization and style. http://www.investopedia.com/terms/r/reconstitution.asp
 Citigroup World Government Bond Index
 Source: Mid-year 2016 SPIVA U.S Scorecard page 13: https://us.spindices.com/documents/spiva/spiva-us-mid-year-2016.pdf