SMSFundamentals | Jul 20 2011
SMSFundamentals is an ongoing feature series dedicated to providing SMSFs (smurfs) with valuable news, investment ideas and services, in line with SMSF requirements and obligations.
For an introduction, Please see Welcome to SMSFundamentals.
By Greg Peel
Overlaying all others, there are two distinctive styles of investment labelled “passive” and "active”. The labels imply just what level of effort an investor must apply to portfolio management – passive means not much and active means a lot, or at least as much as one is willing to apply or considers necessary. The simplest illustration of the distinction can be made with regard to stock investments.
If one has made the decision to invest in “the Australian stock market” then one might take a passive approach and invest indiscriminately in the ASX 200 index, or one might take an active approach and invest in a personally selected portfolio of stocks. In the former case, index trading implies an investor holds all the stocks in the ASX 200 index in their appropriate weightings. In the latter case, “stock picking” implies an investor decides which stocks to invest in and at what weightings.
There would be little point in maintaining an active portfolio if the investor did not believe he or she could “beat the market”, providing a more positive (or less negative) return than the index in the course of an investment period. To do this, the active manager must correctly decide which stocks in the index, or not in the index, are providing greater value at anytime than others and weight the portfolio accordingly . An active manager must time decisions carefully and must generally stay ahead of “the herd”. As the labels suggest, “passive” is more of a set-and-forget sort of approach while “active” means dedication to research and education, a close eye on the market and the ability to move swiftly.
There are, of course, degrees. One might formulate one's own portfolio which is very different to the ASX 200 with a one-year time horizon and not touch it until 12 months are up, which is sort of passive-active, or one might chop and change the portfolio make-up and weightings every single day, which is very active-active. But let's just say that index trading is passive and anything else counts as active.
That's stocks. We can widen that investment horizon now into a more diversified portfolio of, say, a mix of stocks, fixed interest, property and cash. If we wanted to be absolutely passive, we could put all our money in some form of available “balanced fund” and let someone else make all those portfolio allocation decisions for us. Alternatively, we could be active and make our own decision at different times about what balance of each asset class we would like to hold. In strong economic times we might lean more towards stocks and property and in weak economic times we might lean more towards fixed interest and cash, for example.
An overriding factor here, of course, is that if we are a smurf (self-managed super fund), then by definition we want to have at least some control over our own investment destiny. If we simply put our money in one passive, balanced super fund then self-management seems a bit pointless. So at the very least a smurf is more likely to make autonomous decisions about such things as asset class balance. But let's assume for the sake of the argument in this particular article that our portfolio includes at least some amount of stock market investment.
That stock market investment can still, in itself, be passive. A smurf may decide that his or her skill in, capacity for or even desire to actively trade is limited beyond feeling “the stock market” will go up, or simply wishing to hold an proportion of “the stock market” without a specific opinion within a diversified portfolio. Let's face it, working smurfs may not have the time to dedicate and retiree smurfs may not wish to spend valuable golfing time stuck behind the computer. And there are many who would simply prefer not to suffer the ongoing anxiety of constant decision making.
So a passive stock market investment simply means buying the ASX 200 (you could of course buy the 20, 100 or 300 but the 200 is considered the market benchmark) and then forgetting about it for the time being. There's one small problem though – the ASX 200 won't forget about you. The index is weighted by market capitalisation, such that its value at any given time is calculated as the share price multiplied by the number of shares on issue of 200 companies and then weighted according to that result. By definition, every time the price of one stock moves all the weightings of every stock change. How often do share prices change? They could change many times in a second.
In other words, in order to maintain a passive index portfolio the passive manager would actually have to be rather active, rebalancing portfolio weights either continuously, or at least daily, or maybe one can just cop a bit of statistical noise and do it monthly or even quarterly, but the wider the gap to portfolio rebalancing periods the greater the “tracking error” will be – meaning over one year the correctly weighted ASX 200 portfolio you started with may show a return nothing like that of the actual Standard & Poor's calculation because all the weightings will have changed. Not to mention the index would have undergone “promotion and relegation” of at least some stocks in and out of the index at regular intervals.
Let's just say the average investor has Buckley's of actually maintaining a DIY ASX 200-tracking portfolio. Even if one could, the brokerage on all those adjustments would simply be crippling.
So either a smurf is simply forced to be an active manager and just choose a less onerous number of stocks to manage, or one could relent and just give the money to an index-tracking fund. As a self-manager, this seems like a bit of a cop out, but then large index-tracking funds pool all unitholder investments into the one lump and their staff are the ones who have to deal with portfolio rebalancing, not you. An index-tracking fund attempts to (but does not necessarily guarantee) to replicate the return on the ASX 200, or some other index, and it's the one who pays the brokerage.
For a smurf content to leave the work to a fund manager, such index-tracking funds could make up all or some of that smurf's equity component in a portfolio. The anxiety then rests with the portfolio manager who is getting paid to perform that service. But therein lies the rub, or at least one rub – fund managers charge fees.
An index-tracking fund might charge any combination of a fee to get in, a fee to get out, a management fee, a performance fee, or anything else they can dream up. The funds management industry is currently under government review with regards to things like also paying kick-back fees out of your money to financial advisers who peddle their product, but suffice to say fees will always exist in some form.
Then there is the small matter of redemptions and redemption windows. If I suddenly want out of stocks, when can I get out? End of the day, end of the month, end of the quarter? Bear in mind that an index-tracking fund cannot, by definition, suddenly decide to exit stocks. If the market is down 25% in the year then a minus 25% return is what you'll get. You wanted stocks – you got 'em.
If the market was up 25% then you'd get that too, net of fees of course. Indeed, an index-tracking fund must always return less than the actual market because of the fees.
Looks like we're back to being active managers again. But then why not? Index-tracking funds don't care if markets go up or down but you obviously do. Any large equity fund, passive or not, can be a lumbering beast unable to react quickly to changes in market conditions and, by sheer size, can push the market in the wrong direction every time it wants to get in or out of stocks or stock weightings. An individual investor can, by comparison, dart in and out of positions at will, make rapid decisions and act on them in a timely manner in sizes that will go unnoticed. The ASX 200 index is diversified across all industry sectors. An active manager can choose to weight towards miners and out of retailers, pick up bank stocks for their yield when they're cheap, snap up an IPO in some promising speculative gold explorer or biotech and stay right away from poor dividend payers or well known market “dogs”, for example.
And there's absolutely no reason why this shouldn't be every smurf's objective, except for two. One is the aforementioned effort and anxiety involved if that is not your wont, and the other is a truth universally acknowledged, however unfortunate, that over long investment periods active managers tend to underperform passive managers.
So why should I even bother, I hear you ask. Well actually while the above statement is statistically supported, those statistics compare the returns from passive fund managers against the returns from active fund managers – not active smurfs or individual investors – who offer their services to the public. Active fund managers usually start with an index like the ASX 200 but then overweight and underweight particular sectors and stocks depending on the circumstances in an attempt to provide an enhanced return. One would hope the “experts” could do this successfully, but the stats say not. But the stats are somewhat misleading.
[Just as an aside, when stock analysts apply ratings like Buy-Hold-Sell, Outperform-Neutral-Underperform or Overweight-Marketweight-Underweight, it is exactly those active managers they are effectively advising.]
Such stats first of all lump all active managers into an average. That's a tad unfair, because some active managers will consistently provide enhanced returns while others won't. Yet others will implode and close down, although they won't be counted either. And within a wide time frame active managers will beat passive managers in certain periods while in other periods they will not.
Active managers tend to underperform in unidirectional markets. Between FY04 and FY07 for example, the ASX 200 returned an average of over 20% because the market went little where else but up. Active managers were still trying to be clever, but then what can one add in such a market? There's more chance of fiddling around the edges too much and ending up blowing it. In topsy-turvy markets such as now, on the other hand, active managers worth their salt should be able to outperform by eschewing index weights and leaning towards better performing sectors.
At the end of the day, active fund managers don't get paid to sit on their backsides and declare their portfolios to be “just right”. They will always risk over-playing the rebalancings and shifting around of positions. Where passive managers are not subject to emotion if all they are doing is tracking the index, active managers are subject to the same panic, hubris, finger-crossing and sleepless nights as any individual investor. Human emotion is arguably the biggest barrier to successful stock market investing.
So where does this leave the humble smurf? Individual passive management is nigh on impossible, individual active management requires a level of skill, passive fund managers charge all sorts of fees and active managers, who usually charge substantial performance fees if they win, don't have a great long-term track record.
There is, however, a solution of sorts. It's called the exchange-traded fund.
Exchange-Traded Funds
Exchange-traded funds, or ETFs, have been listed in Australia for quite a long time, yet Australia is still considered at this point to be an ETF “youngster”. In the US and Europe, ETF listings have exploded, and not just equity ETFs but commodity, fixed income, cash and other ETFs are available, as well as leveraged equity, short-stock, emerging market – you name it, just about any ETF you could dream up is already listed in the US.
So what, exactly, is an ETF?
Perhaps the simplest example in Australia is the SPDR S&P/ASX 200 fund (ASX code STW). Doesn't sound too simple really, but it is.
SPDR stands for Standard & Poor's Depository Receipt and S&P is Standard & Poor's – the agency which calculates the ASX (Australian Securities Exchange) 200 stock index under licence. Basically SPDRs are ETFs listed on stock indexes across the globe, such as the S&P 500 or, in this case, the ASX 200. They are colloquially known as “spiders”.
The Spider on the ASX 200 replicates the ASX 200 index. This ETF was issued and listed by State Street Global Advisers – global keepers of the spiders if you like – whose job it is to passively manage the underlying portfolio. In other words, State Street is just like your common or garden index-tracking fund manager in this sense, and the movements in the price of the listed spider ETF replicate the movements in the price of the ASX 200.
Because the spider is listed on the exchange, it acts for all the world like any stock. State Street issues spiders and then ensures liquidity through an obligation to maintain a tight bid-ask spread, meaning a buy and sell price. But once a spider is bought by an investor, that investor can sell it at any time. Hence while State Street always ensures a market, often there are plenty of buyers and sellers on either side without State Street's involvement. It's just like a company issuing shares and then the market taking over the trading of those shares.
It is State Street's responsibility to ensure the spider on the ASX 200 always replicates that index. If it didn't, no one would trust to buy it. If there are more buyers than sellers, risking the spider price exceeding an index-replication, State Street issues new spiders. If there are more sellers than buyers, risking the spider price falling below the index-replication price, State Street buys back existing spiders.
And that is how an ETF works. An issuer identifies its target replication, be it a stock index, the gold price, a basket of emerging market stocks or whatever, and undertakes to provide the same return on the listed EFT as the underlying asset. An investor can buy that ETF just like one might buy BHP shares. There are no entry, exit, or performance fees to be paid by the investor, other than a minimal embedded management fee (more on that in a moment). An investor's cost is otherwise simply standard brokerage, in and out, and the gap in the bid-ask spread on entry and exit. Given the sponsor is obliged to stand as buyer or seller at any time on a given spread, ETFs are not subject to sudden loss of liquidity and possible free-falls on a lack of buyers. In that sense, they're even safer than shares.
There of course has to be some management fee, given issuers do not offer ETFs out of the kindness of their own hearts. In the case of the spider on the ASX 200, State Street creams off 0.3% per year from the ETF price. In other words, you as the investor will receive the annual return on the ASX 200 less 0.3%. And replication is not a perfect game. Portfolios need to be rebalanced, as noted earlier, so there is always the risk of “tracking error”. State Street does not guarantee the ASX return less fee. But since its inception, the Spider 200's average tracking error has been 0.1%. Bear in mind that can be minus or plus.
Very importantly, however, the spider passes on all dividends and franking credits to the investor. This is done quarterly on a pro-rata distribution to all spider holders of the dividends accumulated by the ETF manager in holding the portfolio of stocks.
Are you ahead of me yet? The Spider 200, usually referred to by its stock code STW, offers smurfs and any investors a way to hold a passive, index-tracking equity portfolio with one phone call to a broker, which provides an equivalent market yield with franking credits, and which can be sold at any time. No need for the investor to try to do this oneself, and no need to tie up money with traditional fund managers who charge a range of fees and limit accessibility.
Such a product provides the investor with a greater level of flexibility. The entire equity allocation of a portfolio could be satisfied by the STW, if that were the investor's choice. A partial investment could be made, leaving room for some other riskier bets outside the index. Or maybe the investor might choose to jump in and out of the equity market more regularly, with the ease of one transaction.
Whatever the investor's desired balance of active and passive management, the STW ticks both boxes. But the STW is certainly not the only ETF on issue. There are many more, offering all sorts of investment options.
Stay tuned for ETFs Part II.
