The cost of investing has become a priority for regulators and investors alike. High costs can exert a meaningful drag on long-term returns and should undoubtedly form part of an adviser's decision-making process. However, low cost should not be confused with value for money, which is often neglected when evaluating discretionary management strategies.
In general, a low cost strategy will incorporate a far higher weighting in passives. There is a place for passive investments in portfolios: they have low fees and can benefit from significant economies of scale. However, they have limitations. A fundamental concern with passives is that they can channel money into areas that have already performed very well. Any strategy or asset class can be a bad investment if too much money goes in and investors buy at the top.
With this in mind, it is worth remembering that markets have been moving higher for almost a decade, notwithstanding the recent bout of volatility. No bull market lasts forever and there are pockets of over-valuation in the market. Often, the market indices on which passives are based are dominated by these over-valued companies. Over the long term, valuation is the core driver of the market, not sentiment.
It is also worth considering risk. At the end of a bull market, investors often focus in on a narrower range of assets, placing more and more of their investment into a few selected stocks. This naturally increases stock specific risk within a portfolio, which can raise volatility, delivering lumpier returns. In our view, this suggests that some passive strategies, while cheap, may not represent great value for money over the next few years.
At the same time, lowering costs is one way to boost performance, but it is only one piece of the jigsaw. Picking the right active investments can also add significant value. Disappointment surrounding the performance of some active managers has driven investors towards passive vehicles, but we strongly believe that the best active managers deliver real value for money. That comes from both targeting mispriced opportunities and avoiding areas of real weakness.
We see this as particularly important today. In a period of technological change a large number of companies and sectors face disruption. Highly indebted companies or those with poor corporate governance are particularly vulnerable and investors risk permanent loss of capital by investing there. We see many businesses facing material threats even though their shares are trading on very high multiples. Often these risks are not being reflected in share prices. Anywhere where fundamentals do not match current valuations creates an opportunity for active managers. We believe that by being more selective, active managers may be able to navigate these markets more effectively than passive funds.
Seeking the most appropriate tool for the job
Source: Smith & Williamson Investment Management / FactSet as at 30.11.18 (unaudited)
At the same time, portfolio balance is vitally important to reduce the risk of permanent loss of capital. With our managed portfolio service, we tilt portfolios to the outcomes we see as most probable, but they are always constructed to ensure a spread of exposures that aim to do well in an array of scenarios. To our mind, this provides advisers and their clients with far better value for money than blindly allocating to individual companies according to market capitalisation, while ignoring valuation measures and business fundamentals.
Today, we find ourselves at the end of a lengthy bull market in equities and bonds. During the past decade it has been easy to conflate low cost with value for money because passive management has given a decent result, cheaply. We believe these returns will not be as easily won in future. Amid political uncertainty, technical disruption, investors will need a more nuanced approach. While there is undoubtedly value in holding passive investments, whose structure can offer exposure to specific sectors or geographies at very low cost, these should be viewed as most beneficial when used tactically, as part of the asset allocation of a sensible and well diversified actively-managed portfolio.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
Investment does involve risk. The value of investments and the income from them can go down as well as up. The investor may not receive back, in total, the original amount invested. Past performance is not a guide to future performance. Rates of tax are those prevailing at the time and are subject to change without notice. Clients should always seek appropriate advice from their financial adviser before committing funds for investment. When investments are made in overseas securities, movements in exchange rates may have an effect on the value of that investment. The effect may be favourable or unfavourable.
Smith & Williamson Investment Management LLP is part of the Smith & Williamson group. Smith & Williamson Investment Management LLP is authorised and regulated by the Financial Conduct Authority.