How quickly can an active manager get out of hard-hit industries like tourism, aviation and hospitality? Photo / File
COMMENT:
Q: I know you recommend index funds for their low fees and generally superior performance.
However, with Covid-19 expected to bring many business failures in tourism, hospitality, aviation, etc, would you still recommend index tracking funds for investors with some spare cash to put into the sharemarket?
Or do actively managed funds actually offer an advantage at this time in being able to predict sectors in trouble and avoid them?
A: Yes to your first question, and no to your second one.
Managers of active share funds — in and out of KiwiSaver — select which shares to hold, and when to buy and sell them, while managers of index funds simply buy all the shares in a market index, such as the NZX50.
Index funds — sometimes called passive funds — are much cheaper to run, and therefore charge lower fees. This helps them to perform better than most active funds after fees, over the long term.
But, as you say, active managers can choose to avoid certain industries. The trouble is that by the time a manager realises prospects for an industry have deteriorated, it's probably too late.
Picture the managers of a whole lot of New Zealand active share funds, which until recently probably had considerable holdings in tourism, hospitality and aviation shares because that's where a lot of the growth was.
At the very first word about the discovery of Covid-19 in China, maybe one or two of those managers predicted the trouble to come, and quickly sold some of their shares in those industries — although selling in a hurry, they may not have got great prices for them.
Other managers would have seen the price falling, and perhaps rushed to sell their shares — but at increasingly lower prices.
Since then, the New Zealand and world sharemarkets have been rebounding. Last I looked, world shares were halfway back to their February high, and local shares were more than halfway back.
That seems weird when the economic outlook is bleak. But perhaps share sellers overreacted in early and mid-March. Or perhaps we're in for more falls. Nobody knows.
We do know, though, that some time in the not too distant future shares will be back on their long-term growth path.
And at some point, many active managers will find themselves buying back some of those shares they sold — quite possibly at higher prices than they sold for. That's not a winning strategy — especially when you consider trading costs.
There'll be other shares they stay out of — possibly including some that later do a surprise phoenix performance, and the managers miss out on dramatic gains.
Meanwhile, index fund managers, with no choice, have just kept holding the shares right through — apart from making what are usually relatively minor changes when their index changes, usually once a quarter.
I'm not saying no active managers would have handled the turbulence well. Of course some have. But will they always be the winners?
Remember that investing in shares or a share fund is a 10-year-plus proposition. It's too risky to put shorter-term money in shares, because you can lose money over short periods — as we've seen lately.
So let's look at 10-year performance. Quite a lot of active share funds do so poorly they don't last 10 years. Others do well some years, badly in other years. And there are usually a few that shine.
But there are at least three reasons why they might not stay at the top:
• Their star stock pickers are enticed away to other funds. And we don't know they've gone.
• The fund attracts many investors and becomes too big. As Dean Anderson of Kernel said last week: "If you've got a billion-dollar fund and the market starts to fall, you can't just turn 40 per cent of it into cash easily."
• The managers might have taken more risk than most funds — which works well sometimes and badly sometimes.
Very long-term studies show the winning funds in one decade often perform poorly the following decade.
Even if one fund keeps outperforming, how do you know in advance which one? It's a better bet to go with a low-fee index fund, regardless of what's happening to the markets at any time.
Q: Re your column last Saturday, how can Smartshares "beat" the market? They are index funds less fees.
A: Good point. If an index fund holds the shares in a market index, it should perform the same as that index, but a bit worse because of fees — albeit low fees.
And yet last week I quoted someone from Smartshares — the largest New Zealand-based manager of passive funds — as saying in a magazine interview that in the October 2018 market downturn, "Only two of the 19 NZ active equity (share) funds beat the market, according to Morningstar, but all of our funds did."
Actually, he forgot that one of Smartshares' five New Zealand share funds, its Top 10 fund, didn't do so well, dropping a bit more than the average active fund in that quarter. More on that fund in a minute.
But to your point about beating the market. In New Zealand, "the market" is usually regarded as the NZX50 index, which includes basically the 50 biggest shares.
But no Smartshares index fund is based on that index. The Top 10 fund holds just the biggest 10 shares, the High Dividend fund holds 25 shares that pay higher dividends, and so on.
The one closest to the NZX50 is the NZX Top 50 fund, but it's based on the Portfolio Index. This caps each share at 5 per cent of the index, whereas the main index is based on "market capitalisation" — the total value of each company's shares. So a really big company has a really big weighting. For example, Fisher & Paykel Healthcare and a2 Milk currently make up about a quarter of the index between them.
As it turned out, in the 2018 downturn all the indexes used in Smartshares funds — except the Top 10 mentioned above — performed better than the NZX50 index. Hence last week's quote.
That's not always the case, of course. In the recent downturn — in the month and year ending March 31 — most of Smartshares' New Zealand share funds performed worse than the NZX50, and worse than most active funds. Oddly enough, though, the very one that did worst in 2018, the Top 10 fund, was easily the best performing New Zealand share fund in the year ending 31 March 2020, and second best in the month of March.
What's more, "Smartshares US Large Growth ETF was the best performing fund out of all 685 managed funds in New Zealand over the last one year and three years to March 31, 2020," says a spokesperson. "Despite the drop in markets, this fund returned 16.64 per cent net of fees over the 12 months to March 31, and 16.07 per cent a year over the past three years."
So what's going on here? In market downturns, some index funds do well and some don't. Ditto for active funds. The main point is that active fund managers have long said, "Index funds are all very well, but wait for a downturn". Here we are in a downturn and some index funds are more than holding their own.
Q: Just as most people have strong political biases, I think most investors have strong style biases. Yours is passive, mine is not.
With that declared, I feel it was not fair to hold up Kernel NZ20 as an outperforming passive fund when discussing KiwiSaver and recent performance — as you did last week.
I'm not even sure if it is a KiwiSaver option. But if it is, it is a very high risk one compared with a diversified portfolio like Milford.
The Kernel NZ20 fund has 35 per cent of its portfolio in two stocks! And those two stocks have done pretty well in a tough time.
Further, you are right to say that most active managers don't outperform the index. But I believe in seeking out the ones that do over a long time. But that's my bias.
My question, though, to a passive fan, is what do you think of the idea that market cap indexes are the worst way to construct an index, and other options like fundamental indexes or equally weighted indexes achieve better returns?
A: Not sure I accept that my preference for passive funds is a bias. It arises simply from decades of watching.
No, Kernel NZ20 is not a KiwiSaver fund, although I don't think that affects anything. And, yes, it is a higher-risk investment than Milford's Active Growth Fund, because the latter includes some lower-risk assets such as bonds. But as I pointed out last week, you would therefore expect the Milford fund to be less affected by the sharemarket drop, but that wasn't the case.
You're right that the Kernel fund benefited from the strong performance of F&P Healthcare and a2 Milk. That's because that fund's index is another one based on market capitalisation — like the NZX50 described above.
Which leads to your question about market "cap" indexes. I asked Dean Anderson of Kernel why he used such an index. "The beauty of market cap indices is their true reflection of the market. As companies do well, they grow in value and shift up the index; as they do worse they become a smaller part of the index and eventually drop out. Ultimately, when you invest in a market-cap index fund, you are buying the market, or part thereof."
I agree to some extent. But when just a few companies dominate an index, that can be worrying. If they do badly, the fund probably will too. Personally, I prefer a fund based on an index like the Portfolio index, also described above. Its 5 per cent cap prevents such dominance.
Good luck with finding active managers that keep performing well. They are rare.
- Mary Holm is a freelance journalist, a seminar presenter and a bestselling author on personal finance. She is a director of Financial Services Complaints Ltd (FSCL) and a former director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary's advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to mary@maryholm.com. Letters should not exceed 200 words. We won't publish your name. Please provide a (preferably daytime) phone number. Unfortunately, Mary cannot answer all questions, correspond directly with readers, or give financial advice.
The New Zealand sharemarket reached its highest level in a month.