Brent Sheather: The power of propaganda

Wikipedia defines propaganda as "a form of communication that is aimed at influencing the attitude of a community forward or against some cause or position.

Propaganda is usually repeated and dispersed over a wide variety of media in order to create the chosen result in audience attitudes. As opposed to impartially providing information, propaganda often presents facts selectively or uses loaded messages to produce an emotional rather than rational response."

One of the most successful propaganda exercises ever was that conducted by the Allies in the Second World War prior to the invasion of France where the invading forces convinced the Germans that they would cross the channel at Calais when in fact Normandy was the objective.

In recent times a propaganda war of a similar scale has been waged by local financial advisers, fund research houses and some fund managers against low cost, passive funds. Some of this mis-information even masquerades as Continuing Professional Development (CPD) and the recipients of the mis-information actually earn credits for listening to this rubbish as part of the education requirements to remain Authorised Financial Advisers.

Before we look at the specific propaganda it is worth considering, as with any crime, what the motive is. For active fund managers the motive is clear enough passively managed funds present a huge threat because their fees are up to 90 per cent below that charged by active managers and passive funds by definition highlight the performance of an index, which is frequently a pretty hard benchmark for most active managers to beat.

Understanding why many Authorised Financial Advisers (AFA's) and stockbrokers don't like passive funds takes a bit more digging. Firstly from a stockbroker perspective persuading a client to own ten stocks and then encouraging them to shuffle those stocks potentially means more fees and also means the client needs to rely on the stockbrokers research. With an index fund you buy it, brokerage is incurred once and that is the end of the brokerage stream.

Other financial advisers tend to bad mouth passive funds because passive funds tend to highlight the importance of fees and if the fund is charging 20 basis points then the financial advisers 100 basis point monitoring fee starts to look excessive. Secondly financial advisers like to perpetuate the illusion that they can add value by picking winners particularly on the basis of research that they buy that identifies active fund managers who outperform so embracing passive management depreciates the value of their advice.

Furthermore when you charge a 100 basis points monitoring fee you have to be seen to be doing something and regularly swapping one active manager for another is good for business, if not so good for performance.

The final nail in the coffin for passive funds from the perspective of the high living financial adviser or stockbroker is that passive funds don't pay commission, don't pay trailing fees, don't give free trips to exotic locations once you achieve a certain level of sales and generally don't sponsor CPD events at expensive hotels.

These issues explain why passive funds are extremely popular with institutional investors in the US institutions typically index half their share portfolios whereas the penetration of retail portfolios is much less. This sad fact was highlighted by the recent mystery shopping exercise conducted by the National Bureau of Economic Research (NBER) which we looked at a couple of weeks ago.

Okay let's get this show on the road and look at a selection of stupid reasons not to buy passive funds. I got these pearls of wisdom from a recent meeting where various "expert" financial advisers gave their reasons for not using passive funds. First silly reason was that passive was the easy way out and as such was the solution used by "unintelligent and uninformed investors".

The same financial planner then said something even sillier he asserted that passive investing means you get volatility and market risk without any upside. How he got to that conclusion I don't know, perhaps it was his medication, but a rational person would think that if you bought the entire sharemarket, in the knowledge that the sharemarket goes up long term, then you would participate in all the upside, less fees of course.

As regards volatility we calculate the standard deviation for about 40 actively managed international share funds and virtually all of them have a higher standard deviation that the index.

The expert then moved to address the fee issue and his comment reminded me of a statement made by the authors of the NBER study which we mentioned last week when they said that "when advisers mention fees they did so in a way that down played fees without lying". The expert's answer to the issue of fees was to quote the performance of one fund with extremely high fees which had performed very well. Great argument but what about the other 99.99 per cent of managed funds? His logic was made all the more ridiculous when he said that it was closed to new money.

Next up the adviser broke new ground in the long history of silly reasons not to buy passive funds. He said that research saying that active funds didn't outperform the index was erroneous because it took into account all of the funds which people stopped supporting and went broke but if you just looked at the funds that didn't go broke they outperformed.

Clearly this fellow is an original thinker but unfortunately he didn't tell his audience how to discern between those funds that were going to continue and those which were not. He then, in a touch of irony, said it is remarkable how wrong some of the research on the active/passive debate is. His comments reminded me of a fund manager who not so long ago said that the managed fund's performance would have been even better had it not held the stocks that went down in price. Oh I love this job!

Last silly reason was that old staple of anti-passive zealots that passive funds underperform when the market falls. The adviser said that passive funds can't protect you from downside risk, which is quite true but he then said active managers do, which is not correct.

Vanguard, the biggest provider of index funds in the world, did some research on this very topic some years ago which we covered in this column in November 2008. The Vanguard study found that despite measuring the performance of only those managed funds which stayed in business US managed funds only managed to outperform when the market was falling half of the time and in Europe managed funds only outperformed in bear markets 40 per cent of the time.

Vanguard then looked at whether those funds that outperformed in one down market did so in other down markets. Alas, success generally did not carry over from one bear market to the next and that, statistically, success in one or two bear markets may have been simply due to luck. Vanguard analysts then looked at how those fund managers that outperformed in down markets adapted to rising (bull) markets.

The study found that those funds that did well in a bear market did so because they were defensively positioned which is great news in a bear market but this orientation proved a significant drag on performance when markets started rising again. Don't you hate it when the facts get in the way of a good rant!

So there you go, hopefully the above will partly offset the ongoing propaganda campaign against passive funds. The bottom line is we need to support active managers to keep markets efficient but we also need to support passive funds so that we keep the active managers efficient.