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Inefficient Portfolio Hypothesis: You don’t always get what you pay for

By Nick Blake, Managing Director, Wealth, at Redington

UK retail flows into low-cost index funds hit record net sales in 2019 at £18bn. This follows a 4% year-on-year growth over the past decade, according to The Investment Association. But why this explosive growth?

It’s likely largely to do with the shift in the value proposition of advisers who have moved their focus from beating the market to helping clients reach their individual goals. This shift is understandable, given advisers have far more control over the latter offering – and clients feeling they’ve got value for money is what ultimately drives ongoing custom.

With many advisers shifting their objectives away from just picking winning funds – which is challenging, even for the most sophisticated shops – why haven’t they just moved to active, multi-asset funds which will do the heavy lifting for them? It turns out some have… but we’ll touch on that in a minute.

Those that haven’t have instead focused on the merits of passive investing. For many investors, indexing is a great place to start, and often a great place to end too! Which is something institutional investors discovered long ago.

Beyond just performance, though, cost has been a huge driver of this change: even when active managers can evidence alpha, it’s often gobbled up in fees before it hits the clients’ pockets. It’s surprising to see how many managers would have produced market-beating performance had it not been for steep fees. There’s no denying active management is difficult, but it’s made even more so with the drag of high fees.

Frustrated with returns, many advisers have turned to index funds, while others have outsourced to those they think might fare better in picking the right funds; hence the growth in multi-asset funds (a 143% increase in AUM since 2011). But is this actually improving client outcomes?

With many multi-asset teams relying on the same resources available to advisers (i.e. the usual plethora of retail share classes available on most platforms), the hope lies in smarter asset allocation. But their abilities will need to outweigh the additional costs associated with outsourcing, which only add to the existing fee problem.

At Redington, we’re often asked to evaluate the performance of an adviser’s chosen outsourcer – the results of which can often be described as mediocre. But when studying this performance, we notice three themes:

  1. Asset allocation: with portfolios often sitting below the efficient frontier, clients are frequently uncompensated for the risks they’re taking.
  2. Manager Selection: efficient asset allocations won’t result in strong performance if the managers are sub-par.
  3. Fees: as we mentioned earlier, fees can have a huge drag on performance, particularly where retail share classes are concerned.

 

When addressed, these three themes can be a source of added value too:

  1. Sharpe-ning (excuse the pun) the asset allocation and spending risk budget wisely;
  2. Finding high-conviction managers; and
  3. Accessing these managers at attractive fees (often via an institutional share class).

 

So, what’s the solution? A risk-efficient asset allocation managed by great active managers who charge low fees! And don’t believe the whole ‘you get what you pay for’ dogma, because while that may be true in many walks of life (think German cars, a good suit, Fairy liquid…), it’s almost always not the case in fund management.

In short, the choice is simple: go for a passive or, if you have the risk budget, go for active – but if you do, make sure you seek out great managers offering relatively low fees.

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