US voice of reason resonates in SA
September 2nd, 2011 by 10X Investments
“Too often, investors believe that mutual funds provide a safe haven, placing a misguided trust in brokers, advisers and fund managers. In fact, the industry has a history of delivering inferior results to investors, and its regulators do not provide effective oversight.” David F. Swenson “The Mutual Fund Merry-Go-Round”
You may not have heard of David S. Swenson, the chief investment officer at Yale University, he is responsible for managing and investing the University’s endowment assets and investment funds valued at $16.7bn (30 June 2010). The fund has generated an annualized return of 8.9% over the past ten years, handily outperforming its benchmark and institutional fund indices.
Mr Swenson, who is credited with developing the Yale Endowment model, has also written a number of authoritative books on portfolio management. As a respected author, academic (he has a Ph.D in Economics) and acclaimed investor, his views are well worth noting.
Mr Swenson’s New York Times Op-Ed article
On August 13, 2011, the New York Times published an opinion piece authored by Mr Swenson, entitled “The Mutual Fund Merry-Go-Round”. Although he addresses the US experience, many of his points are universal, and are just as relevant to the South African situation.
As the title suggests, the article is highly critical of the level of switching that occurs in the US mutual fund industry (the equivalent of South African unit trusts). Individual investors are notorious for following a “buy high, sell low” strategy and must accept responsibility for their own poor investment behavior; according to Mr Swenson, this does not however excuse the industry using market volatility to profit at the expense of these investors:
“The companies that manage for-profit mutual funds face a fundamental conflict between producing profits for their owners and generating superior returns for their investors. In general, these companies spend lavishly on marketing campaigns, gather copious amounts of assets — and invest poorly. For decades, investors suffered below-market returns even as mutual fund management company owners enjoyed market-beating results. Profits trumped the duty to serve investors.”
One way the industry does not serve investors is by churning funds. The industry aggressively markets the funds that have outperformed in the recent past and advisors happily switch their clients into these funds (and out of their “under performing” funds). But investors ignore the fact that the fund performance mainly mirrors the underlying share price performance. Switching is therefore tantamount to buying after share prices have gone up, and selling after share prices have come off. This is a losing strategy.
Investors not only incur switching costs but also lose out on future relative performance as the funds bought then typically under perform the funds sold. Mr Swenson quotes a Morningstar study that found that if mutual fund investors in 2000, as a whole, had simply bought and held their funds for 10 years, their investment outcomes would have improved by an average of 1.6 percentage points per year. This adds up to 17.2 percentage points over 10 years and literally hundreds of billions of dollars of value. Imagine then the impact over a 40-year savings span, and how much money investors lose by churning their funds.
Unfortunately, investors understand too little about financial markets to make informed decisions or evaluate their portfolio results and believe they are doing well if when they are not. They are easy prey for a profit-driven investment industry.
Recommendations to stop the music
Firstly, individual investors should become financially educated, ignore the sales pitches and invest in a well-diversified portfolio of low-cost index funds. This would reduce the fees paid to the investment industry and leave more money in the hands of the investing public.
Second, the regulator (the SEC in this case, the FSB in South Africa) should employ its powers to encourage individual investors to embrace low-cost index funds and shun the broker-driven churning of expensive, actively managed funds. He recommends that every mutual fund must offer an index-fund alternative, listing the full fee differential and the likely impact on expected performance. Over time, a head-to-head performance measurement would demonstrate which offering would deliver a higher return.
Third, the regulator should hold the mutual fund industry to a “fiduciary standard” that puts clients’ interests first. Such standards would subordinate the interest of brokers, advisers and fund managers to the interests of the individual investors that the industry claims to serve.
The South African experience
The South African experience is very similar. Over the last 15 years, between 60% and 80% of unit trusts (as a percentage of quarterly unit trust market value) are repurchased annually. Most of those repurchases appear to flow back into unit trusts however (given the extent to which gross sales and repurchases track each other).
Fig 1: Annualized sale and repurchase of SA unit trusts
Source: I-Net Bridge
In South Africa, the situation is exacerbated as there are literally hundreds of equity unit trusts, but less than 150 investable stocks. In other words, investors keep buying the same stocks in different combinations.
Unfortunately, index funds are nowhere near as ubiquitous as they are in the States, and they are generally not marketed, other than by dedicated index trackers (e.g Satrix). Most US investors know Vanguard, the pioneer of low-cost index investing and the largest mutual fund company in the US. Despite Mr Swensen’s comments, many US investors already understand to use low-cost investing, with close to $1trillion invested in ETFs. Most South African investors still place their faith in active management, with barely $2bn invested in tracker funds.
One reason is that few South African investors fully appreciate the impact of fees. But then it is difficult to quantify the impact of fees, when the fees themselves are not quantified. Fee disclosure in the South African unit trust industry is poor (as identified by a recent Morningstar study). The study noted that “historical expense ratio information, detailed fees, trading costs, and portfolio holdings were generally lacking or difficult to obtain”. It added that “funds in South Africa rarely include an example of the impact of fees.” This would go directly to Mr Swensen’s second recommendation.
Unfortunately, the South African investment landscape lacks authoritative investment voices – voices such as those of David Swensen, John Bogle, Charles Ellis, Warren Buffet and Burton Malkiel – to speak on behalf of ordinary investors, and sound the alarm on fees and high-cost active management.
On Mr Swenson’s third recommendation, forcing the industry to place the interest of investors first, the FSB has introduced qualifying examinations to educate advisers, brokers and other financial intermediaries on their fiduciary duties and responsibilities. This may raise awareness of ethical requirements, but it unlikely to improve the morality of the investment industry.
No, for as long as the investment managers and financial intermediaries view the other as the client, the investor is likely to remain the object rather than the subject of the industry.
 Yale University Endowment Update 2010
 Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment (Free Press, 2000) and Unconventional Success: A Fundamental Approach to Personal Investment (Free Press, 2005)
 Blackrock ETF Landscape End 1H 2011
 Blackrock ETF Landscape End 1H 2011
 Morningstar Second Global Investor Experience