Low cost should never be confused with value for money, warns Mickey Morrissey, and yet the latter consideration can often be neglected when evaluating discretionary management strategies
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. That said, 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. Of course there is a place for passive investments in portfolios - they have low fees and can benefit from significant economies of scale. They do, however, 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 run lasts forever and there are pockets of overvaluation in the market. Often, the market indices on which passives are based are dominated by these overvalued 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 some passive strategies, while cheap, may not represent great value for money over the next few years.
At the same time, while lowering costs is one way to boost performance, 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 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 fundamentals do not match current valuations creates an opportunity for active managers. By being more selective, active managers may be able to navigate these markets more effectively than passive funds.
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 - though 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 provided a decent result, cheaply.
These returns look unlikely to be as easily won in future. Amid political uncertainty and 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, we strongly believe 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.
Mickey Morrissey is a partner and head of distribution at Smith & Williamson Investment Management
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