a differentiated approach to asset allocation and product selection

A differentiated approach to asset allocation and product selection

Travis Morien

Compass Planners Pty Ltd

http://www.travismorien.com

Tribeca Targeting High Net Worth Investors Conference25th and 26th October 2004, Four Seasons Hotel Sydney

Active vs. passive investing

Pictures by Vanguard Investments

“Properly measured, the average actively managed dollar must under-perform the average passively managed dollar, net of costs”

(Bill Sharpe)

Pre-fees:

-4% +4%

Distribution of Manager Returns vs. Benchmark

Source: “Arithmetic of Active Management”, Financial Analyst Journal, Jan 91.

Average = 0% Average = -1%

-5% +3%

Post-fees:

Good Managers

Percentage of active funds underperforming their benchmark index after fees in the 5 years to 31 March 2004

51.0% 52.0%75.0% 76.0%

100.0%

0%20%40%60%80%

100%

Aus shares Intl shares Aus listedproperty

Aus bonds Aus cash

Underperforming OutperformingSource: Mercer/Morningstar IDPS Survey

Number of Australian Share managers outperforming the S&PASX300 Index, post fees (12 months to 31 July) and value minus growth returns

12 18 22 3354

28 21 28

10 7 8 12 16 5

43 56 58

35

-80

-60

-40

-20

0

20

40

60

1996 1997 1998 1999 2000 2001 2002 2003 2004

Above Index Below Index

Top chart source: Mercer/Morningstar IDPS Survey Bottom chart source: Dimensional Fund Advisors

Citigroup BMI Value - Citigroup BMI Growth

-15-10

-505

10152025

Value outperforms

Growth outperforms

Every US large cap fund with a 15 year history vs the S&P500 and CRSP 1-10 indexes. 15 Years ending 31 December 2001 (285 Funds)

Graphic by Dimensional Fund Advisors

3 years 5 years 7 years

Australian shares 0.77% 0.25% 0.41%Global shares 0.79% 0.39% 0.66%Fixed interest 0.09% 0.20% 0.19%Balanced pooled funds 0.52% 0.22% 0.20%

Source: Russel Investment Group, periods ending 30 June 2004, “Insights” IN107.

Survivorship bias: amount median prices are overstated per year

Source: PM Capital

"Investors continue to sour on stocks. So far this year, investors have made net withdrawals of $11.3 billion from their stock mutual funds

according—including a hefty $3.7 billion just last week—according to AMG Data Services.” Source: Gregory Zuckerman, "Investors Rush to

Buy Bonds, Fleeing Stocks," Wall Street Journal, March 11, 2003

S&P500 index 2000 - 2003

750850950

105011501250135014501550

1/01

/00

1/04

/00

1/07

/00

1/10

/00

1/01

/01

1/04

/01

1/07

/01

1/10

/01

1/01

/02

1/04

/02

1/07

/02

1/10

/02

1/01

/03

1/04

/03

1/07

/03

1/10

/03

S&P500 data source: http://finance.yahoo.com

Annual returns of “buy and hold” index vs actual annual returns enjoyed by US mutual fund investors

from 1984 to 2002

12.22%

2.57%

11.70%

4.24%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

US Stocks US Bonds

Index Mutual fund investor

Source: DALBAR, Inc. Media release of 2003 update of “Quantitative Analysis of Investor Behaviour” study.

The diverse world of passive investing

• Traditional index funds (BGI, Vanguard) • Enhanced index funds (BGI, Macquarie)• Exchange traded funds (Streettracks)• “Style indexed” funds (Vanguard ASHY)• Asset class funds (Dimensional)

Beating the market - passively

Fama and French’s Three Factor Model

Graphic by Dimensional Fund Advisors

11.99%

10.37%9.60%

14.92%

13.26%

9.56%

0.00%2.00%4.00%6.00%8.00%

10.00%12.00%14.00%16.00%

Large Small

Value Neutral Growth

Fama/French indexes on the US marketAnnualised returns July 1926 – August 2004

Source: Dimensional Fund AdvisorsFigures do not include fees, taxes or other costs and past performance may not be indicative of future results.

10 year rolling returns US large cap value, neutral and growth, July 1926 to August 2004

-15.00%-10.00%

-5.00%0.00%5.00%

10.00%15.00%20.00%25.00%30.00%

Jul-3

6

Jul-4

2

Jul-4

8

Jul-5

4

Jul-6

0

Jul-6

6

Jul-7

2

Jul-7

8

Jul-8

4

Jul-9

0

Jul-9

6

Jul-0

2

F/F Lrg Val F/F Lrg Ntl F/F Lrg Gro

10 year rolling returns US small cap value, neutral and growth, July 1926 to August 2004

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%Ju

l-36

Jul-4

2

Jul-4

8

Jul-5

4

Jul-6

0

Jul-6

6

Jul-7

2

Jul-7

8

Jul-8

4

Jul-9

0

Jul-9

6

Jul-0

2

F/F Sml Val F/F Sml Ntl F/F Sml Gro

Historical drawdown US large caps

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

Jul-2

6

Jul-3

2

Jul-3

8

Jul-4

4

Jul-5

0

Jul-5

6

Jul-6

2

Jul-6

8

Jul-7

4

Jul-8

0

Jul-8

6

Jul-9

2

Jul-9

8

Jul-0

4

F/F Lrg Val F/F Lrg Ntl F/F Lrg Gro

Historical drawdown US small caps

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

Jul-2

6

Jul-3

3

Jul-4

0

Jul-4

7

Jul-5

4

Jul-6

1

Jul-6

8

Jul-7

5

Jul-8

2

Jul-8

9

Jul-9

6

Jul-0

3

F/F Sml Val F/F Sml Ntl F/F Sml Gro

GROWTH OF DOLLAR (LOG PLOT)

Global Value Gross A$

Global Lge Gross A$

Global Small Gross A$

Valu

e of

Dol

lar

Time Periods: 1/80 to 9/04

0.1

1

10

100

12/79 1/83 2/86 3/89 4/92 5/95 6/98 7/01 8/04 9/07

Source: Dimensional Fund Advisors

Global value 17.75%pa

Global small 16.06%pa

Global large 13.78%pa

Figures do not include fees, taxes or other costs and past performance may not be indicative of future results.


Aust Value Gross A$

Aust Large Gross A$

Aust Small Gross A$

Valu

e of

Dol

lar


0.1

1

10

100

12/79 1/83 2/86 3/89 4/92 5/95 6/98 7/01 8/04 9/07


Australian value 19.97%pa

Australian large 13.02%pa

Australian small 12.06%pa

Figures do not include fees, taxes or other costs and past performance may not be indicative of future results.

Industry follows academia


MSCI World Index A$

MSCI Emerg Mkts Free A$

Valu

e of

Dol

lar


0.3

8

1

12/87 1/90 2/92 3/94 4/96 5/98 6/00 7/02 8/04 9/06

Emerging markets vs. MSCI world

7.00%

8.00%

9.00%

10.00%

11.00%

12.00%

13.00%

4.00% 4.50% 5.00% 5.50% 6.00% 6.50% 7.00%

Monthly standard deviation

Annu

alis

ed re

turn

0%

10%

100%

50%

20%

30%

40%

60%

70%80%

90%

Adding emerging markets to an international shares portfolio

MSCI World Index + MSCI Emerging Markets Free Index, January 1988 to September 2004

Percentage emerging markets

Choosing active funds

What do we want from active funds?

• Active funds potentially can have higher performance

• Passive funds are not available for all asset classes

• Perhaps something very different to the index for diversification

Core/Satellite Approach

Sector Index Funds: Tailor strategic allocation Increase index core where

confidence in active is low

Active “Satellite” Index Core

Property

Fixed Interest

Cash

Australian Shares

International Shares

Graphic by Vanguard Investments

80% x 0.286%pa + 20% x 6.356%pa = 1.5%pa

Wholesale index MER + aggressive fund MER = low tracking error MER

The cost of active management from a low tracking error manager

1.0%

3.0%

5.0%

7.0%

9.0%

11.0%

13.0%

Nov 1987 Feb 1989 May 1990 Aug 1991 Nov 1992 Feb 1994 May 1995 Aug 1996 Nov 1997 Feb 1999 May 2000 Aug 2001 Nov 2002 Feb 2004

Tra

ckin

g E

rror

(%pa

)

1 Year Rolling Tracking Error

Tracking Error in Australian Shares Specialist from Nov 1987 to Aug 2004Median versus ASX-300 (before tax and before fees)

Median

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

Feb 1986 Jun 1987 Oct 1988 Feb 1990 Jun 1991 Oct 1992 Feb 1994 Jun 1995 Oct 1996 Feb 1998 Jun 1999 Oct 2000 Feb 2002 Jun 2003

Tra

ckin

g E

rror

(%pa

)

1 Year Rolling Tracking Error

Tracking Error in Overseas Shares Specialist from Feb 1986 to Aug 2004Median versus MSCI (before tax and before fees)

Median

“The whole concept of dividing it up into "value" and "growth" strikes me as twaddle. It's convenient for a bunch of pension fund consultants to get fees prattling about and a way for one advisor to distinguish himself from another. But, to me, all intelligent investing is value investing.”

Charlie Munger

Growth ValueValue

Perpetual, MBA, Dimensional

GARP

BT, ING

Relative Value

Lazard

Growth

Colonial FS, Credit Suisse

Neutral

UBS

Indexed

Vanguard

The Style Universe

Graphic by Vanguard Investments

Tax efficiency• Income/growth and franking credits• Turnover• Tax loss selling• Hold range• Short vs. long term CG realisations• Tax liability on existing portfolio• Consider your turnover as well, how often will you

switch an active manager compared to a passive one.

Vanguard is now reporting after tax returns, Morningstar will start tracking them from next year.

Capacity issues

• Market size (large cap vs. small, domestic vs. international)

• Portfolio turnover• Contrarian vs. momentum• Active positions/index weightings (tracking

error)• Large size offset by possible new

opportunities and market clout.

Why does turnover matter?

• Ruins tax efficiency• Increases brokerage and market impact

costs, making it increasingly difficult to outperform as the portfolio gets larger.

• According to a US researcher, the Plexus Group, managed funds incur costs of around 0.8% on each side of a transaction. It costs about 1.6% round trip to buy and sell a stock.

Key person risk

• Skill vs. process• Incentive structure• Institution vs. boutique• Staff equity ownership• Eating their own cooking

Suggestion for picking active funds1. Avoid “index huggers” that charge a full active MER.

Funds with concentrated high conviction portfolios may actually represent better value on a price per active position basis.

2. Avoid tax inefficient funds for investors on high tax rates. The tax inefficiency penalty can cost several percentage points per year. If you must use inefficient funds, use super.

3. Avoid “growth at an unreasonable price” funds and funds with excessive turnover. Seek out funds with a value philosophy, but not necessarily funds pigeonholed into a “value” classification.

4. Look for fund managers with a performance culture rather than a FUM gathering culture that adequately reward their key staff.

Asset allocation and risk management

"The essence of risk management lies in maximising the areas where we have some control over the outcome while minimising the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us."

Peter Bernstein

Bernstein, P. L. Against the Gods: The Remarkable Story of Risk. Wiley;

New Ed edition (1998)

“The determining question in structuring a portfolio is the consequence of loss; this is far more important than the chance of loss."

Peter Bernstein

Bernstein, P. L. Management of Individual Portfolios. The Financial Analysts Handbook; Levine, S. Ed.; Dow Jones Irwin Inc: Homewood Il, 1975.

• Risk is the probability of not having sufficient cash with which to buy something important.

• Risk is a function of a portfolio's assets and its liabilities, in particular the cash flow between the two over time.

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000D

ec-1

979

Dec

-198

0D

ec-1

981

Dec

-198

2D

ec-1

983

Dec

-198

4D

ec-1

985

Dec

-198

6D

ec-1

987

Dec

-198

8D

ec-1

989

Dec

-199

0D

ec-1

991

Dec

-199

2D

ec-1

993

Dec

-199

4D

ec-1

995

Dec

-199

6D

ec-1

997

Dec

-199

8D

ec-1

999

Dec

-200

0D

ec-2

001

Dec

-200

2D

ec-2

003

Capi

tal v

alue

$0.00

$50.00

$100.00

$150.00

$200.00

$250.00

$300.00

Annu

al in

com

e

Shares capital Cash capital Dividends Cash interest CPI Inflation

Source: Reserve Bank of Australia

Dividends vs. interest, ASX200 index vs. treasury bills

Income planning for pensions• Dividends are fairly reliable for diversified

portfolios• We can’t eliminate capital volatility but we can

make it less relevant through portfolio structuring.• Fund near term capital withdrawals with cash, if

you aren’t drawing down on shares then share market volatility is sidestepped.

• This turns asset allocation into a mere budgeting exercise! Put aside enough cash to cover the dividend shortfalls and you’ll reduce your need to sell shares.

Evolving asset allocation during the accumulation phase

$0.00

$200,000.00

$400,000.00

$600,000.00

$800,000.00

$1,000,000.00

$1,200,000.00

0 1 2 3 4 5 6 7 8 910 11 12 13 14 15 16 17 18 19 20

Growth assets Medium risk assets Low risk assets

Three dimensions of risk profiling

• Tolerance of loss • Timing of cash flows (time frame)• Tolerance of tracking error,

unconventionality and complexity


Large Portfolio

Tilted Portfolio

Valu

e of

Dol

lar


1

10

100

12/79 1/83 2/86 3/89 4/92 5/95 6/98 7/01 8/04 9/07

Large Tilted

Annualised Return %pa

14.01 16.36

Total Cumulative Return %

2468 4150

Monthly Standard Deviation %

4.19 3.92

Monthly Average Return %

1.19 1.35

Annualised Standard Deviation %

14.50 13.59

20% Australian large

20% Australian value

10% Australian small

20% global large

20% global value

10% global small

50% Australian large

50% global large


Portfolio drawdown (maximum loss)


0.00%5.00%

10.00%15.00%20.00%25.00%30.00%35.00%

Jan-

80

Jan-

82

Jan-

84

Jan-

86

Jan-

88

Jan-

90

Jan-

92

Jan-

94

Jan-

96

Jan-

98

Jan-

00

Jan-

02

Jan-

04

Large Tilted

Disclaimer:This article contains the opinions of the author but not necessarily the author’s employer or any of the individuals or companies mentioned in this presentation, and do not represent a personal recommendation of any particular security, strategy or investment product. The author's opinions are subject to change without notice.

Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

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