'Opportunity there, if advisers can grab it'

So 8.5%pa net of fees after platform cost of 1% plus MER of 1% (i'm being generous here) means a 10-11% pa gross return. Excuse me but stockmarket returns of 20-30% are not normal and neither is 10-11% pa from a properly diversified portfolio. If the industry thinks it can attract new clients from term deposit funds with those promises then it is in dreamland.

Graemetee: there are industry participants with a long track record of generating circa 10%pa net of fees... making 'dreamland' a reality

Dreamland doesn't stop there. Many Advisers just don't appreciate that many Bank Term deposit investors have a much higher aversion to investment losses (even temporary losses) than most investors Advisers normally deal with. While they can be gullible to plausable pitches for higher returns, exposures to even small allocations to highly volatile funds can severely damage their trust in their Adviser in any market correction. However they can be encouraged into modest diversification with quality assets that are often less volatile (e.g. some allocation to direct shares in major companies they understand), that are not undermined by layers of fees, and have realistic returns expectations, based on sound projection techniques. Unfortunately the above article smacks of the old tactic of flogging some managed funds after they have finally put some good runs on the board, and also with the belief that the managed funds investment mandates will suit all investors .

Independent Observer needs to back up their claim with specifics otherwise this reality is still 'dreamland'.

This article worries me as it seems the author doesn’t have a good grasp of reality, especially as it relates to retail investors. First off the risk free rate for mum and dad is what they can get in the bank on a 12 month deposit and that’s about 4%. Secondly all the independent research i.e. that which is worth reading says that the forward equity risk premium is about 3.5% so we get to prospective returns for international equities of about 6% over the very long term. If we assume an additional 2% for Australasian equities that’s 8%. The weighted average yield on a high quality bond portfolio is going to be 5% max to give a weighted average return on a balanced portfolio of 6%. If we take off the industry average fee structure of 2 – 3% pa that delivers a return to mum and dad below bank deposit rates. Not a good look.

So I agree there is an opportunity there to exploit the equity risk premium on behalf of clients but we need to get fees down in order to make the proposition attractive. Clayton’s 8.5% is dreamland unless of course we get a huge crash in the stock market thereby doubling dividend yields. Oh I forgot we could make an allocation to venture capital which returns 22% pa. Yeah right!

Regards Brent

I'll start with the obvious:
Berkshire Hathaway's performance from 1964 to 2012: Net returns of 19.70%pa - with 9 of the 48 years delivering an annual performance less than 10.0% (4 of which occurred in the last decade).

Good point Independent Observer but I just spoke to Warren and he doesn’t want my $50k so what next?

IO, Berkshire Hathaway doesn't have a NZ office and I don't want to buy their shares at a premium, get no dividend and have all my money in one stock, please name another?

Brent is correct at one level – in that the real life risk free rate is more likely to be the local term investment rate than the OCR… say 4%

Like so many things in this industry, there is no consensus from “independent research that is worth reading” on the forward equity risk premium. Recent research suggests an appropriate equity risk premium of circa 6% - requiring after fees (before tax) returns of circa 10%.

We may need to agree to disagree on that one – albeit that this is the easy part of my response

Unfortunately Brent’s ramble suggests that he is a student of Efficient Market Hypothesis and the nonsense that investors must have a balanced Modern Portfolio of appropriately correlated exposures. This outdated and archaic myth (first devised in 1956 when computing power was at its infancy) also suggests that a low cost passive or index exposure will deliver an appropriate result for investors. This endless pursuit for mediocrity has consistently failed to deliver – and under this philosophy, investors will consistently fail to achieve an appropriate return for the risk that they are exposed to.

In the land of reality, investors simply want to receive an appropriate reward for the risk that they are taking. At the end of the day, investors are happy to share the spoils with the “experts” who are managing their investments, as long as their net return expectations are being met. A net return of 10% is achievable, and is being achieved – although not so much by the folks who rely on 1956 theories.

Graeme - a bit of research will help you to undercover the various managers who have managed to consistently deliver above 10% net of fees.

When you're done - lean over the desk and inform Brent :-)

Hi Clayton, I’m afraid you are wrong there. There is definitely a consensus from independent research on the forward equity risk premium. It may be that you just haven’t read it. I’ve referred to it a number of times in my articles so I suggest you read the 2013 version of the Global Investment Returns Yearbook from the three London Business School professors who are generally held to be the global authority on long term investment returns. They reckon a 3.5% risk premium and a 6% total return. Their view is shared by Clifford Asness, ex AQR who chaired a 2012 meeting of experts organized by the CFA Society in the US. John Bogle also has the same view as does Robert Arnott who authored a brilliant study in the Financial Analysts Journal in 2001 showing that extrapolating historic returns of 10% was ridiculous. Last but not least, the chief regulatory authority in the UK, the Financial Services Authority commissioned Price Waterhouse to come up with the numbers and their analysis was refined by the GIRY authors.

There is no doubt that a realistic estimate of returns is a huge threat to everybody in the industry given current fee structures but promising 10% and then under-delivering will get you offside with your clients and maybe even the FMA but it is good to draw out the industry’s views because once you have shown your hand the investing public can decide.

I found your comments on passive funds particularly humorous given the huge amount of money globally which is going into passive funds from actively managed funds. You are probably aware that the latest initiative from the FSA (RDR) is effectively making advisers buy some passive funds and thus do the right thing for their clients. Again passive funds are a huge threat to your business and the industry at large but the trend is obvious and the sooner market participants get to grips with reality the better.

IO, I have taken your advice and conclude that promising 10% pa returns after fees is in fact dreamland.

Brent - a bit of reading that may have escaped you. This may assist you & your colleagues in understanding the failings of EMH & a passive approach to investing.

Griffiths, N. Kessler, R. (2012), "The Risk Management Dilemma - You Can't Eat Relative Returns",
Ineichen, Alexander & Silberstein, Kurt (2008) “AIMA’s Roadmap to Hedge funds”, Alternative Investment Management Association
Lleo, S. (2009), “Risk Management: A Review”’ The Research Foundation of the CFA Institute
Scholes, M., Jenson, M., Black, F. (1972), "The Capital Asset Pricing Model: Some Empirical Tests", Praeger
Lowenstein, R. (2000), "When Genius Failed: The Rise and Fall of Long-Term Capital Management", Random House
Pain, J. (2010), "Alice in Wonderland Meets the New Reality", The Pain Report, www.thepainreport.com.au

Just saying.........the MJW Survey to 31 December 2012 shows that ever single active NZ equity manager returned over 10% per annum for the 10 years to 31 December 2012 (the only funds to go under 10% per annum were the passive index NZ share funds).

Changing directions slightly, while I agree with the concept of the risk premium being say 3.5% per annum, and that this has all sorts of wider implications that Brent has referred to, simply taking the current risk free rate and adding 3.5% per annum to it will tell you little about the near to medium term returns (say for the next 10 years).

If this was an ideal forecasting tool, then why in the last 5 years did global shares produce negative returns (especially as 5 years ago the NZ cash rate was more like 8%)? If you extend this, why are returns from global shares over the last 10 years so low (as the cash rate at 31 December 2002 in NZ was more like 5.75%, so adding say 3.5% per annum to this implied healthy returns).

Key point here is be careful about ripping a page out of some bright b#ggers homework book and using it to expound "the truth, and nothing but the truth", especially when it comes to forecasting or predicting stuff. As some bright Noble Laureate said "Prediction is very difficult, especially if it is about the future."

And finally,don't put me in a box with independent Observer and Clayton. While I agree with the concept that there will be term deposits looking for a home, people should be careful not to over promise stuff to their clients (which is why I find myself more aligned with Brent and Graeme's views here).

Good comment Colin. I don't doubt the research that that NZ shares earned 10% pa as the NZ Stockmarket gross index returned 9.1%pa over the last 10 years so an active equity manager that didnt earn this before fees should be sacked. My point is if you want to attract retail depositors from the safety of bank deposits you cant just sell them a NZ equity fund as an alternative. This would not just get you in trouble with the FMA but probably the courts as well. After the finance company debenture scandal the industry doesn't need a "NZ equity scandal".

Hi again, this is my last post on this subject. To Clayton I say two things …. first, the rest of the world must have missed reading this research as well as you say if it criticizes passive funds. As you know globally there is probably two dollars going into passive funds for every dollar going into active at the moment. Secondly I can’t see how on earth the failings of Long Term Capital Management has anything at all to do with passive funds, quite the reverse.

Hi Colin, thanks for that. Unfortunately all the international research on forecast returns seems to be directed toward international equities and I quite agree that the outlook for returns from NZ shares is much better than that for international stocks and I am not just thinking about FDR. Our own research model shows that NZ equities have returned 9.1% pa for the 10 years ended February 2013 but, as you probably know, responsible fund managers/advisers don’t put all their money into NZ shares. For the last 30 years or so asset allocation has been 40% bonds, 10% property and 50% shares and the shares split 1/3 NZ/Australia and 2/3 international. In any case the forecasts are for the future not the past and as you know if shares get more expensive in terms of lower dividend yield the prospects for returns are impacted.

While we are on the subject of passive performance the easiest way to beat the index in NZ over the last 10 years has been to underweight Telecom. It returned 5% pa in the same period so it doesn’t surprise me that active managers could have beaten the index. Mind you my data for the passive funds is after fees and it is to Feb 2013 and it wouldn’t surprise me if your data was pre-fees. Really, producing research pre-fees should be illegal or perhaps the entities producing the pre fee research should be compelled to pay people’s fees for the next 5 years. That would certainly focus some minds.

One last thing your third paragraph is incorrect because if you forecast returns for global equities you can’t use the NZ cash rate, you have to use a proxy for the global cash rate and most people use short term US Treasury bills. Glad to see you don’t align yourself with those other two! The world is changing and our industry must deliver if we are to stay viable. At 55 I don’t have a long term investment horizon but it would be good to leave this industry in good hands and with a sensible and realistic business model.

Having read your article Clayton, I am more than a little concerned.

Anyone who uses 3 years of performance data with correlation co-efficients ranging from 0.2 - 0.6 to support their theory that 'you get what you pay for’ from an adviser really should be opening a stall at Ellerslie Race Course on cup day to tout for clients. I would suggest that these are the appropriate, prospective clients for the investment 'strategies' of the small group of 'benchmark unaware returns' boutique fund managers (I interpret this as being unable to properly measure the risk they take). It is likely that selling this approach to the average investor with a moderate appetite for risk would conflict with the Code.

I recall one of Brent’s articles a year or 2 ago where he drew on research which looked at thousands of fund managers' fees and returns over significant periods of time. It concluded that there was a significant and negative correlation between fees and returns… to be clear, the higher the fees the lower the returns; not really a surprise!

In conducting any serious research you need to understand how significant a level of correlation is for the amount of data gathered; i.e. half a dozen data points and an R2 of 0.2 – 0.6 is probably not that significant from my understanding of statistics; e.g. 2 data points give you a straight line but there may be no correlation, 3 data points may give you a straight line (R2 = 1) but still the actual correlation may be found to be tenuous or even non-existent with more data added, etc. Using just 6 data points from 3 years of returns smacks of yet another case of 'enough research will tend to support your theory'. People who use decades of data (e.g. the GIRY publishers) with hundreds of data points can make more serious claims than those with just 6. What would your study show with data for returns over 10 years, 20 years or 50 years? If you don’t have that sort of data then I would suggest you are applying a tenuous theory not supported by sufficient data to warrant applying it to mum’s and dad’s retirement nest egg. Ponzi schemes have recently been shown to give great returns over the short to medium term.

I would not be betting my 'hard earned' on your 'research'.

Thanks Brent.

Just saying (again), that the median "Core" active global equity manager, that NZ clients use, in the same MJW survey beat the index by 0.9% per annum for the 10 years to 31 December 2012.

Agree that you need to take fees in to account in accessing the active passive debate.

And lets think about it more. If you have $800 million of investors money (I think you said that somewhere on this site before), and roughly 2/3s of 50% is in global shares (which is roughly $265 million), then I reckon you could demand pretty sharp management fees for your clients from active global share managers. My bet is that you would pay less than the 0.9% of outperformance that the managers in the MJW survey provided in the last 10 years.

The point here is that I think you should then use this type of research and thought to push the pros and cons of active management (rather than simply lumbering active strategies with some number you have decided works for your argument).

As a complete aside, is there a chance that because a lot of NZ based global share funds are multi-manager strategies that they are accessing the best global share managers (rather than just "average" ones). From memory Jeremy Grantham says something like "there is nothing as supremely useless as the average active fund manager". I don't think he would let you use this as an argument against using GMOs active global share funds (or even those of his good competitors). He is just highlighting that average ones will given you the market (index) return less fees. Like you, I would not be keen not keen on paying active management fees for average managers - even if their fees for active management are low.

Again I don't disagree with the general thrust of what you are saying. However, I do also get a giggle out of expressing opinions disguised as facts (and then attacking anyone who asks you to consider other positions). I think that we need to come up with an expression or acronym that captures this approach (like a "Brentisim". Anyone got any ideas?

Ok this is my last post on this story. I see that Heathcote Investment Partners “introduces fund managers to financial advisers and large scale investors”. For the record does your firm introduce financial advisers to passive fund managers or just active? I am writing an article on conflicts of interest hence the question.

Regards
Brent

Hi Colin

I didn’t read that in your first post that the managers were investing in global equities. But the outperformance is easily explained by hedging. The index is unhedged and as you know most NZ based managers hedge between 50% and 100% of their international equity portfolios. Hedging probably accounts for 2%, 3% or 4% of returns and hedging only works when the NZ$ is rising against overseas currencies and/or there is a worthwhile differential between local and overseas bond yields. This situation won’t last forever and even if it did to my mind hedging isn’t a no brainer because if there were some huge disaster to hit NZ people who own hedged equity portfolios would not benefit from the collapse in the NZ$. Diversification is the No. 1 rule and hedging is inconsistent with diversification.

On the second point we have about $650m in invested money but haven’t negotiated any improved fee deals from fund managers as we use ETF’s and UK investment trusts which already have very low fees. For example Australian Foundation has an MER of 19 basis points.

Lastly we are quite happy to pay active managers their (low) fees if they approximate the index. It is unrealistic to expect them to outperform and we tolerate periods of underperformance. We pay the active fee to keep markets efficient.

You also say that I express opinions disguised as fact. It would be good to see some examples of this, just to confirm that they are fact or opinion. But I like your suggestion of Brentisim and it could well represent my most significant contribution to this industry.

Regards
Brent

R1: Thanks for reading my article. This was edited down (and the various disclosures removed – so I can understand the frustrations around the small samples taken) - with the full article available on the Heathcote website.

Whilst I’m tempted to expand on the various litany of theories that I’ve been exposed to over the years (remember the nifty fifty, passive v active, ETFs), it’s probably easier to simply test the theory of after-fees-returns versus passive exposures with your clients.

Sadly it’s been noted that some advisors have already admitted defeat and are unable (or unwilling) to identify investment capabilities that can deliver a meaningful return to their investors, with claims that these are only available in dreamland. Claims of vested interest are accurate, as the nonsense that is being espoused on modern portfolio theory and efficient markets is ultimately penalising the investor.

Clayton - couldn't agree with you more.

Sometimes I don't know what to make of Brent's articles / comments and whether they're actually tongue in cheek or he actually believes in what he's writing.

But, yes, agreed he's doing his clients a disservice but not seeking out the best investment opportunities.

But I guess his passive / low fee investment approach shooting for mediocre returns (maybe this is what Brentism is a euphemism for) gives him plenty of time to write articles and post comments on message boards.

LOL Brent........The manager's global share returns in the MJW survey are unhedged (as are the index).

So herein lies the proof about "opinions expressed as facts" (you emphatically said the reason is hedging, when hedging has nothing to do with it).

One look at the survey (which is online) would have confirmed this for you (but no - you had to make up an answer to suit your story).

I still like many of your views, but again think that some of what you say needs to be called for what it is (I had to find the acronym myself for this stuff, so let's call your view about currency what it is, being: "BS").

Hi Colin, I didn’t bother reading the report and the reason I didn’t is that a couple of weeks ago I looked at another report by a consultant which showed that over twenty years local pension funds’ hedged international share portfolios outperformed an unhedged index by 1.3%. The managed portfolios were also pre-fees so I naturally thought the MJW research confirmed the data in the longer term survey. So yes you are right over ten years but over twenty years what I said is correct. For the record I am sure you would agree that performance comparisons should include fees and highlight the treatment of hedging rather than a note hidden away at the bottom of page 5 when the table was on page 3.

Have a nice Easter. Regards Brent

I also find it laughable that Brent can use three isolated studies to predict forward returns.

I'd be wary of anyone (especially Professors and academics - what's that about those who teach)who proclaims they can predict (prophesize might be a better term) what's going to happen in global markets.

It's quite frankly absurd.

The comments seem to have strayed from the original subject matter and onto Brent bashing (another acronym perhaps?) and the subject of passive versus active management. The pro-active management lobby feels threatened by the passive management lobby – why is this? Obviously their business models rely heavily on the notion of using active managers to justify their services (and fees) and comment to the contrary is an obvious threat to their livelihoods.

As far as doing client’s a disservice, LOL, that must be a joke – looking for low cost equity management may be easier than trying to identify the next Warren Buffet but if it means more income in a client’s pockets and less in fund managers and advisers pockets I would say that is delivered clients a good service not a disservice. As for wasting time on blogs – well the same might be said of you (and me). Signing out Graeme Tee.

"I'd be wary of anyone (especially Professors and academics - what's that about those who teach)who proclaims they can predict (prophesize might be a better term) what's going to happen in global markets. It's quite frankly absurd."

You need to remember the time frame Brent is talking about - these are average expected returns over a 20+ year time horizon.

Oddly, forecasting over the longer term seems easier than in the shorter term.

For instance - what will real US corporate earnings growth be? In the next year it is highly variable. But over the next 30-years it will pretty close to real GDP growth. Corporate profit growth can't diverge much from GDP growth in the very long term (since if profits grew faster it would eventually become 100% of GDP). GDP is not easy to forecast - but the bounds of uncertainty over the long term are not that large, we are probably talking about a percentage point either way.

I think the work Brent is quoting is correct. It seems pretty obvious: buying assets today (like a 10-year US bond at 1.85% or the S&P500 at a 2.0% yield) do not look likely to have say 10%+ returns over the next 10 years. They could, but some pretty extreme things will need to happen. Most likely the return after tax, inflation and fees will be low.

Where I part company with Brent is that he seems to see financial planning as mostly about investing money. Returns will be lower, so fees should be lower.

For me the main challenge for advisers is working with clients so they can see their options if the next 20-30 years do average low returns. What should clients do - take more risk, wait for a correction (ie better prospective returns), spend less, sell assets, run down capital, get a 2nd job?

The value of an adviser getting these things right for a client are as high today as in the past.

Clients should be paying advisers to provide personalised advice, not just to be an alternative to using a balanced fund effectively charging a performance fee on expected returns.

Interesting thread with some pithy comments. For what it's worth I think treating active v.s. passive as a philosophical divide is pointless. Available investment returns lie on a continuum from fully passive to fully active with beta and smart beta and alpha and everything in between on that line. Like all things they each have their appropriate time and place.

To be sure the academic and empirical evidence, dating largely from the 1970s, is overwhelmingly in favour of the purely passive approach. But, since the 1990's there has been some significant research supporting active management see people like Andrew Lo, Petajisto etc.

For relatively unsophisticated mom and pop investors passive with perhaps a smattering of excitement in the form of some more active investments seems appropriate but for those who believe they have the ability to select those active managers that are above average well and good provided they recognize that they will only get it right half the time and the same managers are unlikely to be in the top quartile or better consistently.

With regard to the ERP. A very simple analysis I did in December of 2009 looking at the long run worst historical drawdowns from equities and then the conditional subsequent 5 year returns indicated that post the 20 - 30 minus 20% plus drawdowns since 1926 the subsequent average 5 year CAGR from equities was +15% which is pretty much exactly what we have had since the March 2009 low. Thus it is clear that the ERP will fluctuate although I also buy into the lower returns for longer argument based on the 10 year plus slog Europe still has to dig its way out of trouble.

For those pure proponents of passive who blindly follow the big dipper up and then down I would ask a simple question- How often do your portfolios turnover?

According to some studies the global average is getting up on 140% per annum which is hardly a strong argument for walking the talk.

Hi CJM - I agree whole heartedly with your comments! 10 out of 10!

Thks cjm for some intelligent comment. The other obvious way any qualified AFA would get to 6% long term equity returns is r= d plus g.g has averaged 1-2% below gdp since 1900 or about 1% above inflation.

If inflation is 2-2.5% as implied by the spread between longest term real and nominal bonds and global div yield is 2.5 then 2.5 plus 1 plus 2.5 is...da dah...what will it be?

Clayton says 12, independent observer says 14, Colin won't say in case he's wrong..sorry the answer is 6.

Anyone not follow that?

On your last point I know my clients..every day they email/phone..I want to do this or I need ..shall I sell this house? My daugther just got divorced. I want to insure my ferret. So it's not just about returns for me either. But if they get to keep more of their savings it's much easier 'getting these things right for a client"
rgds b

Just read some of the latest research from Smithers and Co (google it if you don’t know who they are) which I might add you have to pay to read. Does anyone else pay for research… and I wouldn’t include much, if any, of the local offerings for financial advisers under that category. Anyway, Graham and of course Clayton might be interested to know that Dr Smithers reckons that the likely long term return for the world stockmarket is 3% real so with inflation of 2-3% that gets us to a similar return to all the other sensible, independent and un-conflicted experts ie 5-6% pa nominal, pre fees, pre tax blah blah. So Graham that is another “isolated study” for you to laugh about. And Independent Observer, if you really can “uncover various managers who can manage to consistently deliver above 10% net of fees” I suggest you start a funds of hedge funds immediately and if you charge the standard 2 and 20 you will be richer than Warren Buffett within 10 years. Good luck!

31 comments (18 if you assume that Brent & related parties are one) indicates significant interest in the underlying themes of passive v active, and the appropriate equity risk premium.

My observations are that many of the advisory community don’t know what they don’t know, and can be swayed by the squeakiest wheels using outdated theories and gross generalisations to underwrite their beliefs.

Investment professionals have, and are delivering net annualized (after fees) returns of 10%+ for their clients – albeit that research is required to identify these folks (ie: screening out the large number of investment folks who are putting their business interests ahead of the interests of the underlying investor).

The alternative is to support the theory of efficient markets, and purchase commoditised vehicles where price has a meaningful impact upon their homogeneity. Index tracking vehicles can be purchased for less than 30bps (probably less if you’re after a mainstream index), although will constantly fail to meet investors expectations (remember how EMH / MPT did throughout the GFC???).

I look forward to reading and contributing to further insights (that hopefully remain devoid of name calling… despite the temptation), that helps to debunk some of the myths that are present in the industry.

Independant Observer brings back memories of those adviser who used to sell finance companies 10 years ago. High returns without the risk. Yeah Right. Lets hope your clients don't end up the same way.

I am probably overdoing this but it is vitally important that advisers and “third party organizations that introduce fund managers to financial advisers” have realistic expectations as regards future returns from equities. It is important so we can tell clients how much they can spend, how much they need to save and most of all so we, as advisers, can get a view on what it is fair to charge. So in the latest edition of the CFA Institute Journal, which I received today and which I am sure all good AFAs read, Rob Arnott is interviewed on forecast returns from equities. He said “the notion that stocks beat bonds by 5% was embraced in the 1990s and is something of a core belief in the practitioner community (he is probably thinking of certain people in NZ). This myth is dangerous because the long term historical excess return is driven in large measure by change in valuation multiple. The long term historical dividend yield for stock is about 4%. If the yield is now 2% that is a big change in valuation multiple. So it creates an inflated historic return which people translate into an inflated expectational risk premium.” So there you go. Anyone have any comment? Clayton, you have gone quiet. Independent Observer what do you think? Graham, anything to say? The average asset allocation is 1/3 NZ/Australia, 2/3 international, so this data is very relevant. Accordingly a comment to the effect that “we were wrong and we agree with you” would be a good start on the road to your rehabilitation and re-integration into the real world.

Regards
Brent Sheather

Some of the extreme and unsupported comments made here (we all know who they are) remind me of a quote that I think related to religious fanaticism and is attributed to Voltaire: "Those who believe absurdities will commit atrocities".

Debates supported by solid research are worth having and serve to improve our understanding and decision-making. Those pushing a mantra not supported by solid research and in which they have a vested interest should be ignored, by the industry and hopefully by prospective clients.