The art of low cost active investing

18 February 2020

Money & Life team

Money & Life contributors draw on their diverse range of experience to present you with insights and guidance that will help you manage your financial wellbeing, achieve your lifestyle goals and plan for your financial future.

Money & Life asks a panel of industry professionals for their thoughts on low cost active investing, including how to better engage with clients about the possibility of outliving their retirement savings.




M&L: In a low return world, how are you generating yield for your clients, while limiting their risks and costs?

Aidan Geysen: I recommend advocating for a total return approach, and separating that decision between yield and capital. That’s because if you are targeting a certain proportion of yield, given where bond yields and cash rates are at, the only way to really achieve that currently is to increase the risk in the portfolio.

It’s much better to establish your goals and determine the return that is going to help meet those goals. So, if that’s retirement, then what is a sustainable spending rate from the portfolio through retirement. And be prepared to spend from a mix of yield and capital. To try and preserve a separate portion of yield at the moment means loading up on equities at a time when it’s perhaps the worst time to do that.

Jason Andriessen: From a total return and whole of portfolio perspective, I agree with not focusing so much on the yield. However, consumers are frustrated that interest rates are so low and they are earning so little on their cash. They are investing in cash for various reasons, and not just for returns. They are parking their cash, waiting for opportunities; they are using it for liquidity and risk management, so there is more to it than just the yield.

Balaji Gopal: When someone is investing purely for yield, they tend to look at the world from a singular lens. It takes them away from becoming objective and they let their emotions take control. That is especially so for someone who is in retirement, and they are relying on this income. However, when they stop receiving that income, it means they often have to make a trade-off with their lifestyle, which most people are not willing to do.

The biggest risk for these clients is when their income starts depleting, they start looking to go up the risk curve, which might deplete their capital and actually puts them in a worse off position.

At Vanguard we believe there are four investment principles: having a plan and clear goals, keeping costs low, diversifying your portfolio, and maintain perspective and a long-term discipline.

M&L: In the current low return environment, how do you get the right balance between low cost passive strategies and more active strategies? 

Aidan Geysen: Clearly, if we could all access the kind of outperformance potential that active holds, then we would do so and we would all be 100 per cent active. However, the world is not that simple. 

 Instead, you are thinking about a combination of active and passive. Knowing that the outperformance from active is uncertain, the planner needs to do their research and due diligence when making their investment decisions. Ultimately, planners need to be satisfied that those active managers they have selected have the skills and can deliver the types of returns you’d expect over time.

How much of the portfolio is skewed to active depends on the outperformance expectation and the confidence you have that the outperformance can be delivered. Of course, the cost that you’re going to pay for that potential outperformance is quite critical.

But what’s also critical to understand is the risk characteristics of any active strategy and what your clients’ tolerance is for those risks, because ultimately, to get value from active does require patience.

Balaji Gopal: Trying to get the right balance when it comes to investing comes back to risk. You could go down the risk profile and accept that your return is going to be lower, which is not ideal, or you could think about going into asset classes where you have active managers that are trying to find the ‘diamond in the rough’. But there are no guarantees that this approach will always work.

We feel that planners have such a strong role to play in terms of educating clients around this context. And, yes, it could be a conversation between active and passive.

It’s about trying to really understand why you are investing in active, and whether it’s about the gross returns that you expect from that portfolio above a benchmark and over fees. And if you feel you can get that based on a manager’s long track record, then ‘yes’, there is a place for active in a portfolio.

But if a manager is coming at a very high cost, and doesn’t really have the track record, you should be examining as to why you would make that allocation to an active manager, instead of staying passive.

So, it all comes back to what you hold, how you are thinking about it, and then getting the right mix between active and passive.

Jason Andriessen: But there is more to it than cost and outperformance. There is also the opportunity with active management to improve diversification and minimise the downside risk, and so, better manage volatility. And that’s really important for retirees, particularly around those risky years on either side of retirement, when you’re in that retirement risk zone and where clients really do want to minimise that downside risk.

M&L: What is your approach to investing, particularly in what is widely considered to be a late bull market?

Jason Andriessen: I don’t think now is a great time to be in the retirement risk zone. It’s very challenging for people approaching retirement. They need to be actively engaging with their decisions.

I think the first thing is to take a total portfolio perspective and then start to compartmentalise. By compartmentalising short to medium-term funds, while the yield will be low, the purpose is to minimise the downside, by investing the other money to roll with short-term volatility, with the intention of not being ‘under water’ when it comes time to rebalance for lifestyle goals.

Marisa Broome: I’d like to add a point in relation to the value of financial advice. Many people phone up planners saying: ‘I’m retiring next year and I want to come in and see you.’ But by then, it’s almost too late. They needed help 10 years before that to make sure they were on track.

The Superannuation Guarantee has helped some people be more prepared for retirement, but questions around the whole sequencing risk issue – do they have enough to retire on, will they be able to accumulate enough in the last 12 months of working or will they have to work longer – are actually being left a little bit too late by too many people and we need to start engaging with people while they are much younger.

If you get somebody on track when they are 30, they are so much better prepared at age 60 when it comes to retiring.

Balaji Gopal: Rather than trying to time the market, we think there is greater benefit for individuals to focus on things within their control. We think cost is a big aspect of that, but also things like saving more earlier, working longer and trying to make adjustments to a person’s lifestyle if they have to, in order to be able to reach that goal. Those things are a lot more important than trying to work out where the market is at and how the investment should be structured.

Again, it comes down to which end of the spectrum you’re at – whether you’re close to retiring or whether you still have time to go. The importance of an individual’s own accountability in their approach to retirement cannot be overstated.

Sarah McDonald: Again, this all comes down to education. A lot of this education is talking about time. For example, for retirees, it’s about where we are allocating these funds and why. You don’t know when markets are going to turn, so you need to stay informed and educated about what’s happening now. It all comes back to the fundamentals of why clients are invested where they are.

We are certainly looking at our model in relation to engaging with younger people, particularly encouraging them to seek advice much earlier within the financial planning process. But I think there is a lot of work that still needs to be done by the profession to engage with people much earlier than we are currently doing. 

M&L: How actively managed should client portfolios be, particularly considering sequencing and longevity risk?

Aidan Geysen: I think sometimes people get caught up seeing both active management and downside protection as synonymous. But in order to achieve that it’s really about understanding the strategy, and that’s where strategy selection becomes very important.

Going back to the 1990s and Bill Sharpe’s essay on The Arithmetic of Active Management, it was established that the average active dollar before costs would match the index. That’s the case whether it’s in a bull market or whether it’s in a bear market. So, understanding the strategy that you are selecting and the role that plays in the portfolio is important.

From a sequencing perspective, one way of managing that sequencing risk could be incumbent on the role of active management and getting that right. When we look at the universe of active strategies, what we do find is that universe actually delivers wider dispersion than the index. So, if you’re just investing in the average active strategy, then that’s probably going to magnify sequencing risk.

But I think one of the most important things is just getting that growth/defensive mix right for where the investor is at their life stage.

The point Marisa made in relation to trying to get people to engage in advice early is critical. Too often, a planner might see someone in a default fund who has 70 per cent or more in growth assets, but only then determine that for their life stage and risk tolerance, they should be at 40 per cent. That’s what introduces sequencing risk.

Jason Andriessen: We’re getting to the crux of planner alpha, which is the benefit of having an active relationship with a financial planner. Sequencing risk is really only realised if you sell down growth assets at depressed prices. And through an active relationship with a planner, you are at lower risk of selling down assets when you’re ‘under water’. So, through judicious rebalancing in a continuous planning environment, that’s something you can control.

There are only a few things that planners and clients can control, so that they don’t run out of money, and the main levers are when you spend and how much you spend, and that can be planned for. 

M&L: What are your thoughts on low cost active investing?  

Marisa Broome: One of the things I like to do for my clients is to make sure that everything we do is done as efficiently as possible. I can help them make decisions that are more cost-effective. If we can spend less on active management fees in some parts of the portfolio, to make that portfolio return stronger and more consistent, then that’s the type of discussion I can have with the client that adds value to the other strategies I do with them.

Balaji Gopal: One of the only true determinants of long-term outperformance for investment managers is cost. Research from providers around the world shows that when you look at the performance of good active managers over the very long-term, in many cases it came down to those managers charging lower fees, and that’s how they were able to generate some of those returns.

And in terms of the amount of time and effort involved in active management, frequent trading might seem like you are in greater control but it doesn’t necessarily get you to those right outcomes. If you compare that to indexing, indexing is low cost and has a very low portfolio turnover.

M&L: Is low cost active investing only achievable through the likes of ETFs?  

Balaji Gopal: We think any sort of investing should be low cost. Even if you are going into an indexing strategy, you should try and pay a lower cost. Therefore, the importance of due diligence cannot be overstated.

ETFs are just another mechanism, which has seen a lot of growth in Australia. The ETF market is now about $60 billion in assets under management and if you look at the time when ETFs really took off, that was post the introduction of the FOFA reforms. ETFs acted as the perfect tailwind towards that fee-for-service model, as well as providing greater transparency and efficiency for both planner and client. They have generated fantastic outcomes for clients, as well as planners and their businesses. I think the low cost ethos has played true for ETFs. 

But from our standpoint, we always think you should start off with your goals, then the strategy in terms of how you are splitting your assets – your style active and passive – and then it comes down to the structure. However, the structure itself should not drive what action you are going to take. 

M&L: How does the profession better engage with clients about the possibility of outliving their retirement savings, as part of a more active strategy towards income generation?

Jason Andriessen: When it come to money, people get cognitive dissonance – the state of having inconsistent thoughts, beliefs, or attitudes, especially as relating to behavioural decisions and attitude change. It becomes too painful for people to think about their financial future. They can’t stand the thought of what retirement might look like, so they don’t set aside money for their retirement. 

Therefore, it’s about flipping the conversation to focus not so much on how much money they will need in retirement but instead, helping them deal with their current challenges.

If planners help their clients deal with their current stresses, then they will earn the right to discuss the long-term with them. And once they get the right to discuss the long-term with them, then they can have meaningful discussions around longevity risk and how to adequately address that.  

Balaji Gopal: We have a fantastic superannuation system in Australia, but people can often confuse the purpose of it. That’s because our super system was designed to give you a lump sum in retirement. It was not designed to give you an income in retirement.

So, when Vanguard looks at retirement income and what is the ideal retirement income solution, we don’t have a silver bullet. However, we think a great solution is a combination of product, advice and technology.

From a planner’s standpoint, if they are able to benefit from using technology to better advise their clients, and if they have the right product they can link back to their clients’ goals with, while protecting their clients from their behavioural biases, then we think that’s the best model going forward. But I cannot overstate the importance of advice.

Marisa Broome: Advice is absolutely critical. I don’t believe advice is ever about product. Advice is about a relationship. It’s about being in someone’s corner helping them achieve their goals, even if they might not know what those goals are.

When I first started on the periphery of the broader industry, rather than the profession of financial planning, most people went to see a financial planner because they had a problem – it was a one-off transactional relationship.

We have slowly developed financial planning into a relationship, rather than a transaction. But there is actually a place for it to be transactional, not about product, but about answering questions on the way through a client’s life journey, as each life stage happens. I think that is where our core is as a profession.

And we are lucky because we are a developed nation with access to technology and a fantastic range of products. So, we have access to many solutions that we can offer clients, as part of a package of solutions that will provide them with peace of mind.

Aidan Geysen: I couldn’t agree more about the value of advice. If you think about the accumulation phase, we’ve been in that mode now for several decades, and it really is all about generating returns.

But as soon as you get into the retirement phase, people’s objectives become incredibly nuanced. However, we haven’t been in this mode of thinking about how the spending strategy interacts with asset allocation.

Therefore, in order to deliver the right strategy for someone, you need to understand what the implications are of how they spend from their portfolio and how that interacts with asset allocation. So, being able to deliver the right solution to clients through advice is going to be absolutely critical, and the key to this is for planners to have these conversations much earlier with clients and not waiting until retirement.

When you can use technology to bring people to an advice relationship earlier, then that’s going to generate better outcomes for people.