Short sharpe shock

It is human nature and a well-known fact that what gets measured tends to be what is easily measured. In the world of fund management, the two items that are most easily and frequently measured are fees and performance.  Investors often overlook measuring risk entirely.

When it comes to active fund management, this approach to measurement has resulted in net capital outflows from active funds into passive investments. According to Morningstar, 2016 was one of the worst years for active management fund flows. US actively managed funds saw outflows of $340 billion for the year.  Passive funds, dominated by Vanguard Group, the poster child for passives saw $505 billion of inflows in 2016.

The reasons for the shift in assets away from active and into passive are part structural, part cyclical and in no small part driven by performance versus fee evaluation.

The structural shift from active to passive can be explained, in part, by growth in assets and changing trends in global pension plan systems. In the US use of 401k plans continues to grow and many employers are opting to provide qualified default funds to relieve them of financial liability. According to ASFA, the Association of Superannuation Funds of Australia, Australian superannuation fund assets continue to grow, reaching 2.3 trillion AUD in March this year up 11.2% over 12 months.  In Australia just under a third of superannuation fund assets are held in self-managed superannuation funds.  In the UK, DC schemes are seeing rapid growth along with ISAs, SIPPs and LISAs – which could become the vehicle of choice for a new generation of savers.

From a cyclical standpoint, investors have experienced a sustained bull market in equities during which the average active manager has underperformed the main indices. Investors have felt that the performance offered by actively managed funds is not compelling when compared to passive indices, and that the fees charged are not justified by the results achieved.  Active management is having a torrid time demonstrating its relevance.

All this leads to investors making the simple choice of opting for a cheap index fund that is generating good returns – but who is considering how to measure the risk that may be lurking in investors’ portfolios, and what the future may hold for index funds when markets turn?

Do the majority of investors have the tools, data or expertise to measure risk? Do they understand risk indicators such as the Sharpe ratio? Quite often they don’t, which brings us back to the point that what tends to get measured is what is easiest to measure.

Decisions by Default

The structural shift from active to passive can, in part, be explained by growth in assets and changing trends in global pension plan systems. People that contribute to long-term savings plans, often through a workplace pension, usually have a choice about how their money is invested and are able to choose from a variety of funds offered by their provider. However, certainly in the UK at least, many of these savers are quite happy with a default fund offered by their pension provider.  With a default fund, the saver does not need to make a decision about how their savings are invested – they may choose this option because they would prefer to leave that decision to their pension provider, or because they don’t have the experience and/or interest to select from a range of options.  According to MoneyWise, over 80% of UK savers opt for a predetermined mix of default funds.

Default funds are often modelled on the traditional and well-understood “balanced portfolio”; a combination of equities and bonds. A balanced portfolio has traditionally seen allocations anchored 60% to equities and 40% to bonds, with allocations increasing or decreasing to either asset class largely depending on one’s tolerance to risk and investment time horizon; the older or more risk averse one is, the greater the allocation to bonds.

The underlying assets of many default fund offerings comprise passive investments.  Why?  Because they are cheap.  In the UK, a 0.5% fee cap is often applied to default funds.  This 0.5% maximum fee includes management charges, custody and administration expenses.  For most investors, this basic turnkey solution is simple to understand and easy to measure.

The majority of investors that choose default funds have neither the tools, data nor expertise to measure risk, which bring us back to a point made in my last note, that what tends to get measured is what is easiest to measure. The bad news for this new generation of passive savers is that risk needs to be given much more consideration. “Just because you can’t see the crocodiles, it does not mean that they are not there” – so goes the old African proverb. The same applies to risk: just because you can’t see it, it doesn’t mean that it is not there.