Does it automatically follow that if you pay more for something it performs better?

The independent research company Morningstar have looked at the relationship between Total Expense Ratios (TERs) and performance. Their conclusions are fascinating.

Before we go on it is probably worth explaining exactly what a TER is.  Fund charges used to be commonly expressed as an Annual Management Charge (AMC). However this was only part of the story and did not include certain other costs. A TER, however, is generally deemed to be a more accurate view of the costs of a fund. It is arrived at by taking costs such as the fund manager themselves, trading costs, administration, and legal fees, adding all these up and then expressing them as a percentage of the overall fund size.

But  does a lower TER mean better performance? Morningstar certainly think so, amongst other things their research found:

“If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.” To see the results, click here.

“Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.”

In their conclusion Morningstar said:

“Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two cheapest quintiles, and you’ll be on the path to success.”

They finished by saying:

“Be sure to go beyond both measures to brush up on a fund’s other key fundamentals. Don’t look for the 10-second answer. You should understand management, strategy, and stewardship, too, before you send in your cheque.”

Click here to read their research in full.

So, if it is all down to cost and we all know tracker funds can be cheap, should we only use trackers?

Trackers are certainly one way of investing but let’s look at some performance figures over the past 10 years to October 2010.

UK Equities

Sector Cumulative Performance
FTSE All Share 33.0%
Average performance of all passive funds tracking the index 25.0%
Average performance of top 10 active UK equity funds 131.70%

Source: Morningstar, Inc. IMA UK All Companies sector as at 31st October 2010. Figures in GBP, bid-bid, net income reinvested. Average of top 10 performing active funds is based on the 10 funds in the sector which have delivered the highest cumulative returns over the 10 year period. Average performance of passive funds are based on the 13 passive funds that track FTSE All-Share Index, with a 10 year track record.

Global Equities

Average performance of top 10 active global equity funds 80.20%
FSTE World Index 17.40%

Source: Morningstar, Inc. Average performance of top 10 active global equity funds based on top 10 performing active funds (excluding investment trusts) in the IMA Global Growth sector as at 31st October 2010. Figures in GBP, Bid-Bid, net income reinvested.

You should of course remember that past performance is not necessarily a guide to the future.

The debate about passive v active funds has gone on for years and will no doubt continue to do so.

Those in favour of passive investment believe that only a very few fund managers manage to beat the market on a regular basis, and those in favour of active management point out that passive funds will always produce a return lower than the index because of charges.

We don’t claim to be able to provide a definitive response to the active v passive debate here, although we will come back to this in future months. However, we do want to highlight the importance of asset allocation and how this is key to investment performance and why the active v passive debate is something of a phoney war.

Why is asset allocation so important?

Earlier this year we interviewed Justin Urquhart Stewart of Seven Investment Management (7IM) and we asked him why asset allocation was so important to successful investing, he said:

“Just pump “asset allocation” into Google and you will come up very quickly with numbers showing that between 85 & 95% of historical returns seem to be down to asset allocation. It’s not that stock picking and market timing are unimportant, but if you are in the wrong asset class to start with, then there is going to be trouble.

The key point is to get the bigger picture sorted out first. So the planning with the client is pre-eminent, and thereafter choosing which asset classes in what proportion and only then get down to fund or stock selection. If you do it the other way around then you are in serious danger of putting the client at greater risk than they actually wanted.

By having a broad range (at least 10) of asset classes, we can establish their historical performance (but can’t rely on it) but more importantly know their volatility. Now blend the volatility together and we create a far more predictable model – even over the past five years.

That’s why asset allocation is not just important, but is vital.”

What next?

Once you have decided on your asset allocation, and are happy that it matches your attitude to risk it is only then that you need to think about what you actually invest in, do you go for passive or active management and it is here where Morningstar’s research comes into its own. Back to Justin Urquhart Stewart:

“There are some very good active fund managers – and there are some awful ones!

The challenge is finding those consistently good ones. Figures certainly show that approximately 70-80% of active managers can’t beat their own benchmark, which would imply that we should just buy the benchmark, the index.

However, these figures can be unfair on good active managers who can perform very well when their sector or focus is making progress, but struggle when their area is out of fashion.

Equally ETFs have some great benefits, both in terms of cost and swiftness of access as well as helping with very precise asset allocation. I have always been amazed at how slowly they have been adopted here in the UK, but few intermediaries were even told about them, as active management firms would obviously dissuade them, and stockbrokers often saw them as an insult to their knowledge of individual stocks!

We have taken a view that both active and passive approaches have their merits and run both our blended Multi Manager funds and our AAP (Asset Allocated Passives) funds which primarily use ETFs and other Index Trackers and more recently direct holdings of baskets of stocks to further reduce the cost to the investor.”

Conclusion, don’t be passive in your asset allocation

We cannot provide an answer to the active v passive question here; however what we can say is that in many ways this is not the most important question. If around 90% of returns are indeed down to asset allocation, logic dictates more time is spent on this decision rather than the active v passive decision.

Even if you decide to use passive funds as the ultimate home for your investment, the figures shown earlier clearly prove that you cannot be passive in your asset allocation; it is not good enough to simply invest in a tracker and hope for the best.

Once you have considered your asset allocation and are deciding which trackers or actively managed funds to buy, focus keenly on charges. If Morningstar are correct, there is a clear link between charges and performance.

But remember to look past the charges and consider other issues fundamental to performance, don’t just look for an easy answer you should also understand the management, strategy and risk of each fund or tracker you invest in before you commit to an investment.

Our View

Here at Investment Sense we believe asset allocation is key, which is why we spend time looking at your circumstances and considering your attitude to risk before we make any asset allocation recommendation.

We then have investment propositions using both passive and active funds depending on your preference to fulfil the asset allocation.

We also focus heavily on charges and work hard to reduce these, spending time reviewing your existing investments both in terms of charges and performance.

If you feel that your existing investment need to be reviewed, we would be very happy to do this for you, call us today on 0115 933 8433 or 0845 074 7778 and speak to one of our highly qualified and knowledgeable advisers.