Active management to stage comeback
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While passive funds may hold several attractive attributes, such as low costs, active management is expected to mount an eventual comeback.
Australia's exchange-traded fund sector is booming, offering investors increased choice at a lower cost.
However, cost should not be the only consideration for investors seeking higher returns, with active management expected to mount an eventual comeback, according to Morningstar's director of manager research ratings, Tom Whitelaw.
"We haven't necessarily seen managers slashing fees here (in Australia), but there has been a change in overall portfolio costs as some investors have moved more expensive actively managed core holdings into passive funds managed by the likes of Vanguard and iShares," he says.
"There they might get similar exposure to a typical large-cap Australian equities portfolio, but for around 0.15 per cent.
"We've also seen some of the newer active fund launches using fees as a differentiator. For example, large-cap Australian equity funds typically charge around 0.9 per cent, so to differentiate a new launch may come out with a base fee at less than half that price, but use a performance fee charge to make up the difference.
"If the manager can only match the benchmark the client won't pay any more, but should they beat their peers the fee increases."
However, there are traps for the unwary in assessing fund fees, Whitelaw warns.
"If you are looking at investing in a fund with a performance fee make sure you're getting that reduction in base fee--what we don't want to see are managers double charging," he says.
"If it's well-structured, it can be a win-win as it incentivises the manager to outperform, and gives the client a cheaper fee if they don't".
Fee versus performance
Whitelaw also suggests investors assess a fund in terms of its overall characteristics rather than just focusing on fees.
Morningstar uses a "5P" process of analysing people, process, parent, price and performance, awarding Gold, Silver and Bronze ratings to those funds which best meet its criteria.
As of 22 July 2016, around 40 funds had earned a Morningstar analyst rating of "Gold".
"If investors are fee-conscious and are happy to get close to the benchmark's return, then the easiest option is to select a passive fund," Whitelaw says.
"But we factor fees into our process. If you have a Gold, Silver or Bronze-rated manager, there might be a higher fee, but we believe the strength of the people, the process and the business more than makes up for this."
Passive funds have benefitted from their relative outperformance in recent years, along with their lower fees compared to active managers.
However, active managers could soon enjoy a comeback, according to Whitelaw.
"Markets have really favoured ETFs in recent years, but like anything else, it's cyclical," he says.
"For example, in international funds, US equities have made up around 60 per cent of the MSCI World Index in recent times, and the strong performance of the US market has helped passive managers outperform active managers who might have seen the US as overvalued and been underweight.
"But if something shocks the US market, such as Donald Trump being elected President, and the economy goes backwards, passive managers can't sell, whereas the active funds can be more opportunistic."
The message for managed fund investors is that performance and diversity are still worth paying for.More from Morningstar
Anthony Fensom is a Morningstar contributor.
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