To the index and beyond: Australia’s slow embrace of passive investing

Published 28 March 2013 07:07, Updated 28 March 2013 13:15

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To the index and beyond: Australia’s slow embrace of passive investing

Tim Murphy, CFA and Co-Head of Fund Research for Morningstar. Photo: Tamara Voninski

Australians, it seems, can hardly be bothered with passive investing.

Australia and New Zealand together make up the only region where there was a decline in popularity of passive investment funds in 2012, according to a report from funds research firm Morningstar in March. Passive investments are those that replicate a given benchmark, typically charging a lower fee than the “active” managers who’ll try to beat that benchmark.

The Morningstar Annual Global Flows Report 2012 found that, in a period of sluggish growth for managed funds in Oceania overall, organic growth in the active sector was up 0.02 per cent compared with a 2.54 per cent decline in passive or index investments.

The Australian trend runs counter to a clear, growing global preference for passive investment vehicles. “While 78 per cent of worldwide fund assets still reside in actively managed funds, passive products captured 41 per cent of estimated net flows – $US355 billion – in 2012,” the report says.

The total market-share statistics also show that Australia lags the world in index-awareness. Actively managed products make up 92 per cent of the Oceania market, with 8 per cent in index funds, compared with the global average of 82 per cent in active funds and 18 per cent in passive ones.

Index products make up 24 per cent of the US market, the most passively inclined country. Morningstar attributes Australia’s relatively slow uptake of index funds to its “bank-dominated distribution as well as superannuation schemes in which a majority of assets flow into balanced (locally referred to as multi-sector) funds”.

Australia’s fund distribution model has stymied the growth of index-style products, says Tim Murphy, co-head of fund research Morningstar Australasia.

“Most investment funds in Australia are intermediated through advisers, most of who are aligned to the ‘big five’ – the four main banks and AMP – which are tied to investment platforms that focus mainly on actively managed funds,” Murphy says.

Despite current industry architecture acting against the growth of passive products, he says there is a demand for index-style investing.

Murphy says the 2012 Australian flow figures were somewhat distorted as investors switched out of indexed fixed income products. Australian investors put more than $3 billion into active global fixed-income funds in 2012 while withdrawing almost $760 million from the passive variety.

“Investors were perhaps reducing exposure to the accompanying risks of international indexed strategies, which have a natural skew towards heavily indebted developed nations with very low interest rate environments,” the Morningstar report says.

Cheap and cheerful

Apart from that anomaly, Murphy says the overall growth trend for passive products in Australia in recent years was positive. And demand will only increase once the Future of Financial Advice (FoFA) reforms come into play in July.

“[FoFA] will force advisers to focus on costs, which should lead to growing interest in passive products,” Murphy says.

The cost differential between index products and active managers can be substantial. As an example, Murphy says the main Australian shares fund from Vanguard, the world’s largest index manager, costs just 18 basis points (or 0.18 per cent) of assets under management compared with 92 basis points for the average active Australian equities fund.

But if investors are looking to reduce costs, and risks, by shifting to index products, they face a much wider range of passive options these days.

Traditionally, index products were manufactured by fund managers such as Vanguard as unlisted unit trusts, and they were designed to mirror the returns of simple market indices, usually for equities, such as the S&P/ASX 200.

These original passive funds, which remain the most popular passive product in Australia, are linked to the price of the underlying shares – the so-called “market capitalisation-weighted” approach.

Enter the ETF

However, since the first index funds came on the market in the 1970s, passive investing evolved considerably. Most importantly, the development of exchange-traded funds (ETFs) transformed index investing globally.

As the name suggests, ETFs are exposures to a particular index traded on the exchange like a single stock. They tend to be much cheaper than their unlisted relatives.

Australia has been much slower than offshore markets (particularly the US) in adopting ETFs; however, the latest data from fund research house Plan for Life shows the local ETF market grew by almost 33 per cent in 2012 – albeit off a low base.

According to Plan for Life, as at December last year, 10 ETF providers managed about $6.5 billion across a range of indices, including Australian shares, gold and emerging markets.

Robin Bowerman, head of strategy at Vanguard Australia, says demand for its unlisted funds and new range of ETFs via financial advisers and direct investors is increasing, driven by cost and dissatisfaction with active manager returns.

“SMSFs [self-managed super funds] are leading the charge into ETFs,” Bowerman says.

Vanguard has been a strong advocate of using passive funds – either unlisted or ETFs or both – as a core part of a portfolio, while active products form a minority satellite role.

However, Mark Oliver, head of iShares Australia, BlackRock’s ETF division, says investors are also beginning to “blend” their active and passive decisions.

For example, Oliver says last year Australian investors primarily used iShares to make active asset allocation decisions to offshore equities – specifically the US and emerging markets sectors.

Rewriting indexing rules

As ETFs have opened up new vistas for passive investors, benchmark pioneers have also re-engineered the basis of index investing itself. Rather than relying entirely on the market cap-weighted approach epitomised by Vanguard, other providers have constructed a range of indices based on fundamental factors such as company sales, dividends and book value.

In Australia, for instance, Realindex, which bases its methodology on US-based fundamental index originators Research Affiliates, reached $3 billion under management in February – mostly courtesy of its distribution arrangement with Colonial First State.

While not claiming to be in the fundamental camp, Dimensional Fund Advisors (DFA), second only to Vanguard in the global passive investing stakes, has also carved out a niche in Australia.

Based on the thinking of American academics Eugene Fama and Ken French, DFA constructs passive-style portfolios that seek to take advantage of historically identified sources of return, such as value and the “small-cap effect” (where small companies tend to deliver higher returns over the long term).

“The active/passive debate is meaningless,” says Jim Parker, head of communications at DFA Australia. “We think that traditional active management is not the way to go, and indexing isn’t the ultimate answer because it’s not necessarily based on real sources of returns.”

Investors are being pitched so-called “smart beta” products, which embed active-like investing rules wrapped up in a passive form, usually an ETF.

For example, products such as minimum variance ETFs (which Oliver says is a popular iShares line) promise to offer index-like returns while screening out the most volatile stocks.

But as the border between active and passive management blurs, Bowerman says investors need to focus more sharply on underlying strategies.“It behooves investors to understand what they’re buying,” Bowerman says. “In our view the cap-weighted approach is indexing, all other ways are active tilts – there’s nothing wrong with that but just don’t call it indexing.”

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