Focus on equities rather than bonds

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Indexing:Is the case stronger for international than domestic investing

Eric Smith – Chief Investment OfficerVanguard Investments Australia Ltd AFSL 227263

30th March 2005

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Focus on equities rather than bonds• Most bond manager performance is a beta bet – overweight lower

grade credit• Two thirds of the money is invested in equities• Costs of participation are high – fees, implementation and tax

consequences

The case for indexing? The question should be is there a case for active.

Australian equities

International equities.

Agenda

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Mercer survey at June 1997• 69 managers/products listed• 67 with a return sometime in the last 12 months• 62 with a return at 30 June

Mercer survey for June 1997 at March 2005• None of the (previously listed) managers without a return at 30 June

still showing in the survey• 65 with a return at 30 June

The problem?• Only 39 return series are still the same• The 12 month average return of the universe has jumped from:

28.16% to 28.74% - an increase of over 0.5%

Survey IssuesAustralian Equity Managers

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10 years to March 2005• It’s a round number• Survey includes dead managers from June 1997 so only two years of

strong survivorship bias

Include all monthly excess returns• 47 managers/products at April 1995• 66 at June 1997 (none lost???)• 102 at March 2005 – gained 96, lost 41• 9353 monthly excess returns

Analyse in quarterly bins

NeverthelessAssume the survey is okay and analyse it

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Median Monthly Excess ReturnsQuarter by Quarter - 10 years to 31/3/2005

-0.200%

-0.100%

0.000%

0.100%

0.200%

0.300%

0.400%

0.500%

0.600%

30/06/95 30/06/98 30/06/01 30/06/04

Median monthly return: 0.054% per monthStandard deviation: 1.04%

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Is there a worthwhile effect• 0.054% per month is 0.65% per annum (log excess returns)• Typical active risk is 2.5% per annum• Hurdle rate is probably 0.5% per annum

There appears to be two sub-universes• Smart and random?• Seasoned and unseasoned?

Slice and dice by return type• For ease of analysis, simply categorise by ‘time in survey’ at the point

of publishing a return.• Have only used a single distinction – those with less than 3 years and

those with 3 or more

NeverthelessAssume the survey is okay and analyse it

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Median Monthly Excess ReturnsQuarter by Quarter - 10 years to 31/3/2005

-0.200%

-0.100%

0.000%

0.100%

0.200%

0.300%

0.400%

0.500%

0.600%

30/06/95 30/06/98 30/06/01 30/06/04

Seasoned managersUnseasoned managers

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Median Monthly Excess ReturnsQuarter by Quarter - 10 years to 31/3/2005

-0.100%

0.000%

0.100%

0.200%

0.300%

30/06/95 30/06/98 30/06/01 30/06/04

Seasoned managersMedian 0.030% per month

Unseasoned managersMedian 0.059% per month

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Everyone was a winner• Median active (non-index/enhanced) manger return was 17.9%• Index return was 13.6%• 51 of 55 ‘beat the index’

However, the active manager universe does not hold the index• Chronic underweighting to mega-cap stocks• Chronic overweight to large-midcap stocks• This is a structurally-driven factor bet, not a positive decision

Beta masquerading as Alpha

March 2000 to March 2001Were all the managers smart?

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A moving universe. In the Mercer survey:• There were 40 or 41 ‘core’ managers/products with 1 years returns in

each of the last 5 years• There are 35 with a current 3 year return• There are 31 with a current 5 year return

Tracking errors against the FTSE World and MSCI All Country are lower on average than against the MSCI World• MSCI World is not the world market

Long history analysis shows ‘stopped-clock’ effects with managers holding fixed positions and looking more like each other than the market.• The outcome is window dependent relative performance

International Equities

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International Equities

FundsNumber of Funds 41 41 40 40 4095th Percentile 11.5 -12.1 -16.9 16.3 10.2Upper Quartile 1.7 -19.5 -19.1 14.5 6.8Median -1.3 -20.7 -20.7 13.4 5.9Lower Quartile -5.3 -22.2 -21.6 11.7 4.85th Percentile -7.4 -23.9 -24.2 9.0 2.5Arithmetic Mean -0.2 -19.6 -20.6 13.1 5.9

BenchmarksMSCI Wld (ex Aus) -4.5 (30) -22.0 (29) -21.9 (32) 12.8 (25) 4.5 (32)FTSE World Index -1.8 (23) -20.9 (23) -21.2 (25) 14.0 (14) 6.3 (17)MSCI AC World -4.4 (30) -20.7 (21) -21.2 (25) 14.0 (14) 6.2 (18)

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Australian equities – active managers are not as hot as they look• Seasoned managers don’t outperform as a group. So how do you

distinguish skill from luck?• Returns to structure mask the outcome. Can a simple model explain

‘median manager’ results?

International equities• Traditional ‘core’ managers have not outperformed the market in the

last 5 years• Returns to structure can mask the outcome.

Conclusion