Reinventing index investing

One glimmer of light to come from the COVID-19 pandemic is the surge in demand for financial advice from Australians. 

The number of unadvised Australians who intend to seek financial advice in the next two years rose to 2.6 million in 2020 from just 1.3 million in 2015, according to Investment Trends’ 2020 Financial Advice Report, which surveyed 4,394 people in July last year.

This presents an enormous opportunity for financial advisers to expand their businesses. However, the cost of serving aspiring Australians with more modest wealth can act as a barrier.

To make financial advice more accessible, product manufacturers must support advisers to find sustainable ways to make advice affordable to a wider range of people, while ensuring that clients’ needs are met and the advice is in their clients’ best interests. 

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LOW-COST MARKET EXPOSURE

While not a new investing concept, low-cost index funds are gaining popularity with advisers looking for ways to build efficient portfolios without compromising on quality.

At Colonial First State (CFS) we are seeing a sustained resurgence of interest in index funds, with almost $2 billion inflows into the CFS Index Australian Share fund and over $1.3 billion into the CFS Index Global Share fund since the start of 2020 alone. 

Index funds provide investors with broad and diversified exposure to market returns at a low price point. 

Fees for index funds are significantly lower than actively managed funds investing in the same asset class. Costs in index funds are kept to a minimum by using systematic processes to track a benchmark index. Portfolio turnover is usually low, which minimises transaction costs and offers the potential for tax efficiency.

In contrast, actively-managed funds draw on the expertise of specialist investment managers. Clients pay for these professionals’ analytical skills, industry knowledge and judgement, as well as the access they have to investments that would otherwise be difficult or impossible for investors to participate in. Such expertise and access can deliver strong returns for investors, but it does come with higher fees to cover the costs of those service benefits. 

Active fund managers that are seeking to outperform the market may change their portfolio holdings frequently, leading to higher transaction costs and tax implications for investors.

SMARTER INVESTMENTS

Beyond their cost advantages, index funds have become far more sophisticated, making them more appealing to investment savvy but cost-conscious clients. 

Traditionally, index funds have focused on giving exposure to a single asset class such as shares or bonds. More recently, multi-sector index funds have become available with strategic asset allocation built in, saving investors and advisers the time and effort of creating diversified portfolios that suit their risk profile. 

Demand for these multi-sector index funds has been strong and there has been strong take up of the four other multi-sector index offerings with balanced, moderate, growth and high growth profiles.

This shows us that Australians are looking for low-risk and low-cost investment options to allow for a diversified portfolio that suit their end goals.

Geared equity index options are set to be added to the mix in the coming months for growth-focused clients who want to boost their returns in the low interest rate environment, while controlling portfolio costs. 

IN SEARCH OF PASSIVE RETURNS

The growth in unlisted index funds has been mirrored by an increase in demand for passively managed exchange traded funds (ETFs). 

Passive ETFs are similar to index funds in that they aim to replicate the returns of a benchmark index, rather than aiming to achieve higher performance by actively skewing their portfolios to capture or avoid particular sectors or investments. Like unlisted index funds, passive ETFs typically have low portfolio turnover and charge low management fees. 

A key difference between the two investment types is that ETFs are listed on a stock exchange and are traded like shares, whereas index funds are unlisted and are purchased like other managed funds. 

This means that every time a client wishes to increase or redeem their investment in an ETF, they will incur brokerage fees. Index funds on the other hand, do not charge transaction fees for clients adding to or redeeming their investments.

For clients making regular contributions to their investment portfolio as part of a wealth creation strategy, the brokerage costs incurred in using ETFs may make unlisted index funds more competitive on the basis of transaction costs.

HIGHER RETURNS FROM A STABLE BASE

Numerous academic studies have shown that asset allocation is one of the biggest drivers of long-term portfolio performance. The influential study 'Determinants of Portfolio Performance‘ by Gary Brinson suggested that over 90% of a portfolio’s long-term returns could be attributed to its strategic asset allocation. 

As index funds do not try to outperform their benchmark, investors looking for returns above the benchmark results will need to augment their portfolio with actively-managed strategies. 

A common approach involves using index products to achieve diversification at a low cost, then adding selective exposures to active funds with particular outcomes in mind.

This is known as a core-satellite approach to portfolio design, with the ‘core’ being the index product and the ‘satellites’ referring to more aggressive actively managed investments. 

A core-satellite investment strategy, particularly when using a multi-sector index fund as the core, allows advisers to efficiently achieve an asset allocation mix that aligns risk with their client’s risk appetite while minimising costs.

For instance, a client approaching retirement with a short-term investment horizon might prioritise capital preservation and investment stability, but still need some potential for growth. 

They might allocate 80% of their assets to a conservative multi-sector index fund that has a 70% allocation to defensive index investments and 30% to growth index assets, providing a stable base of returns. 

To that core, they may add ‘satellite’ exposures to income-producing assets, such as global infrastructure and global property, and funds expected to deliver higher growth prospects over time, such as Asian shares or small companies.

Meanwhile, a wealth accumulator client looking for growth, with a longer investment time horizon and a higher risk tolerance, might consider a 75% allocation to a growth-focused index option as a core, with smaller satellite exposures to funds giving access to specific themes, regions or gearing. This might include allocations to technology funds, emerging markets funds or small companies share funds that the adviser and client believe will outperform over the long term.

Using this core-satellite portfolio approach combines the benefits of passive investment – including low cost, diversification and tax efficiency – with the potential for outperformance offered by actively managed strategies.

MANAGING OPERATING COSTS

Of course, investment expenses are only part of the cost of advice equation. The costs and complexity of running a modern financial advice business are high, with compliance demands and work overload both significant sources of stress for financial planners.

To reduce the burden, advisers need access to a comprehensive reporting suite that enables them to efficiently keep track of their clients and their business. They need access to technical support on demand from platforms, software and other service providers where relevant.

In this era of COVID-19, the ability to interact with clients in a digital world, using electronic signatures and executing client transactions digitally in conjunction with planning software and other tools has never been more important. Platforms and other adviser technology are evolving to support these requirements.

VALUE OF ADVICE 

Advances in technology are helping advisers to provide clients with more information about their portfolios. For example, portfolio holding tools that accompany the new breed of index funds now available give advisers and their clients a detailed view of the underlying assets in each investment option, right down to the names of familiar companies they are invested in. 

This level of transparency can make it easier for clients to fully appreciate the investment strategy that the adviser is recommending. 

We know from our own adviser research that clients want to be more engaged with their investments. Advisers can assist clients to become actively engaged in their portfolios by helping them to develop a deeper understanding of the investments they hold. With a greater level of understanding, clients are more likely to value the advice they have received.

How highly the client values advice is a critical factor in how much they are prepared to pay for advice. This is the case both for clients with lower levels of wealth where affordability is a consideration, and for higher wealth clients who are becoming increasingly cost conscious as information allowing for cost comparisons becomes more readily available.

Improving business efficiency gives advisers the option to pass operational savings on to clients in lower fees for their service. Building portfolios around increasingly sophisticated index-based investment solutions lowers the cost of investing. When combined, these measures, can help advisers to achieve goals for their clients, as well as growth for their business.  

Bryce Quirk is chief distribution officer at Colonial First State.