Reforms to boost indexing appeal

Financial planners have already started to focus on costs as a result of the proposed Future of Financial Advice reforms package, which could significantly boost the appeal of indexing over the next few years. Janine Mace reports.

Although the disappointing performance by active managers during the GFC may have been the first spur to advisers to take a serious look at indexing, the Future of Financial Advice (FOFA) reforms package may be what really gives indexing the inside running.

As Vanguard Australia’s principal, corporate affairs and market development, Robin Bowerman explains:

“Financial planners felt active management did not deliver, so they opted to buy the market. Now the FOFA reforms are driving structural change to fee-for-service and we are seeing quite a shift to index funds as this takes away the payment distortion and increases the shift to an asset allocation emphasis.”

He believes this will only increase in the next few years.

“As advisers move to fee-for-service, there will be more of a shift to index funds due to their lower cost and asset allocation benefits,” he said.

The development mirrors a similar trend in the US when fee-for-service was first introduced, explains Bowerman. 

“It changes things and the question becomes what is the right thing for the client. The best asset allocation becomes the key.”

He believes FOFA will drive major changes in the investment side of the business. 

“With the FOFA reforms, more financial planners are using direct equities to invest, so they are also driving the growth in the ETF market,” Bowerman said.

Standard & Poor’s director of fund services, Paul O’Connor, expects to see greater use and acceptance of index funds in the Australian retail space as advisers come to terms with the new reform and investment environment. 

“Financial planners need to reiterate their value proposition, and the core plus satellites approach using indexing is an increasingly important part of that,” he notes.

Searching for savings

Susan Darroch, State Street Global Advisors (SSgA) Australia’s head of global structured products, echoes Bowerman’s comments about the US experience. 

“As the US moved towards a fee-for-service environment there was a real correlation to the take-up of ETFs in that market. It led to a very noticeable increase in ETF inflows.”

She believes the current focus on cost is having a significant impact in the retail market and is helping boost the appeal of indexing.

“Fees have become a focus and that has definitely helped with the acceptance of indexing in the market.This is particularly the case in the booming ETF market. 

“Cost is a very big issue, as most managed funds charge 70-100 basis points, whereas it is 28.6 basis points in our SPDR STW fund. This is a huge difference for retail investors,” she notes.

Darroch claims the cost differential has been a major reason behind the popularity of ETFs.

“We are definitely seeing an influence on ETFs and a growth in the Australian market for ETFs due to this cost emphasis. As the financial planning industry moves from commission to fee-for-service, it will help the ETF market to grow,” she says.

“There is a real push for lower costs and this will help growth overall in the index market.”

O’Connor is another who believes the emphasis on cost due to FOFA and the lower investment return environment is making indexing more popular in the retail market.

“The financial crisis has led to a focus on fees and indexing is a cheap way to grab market beta. If world markets are setting into a growth pattern, then it can be a good way for investors to get access to that cheaply,” he explains.

“It has been a core area and one of the main reasons why investors have considered the use of index funds. The impact of FOFA and fee-for-service is likely to be a further kicker for index funds and ETFs,” O’Connor said.

As advisers focus on costs, the after-tax benefits of index funds are also becoming important, according to Realindex Investments chief executive officer, Andrew Francis.

“That is where most index strategies have a natural level of competitive advantage versus a high turnover strategy. There is a smaller advantage in the superannuation and pension sectors, but in high tax brackets there can be a significant difference in the outcome for the investor,” he explains.

Darroch agrees: “By their nature, index funds are much more tax effective than an active portfolio.”

She believes there is growing interest in after-tax returns and this is highlighted by the launch of the FTSE after-tax series of indices. (An ETF based on one of these indices is already in the planning stage.)

“In this market, there is definitely an after-tax focus, and this can be seen in the FTSE indices,” Darroch notes.

Sophisticated strategies

Against this background, advisers are becoming increasingly sophisticated in their use of index funds.

According to Bowerman, the institutional strategy of core plus satellites is now gaining ground in the retail market. 

“Institutional investors have been using it to lock in beta and to ‘de-risk’ the portfolio and then use satellites with high performance managers to capture alpha. Five years ago, the debate was about indexing versus active, but now financial planners have figured out that core plus satellites can be the best approach,” he explains.

“Financial planners have worked out they don’t need to be the best stock-pickers, but rather, it is about developing well-constructed portfolios,” Bowerman says.

Francis agrees: “Core plus satellites is getting a lot of traction with planners now, although the particular use comes down to the individual clients and their goal and situation.”

This acceptance is seeing advisers use core plus satellites strategies both within asset classes and across the total portfolio. It also fits neatly with Australian investors’ love of shares – particularly in the SMSF market.

“SMSF investors are very comfortable with developing a direct Australian equities and cash portfolio and then using ETFs to buy additional exposure,” Bowerman explains.

“They are less comfortable with international equities, so they are using ETFs to get global exposure for their portfolios.”

Advisers are also using a core plus satellites strategy with strongly performing active managers. 

“We are seeing advisers blending the Vanguard International Equity share fund with the high conviction Platinum International Equities fund for this asset class,” Bowerman notes.

According to Darroch, the flexibility of the core plus satellites approach is behind much of the growth in the ETF market, because it can be used in different ways with different indices.

“Satellites are now not just an active fund, but they can also be a satellite that focuses on a different index. The core could be a standard pure replication index fund, and then you have minimum volatility satellites, or a valuation tilt satellite. It is about looking at the overall investment objective and putting all the pieces together,” she explains.

O’Connor believes the use of core plus satellites in the retail market echoes the trend in the institutional market of focussing on single manager, sector specific investment funds.