Reducing investment costs
Tuesday, 22 June 2010 14:19 |
Any good negotiator will know that real power comes from knowing what you want and being prepared to walk away from the table. If the deal is worth doing, it is worth doing right. If someone is too eager to sign on the dotted line, the chances are that the terms reached will be poor. This analogy is remarkably true of investing too.
As we explain to our clients on a regular basis, our belief is that stockmarkets are efficient due to the sheer number of transactions, with buyers and sellers setting an appropriate price. The number of shares traded on the London Stock Exchange in March 2010 was over 47 billion! However, within a stockmarket, as with any other market, different buyers have different requirements.
For instance, managers of index funds who manage portfolios to track a specific benchmark will often suffer costs and portfolio turnover to keep their fund as close to the benchmark as possible. Ironically, in the attempt to track the market as closely as possible their costs can rise, leading to market underperformance! We use Vanguard and Legal & General for “main market” (e.g. FTSE All Share) equity exposure in our portfolios. Both companies fall into this category, however, we are pleased to say that they have flexibility in their trading rules so as not to be slavish followers of an index every day.
Another type of manager, the “active” manager believes so strongly that a stock is undervalued at a particular point in time that they will almost pay any cost for a security and will often chase a price higher. Where active managers often contend that they add real value is in smaller companies as they are less well researched. However, S&P research from April 2009 suggests that, on average, active managers actually tend to perform even worse in the smaller company sector because the illiquidity of the shares forces them to pay even more!
A third category of fund manager, however, is indifferent to whether it buys stock A or stock B if they both fit the necessary characteristics that the manager requires. With a stockmarket being so large, and portfolios being so well diversified, their view is that there is no real need to buy a particular stock at any one time. This type of manager therefore has the flexibility to wait until the market comes to him – in other words can buy shares from forced sellers who will accept almost any price, rather than being driven to pay too much. In this way the manager provides liquidity to the market.
Dimensional Fund Advisors, who our clients will be familiar with, fits into this final category. Due to its unique approach to investing, neither hugging an index, nor being a traditional active manager, it can provide liquidity to the market where it is needed. Market segments that need liquidity are the areas Dimensional specialise in – smaller companies and value companies. Dimensional does not provide liquidity for free though. It benefits from this through achieving better prices on companies it buys and sells.
Sunil Wahal, vice president of research at Dimensional has recently completed some research on all the US equity trades Dimensional placed between January 2007 and October 2008. This shows that on average, Dimensional paid 15 basis points (0.15%) below the best ask price when it was buying stocks and 13 basis points (0.13%) above the best bid price when it was selling stocks. The benefits were even greater when looking solely at smaller companies.
This demonstrates that Dimensional’s flexible approach - being prepared to walk away from the table - is a real source of added value. This is the type of fund management partner we want to work with – one that it dedicated to intelligent techniques and is passionate about keeping costs down. As we like to explain to all of our clients, costs are one of the certainties in fund management whereas future returns are always an unknown. Anything that can be done to reduce costs is something of great benefit to all our clients, and is something Evolve works on tirelessly on our clients' behalf.
As we explain to our clients on a regular basis, our belief is that stockmarkets are efficient due to the sheer number of transactions, with buyers and sellers setting an appropriate price. The number of shares traded on the London Stock Exchange in March 2010 was over 47 billion! However, within a stockmarket, as with any other market, different buyers have different requirements.
For instance, managers of index funds who manage portfolios to track a specific benchmark will often suffer costs and portfolio turnover to keep their fund as close to the benchmark as possible. Ironically, in the attempt to track the market as closely as possible their costs can rise, leading to market underperformance! We use Vanguard and Legal & General for “main market” (e.g. FTSE All Share) equity exposure in our portfolios. Both companies fall into this category, however, we are pleased to say that they have flexibility in their trading rules so as not to be slavish followers of an index every day.
Another type of manager, the “active” manager believes so strongly that a stock is undervalued at a particular point in time that they will almost pay any cost for a security and will often chase a price higher. Where active managers often contend that they add real value is in smaller companies as they are less well researched. However, S&P research from April 2009 suggests that, on average, active managers actually tend to perform even worse in the smaller company sector because the illiquidity of the shares forces them to pay even more!
A third category of fund manager, however, is indifferent to whether it buys stock A or stock B if they both fit the necessary characteristics that the manager requires. With a stockmarket being so large, and portfolios being so well diversified, their view is that there is no real need to buy a particular stock at any one time. This type of manager therefore has the flexibility to wait until the market comes to him – in other words can buy shares from forced sellers who will accept almost any price, rather than being driven to pay too much. In this way the manager provides liquidity to the market.
Dimensional Fund Advisors, who our clients will be familiar with, fits into this final category. Due to its unique approach to investing, neither hugging an index, nor being a traditional active manager, it can provide liquidity to the market where it is needed. Market segments that need liquidity are the areas Dimensional specialise in – smaller companies and value companies. Dimensional does not provide liquidity for free though. It benefits from this through achieving better prices on companies it buys and sells.
Sunil Wahal, vice president of research at Dimensional has recently completed some research on all the US equity trades Dimensional placed between January 2007 and October 2008. This shows that on average, Dimensional paid 15 basis points (0.15%) below the best ask price when it was buying stocks and 13 basis points (0.13%) above the best bid price when it was selling stocks. The benefits were even greater when looking solely at smaller companies.
This demonstrates that Dimensional’s flexible approach - being prepared to walk away from the table - is a real source of added value. This is the type of fund management partner we want to work with – one that it dedicated to intelligent techniques and is passionate about keeping costs down. As we like to explain to all of our clients, costs are one of the certainties in fund management whereas future returns are always an unknown. Anything that can be done to reduce costs is something of great benefit to all our clients, and is something Evolve works on tirelessly on our clients' behalf.
