Analysts tout the merits of cruise-control investing
Putting money in index-tracking funds has widespread support in much of the world, and this passive, sit-back-and-earn strategy is gaining advocates in the UAE as well, writes Rory Jones
Gordon Murray spent the last days of his life preaching the merits of passive investing.
An ex-Wall Street banker, Murray died of brain cancer last month at the age of 60, but not before he saw his book, The Investment Answer, become a global best-seller.
The "answer", he argued, is that active investment managers do not, over time, beat the market, so investing passively across index tracking funds will ultimately provide the best return in the long run.
For a former Goldman Sachs bond salesman, who later became a managing director at both Lehman Brothers and Credit Suisse, this book constituted a major U-turn in his investment approach.
For 25 years, Murray had encouraged active fund managers to buy his bonds so that they might outperform the return on the overall market. But after retiring in 2001 and meeting his financial adviser and co-author, Daniel Goldie, Murray's perspective soon began to change. He then started to advocate passive investing through index-tracking funds.
The most common form of an index-tracking fund is an exchange-traded-fund (ETF), which is widely available on international markets. But despite the many global advocates for ETFs, they have yet to become popular or widely bought in the Middle East.
"Most of the UK and European clients are less familiar with passive investing through exchange-traded funds," says Vince Truong, a senior financial planner at Holborn Assets in Dubai. "A lot of advisers aren't even that well educated in the product."
Clients from outside North America are less clued up on ETFs, he says. "I think there needs to be more education on passive investing."
So what is passive investing and how do ETFs work?
The word "passive" somehow conjures an image of investors hoping for the best and blithely throwing money at an asset class - be it a stock, bond, commodity or mutual fund.
Passive investing, or index investing, certainly contains an element of hope. But it also involves less work. Investors buy into a mutual fund - a pool of investors' money - which then tracks an index.
This could be one of a number of indices globally, whether it's the S&P 500 in the US or the FTSE 100 in the UK. On a basic level, if the index goes up 5 per cent, then the ETF goes up 5 per cent and the investors make a 5 per cent return. On the downside, if the index falls, so does the value of the ETF and the investors' capital.
"The ETF phenomenon is still relatively new in the UAE, but it's growing all the time," says Sean Kellerher, the chief executive of Mondial Financial Partners. "We are beginning to recommend global ETFs more and more to clients."
Passive investing, or buying ETFs, differs to active investing, whereby individuals or mutual funds try to buy a number of assets in the hope that they will go up more than the assets in the market as a whole.
The difference in approach can be equated to Formula One racing drivers. "Active" sports fans will pick the driver and car at the start of the season that they believe is going to win. After much research of the cars and drivers' statistics, punters might predict that the Australian, Mark Webber, is going to secure the overall title this year.
On the other hand, "passive" sports fans will be unsure who is going to be the best driver. Instead, they might predict that at the end of the season, all drivers as a whole will have recorded faster times than the year before. Rather than examining each driver's statistics, the passive fans might think that F1 drivers will be faster because technology and drivers' capabilities improve over time.
The investing concept is the same. Advocates of passive investing and buying ETFs believe that active investors cannot outperform the market overall in the long term. In the sport case, passive investors don't believe that fans can pick the winner of the F1 title consistently each year for a sustained period. They would rather predict that the whole field clocks faster times.
In terms of investing, passive investors think that over time, indices will go up as economies grow, so buying an ETF gives you broad exposure to that growth through a single investment. Active investors claim that markets are often inefficient - pricing and readily available information does not reflect the true value of an asset. They argue that this is particularly the case in emerging economies, so in the short run, opportunities to buy abound.
But which camp has the right approach?
Jeffrey Molitor, the chief investment officer in Europe for Vanguard Asset Management, says the universe of active investors and managers who can outperform the market over a long period of time is very small.
Many have bad years, Mr Molitor argues, when they pick poor performing assets. Also, many mutual-fund managers do not run money for periods as long as investors might want. If you're a 25-year-old investor and you're saving for a pension, then there are very few - if any - mutual funds you can invest in that will have the same manager for the 40 years until you retire.
"The one thing for certain is that fees are higher if you invest in a mutual fund that is actively managed or if you're an individual who buys and sells assets," Mr Molitor says.
According to his company's research, investing in mutual funds run by active managers will be, on average, 1 per cent more expensive each year than passive investing. "That's a big difference in return over 25 years," Mr Molitor says.
Even if you take out expenses, the data says that the aggregate of professional managers underperform the market, he says. "That's not to say there are not good managers and there are not inefficiencies to be exploited, it's just difficult to do."
Gordon Murray and Daniel Goldie's advice in The Investment Answer is to hire a financial adviser who pays a fee, rather than one who receives an ongoing commission from an insurance-plan provider. Then split up your money between stocks and bonds - domestic and foreign - and gain exposure to these through index-tracking funds.
According to financial advisers, most savings products in the UAE only offer investments in actively managed funds through insurance companies. These products generally pay the adviser an ongoing commission, which they would not receive if they recommended clients buy ETFs through a bank or online broker.
For high-net-worth individuals, Mr Kellerher says, it's a "no brainer" to invest in an ETF for a developed market. "You might think that investing passively through ETFs is best," he says. "But you still need to decide how to allocate those ETFs into which assets and indices, so this is where an adviser can help."
"At the end of the day, I'm an active allocator," Mr Truong says. "But I will pick passive investments for my clients because they are a saving in terms of price.
"I don't think emerging markets are efficient, so I would pick actively managed funds here. I'd use ETFs for core holdings in global developed market."
Updated: March 3, 2011 04:00 AM