VINCE SCULLY | Life Sherpa
VINCE SCULLY | Life Sherpa
Should I be investing actively or passively? Will I make more if I have an "expert" managing my dosh? Is making the most money even the right goal? There are no one-size-fits-all answers. Your investment journey is unique, and finding the right approach may involve a mix of both index and active funds.
I would say that there is, is actually no such thing as passive. That choice of an index and indeed construction of index are both active decisions. I'd rather think of the word as being rules-based or index-based, that it's not actually a passive decision...There is a committee that decides what's in the ASX 200. So it's not purely a mathematical construct. So by choosing the ASX 200, you are by definition saying, I wanna put half my money in the top 10, which means I'm taking a large capitalization position, I'm putting 27% of my money in financials, and I'm putting 24% of my money in materials. So half in the top 10, half in financials and materials.
It did my head in a little but eventually made sense. Any investing decision, even passive, is a rules-based decision.
We also had a look at the history of indexes (indices!) and the question that it answers.
It really started as a way of answering the question, how did it go on the market? As long as we've been trading, whether it's wool or shares, we've always wanted to know that question. Go back to the 16th century and Shylock Merchant of Venice goes, what news on the Rialto? Right? How do we go on the market today? And so we created various ways of doing that. We started with, you know, did individual shares go up or down? Did more of them go up or down? Or did more of them go up than went down? So we then had the declines versus advances rule, and then when we developed a bit more sophisticated technology, you could squinting out, does it look mostly red or mostly green? And then we started to build indexes, or indices, even the Dow Jones', 1920s. 1920s. And that was really just a basket of stocks that whoever created it thought broadly represented the market. But as technology improved and we had the ability to process lots of data in real time, we started to move on to broader based indexes. So the S&P500 is 500 shares, unsurprisingly, and they're very eclectic mix, and it's not cap-weighted. So the big ones, the most popular ones are now capital, capital weighted so that the bigger, the bigger a proportion of the market a share is the bigger it's component of the indexes. And that's become a way of answering the question, how did it go in the market?
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One of the things that I always come back to when people ask me, should I buy index funds or active funds? I'm like, well, that's a bit like walking into a bottle shop and saying, should I buy bottles of cans before you've worked out what you wanna drink? So if you wanna drink beer and you're going camping, cans are probably the right answer because they're lighter to carry. You can crush them when they're finished and they cool down quicker. On the other hand, if you are having a Wagyu steak and you want a full bodied Shiraz, you probably don't wanna be drinking out the can. You probably want out of a bottle and you probably want a bottle with a cork. So what do you wanna drink is the first question.
G'day, and welcome back to shares for beginners. I'm Phil Muscatello. What is an index? What if there's more than one? Do you say indexes or indices? And should you invest in an index or consider a manager who actively seeks high returns? Joining me is Vince Scully from Life Sherpa G'day, Vince
Vince (1m 4s):
Goodday. Phil, it's great to have you in the studio.
Phil (1m 7s):
I know it's really strange. No, I'm, I'm not in my usual studio here at the moment, and it's very, very comfortable and highly professional. So, how's things going, Vince?
Vince (1m 17s):
Going great. Life Sherpa is having a great year and it's just a great time to be in advising. Despite what you might read in the paper. Yeah, I keep telling all my colleagues that there has never been a better time and,
Phil (1m 30s):
But everyone's leaving the industry and there's all the new regulations and no one knows what's gonna happen with the new review, the levy review, but it, it's all copacetic, is it?
Vince (1m 40s):
All change is good change though, Phil.
Phil (1m 41s):
Proud of destruction.
Vince (1m 43s):
And of course, you know, with fewer advisors and more people needing advice, that's obviously great if you're an advisor. Not so good if you're a consumer, of course. Which is why I created a Life Sherpa so that we could get affordable advice.
Phil (1m 55s):
I just wanted to start off, I wanted to, I was mentioning that I wanted to tell you a story Yeah. That I heard at the Australian Shareholders Association Annual Conference last week. And it was one of those things where at lunchtime you end up on those little tables and you end up talking to people that you would just randomly meet and was talking to an electrical engineer and a grandmother, I don't want to categorize it too much, but she looked very grandmotherly and that was why she was there, because she'd inherited some shares. She wanted to learn about shares and she wanted to teach her grandchildren about investing. And lovely, lovely woman. Hello Rosaline, if you're listening. I did tell her about this podcast.
Vince (2m 36s):
And was she in fact a grandmother?
Phil (2m 37s):
She was, yeah. But she was talking about teaching her grandkids and about which ones were interested and which ones weren't. And, but the problem is, one of her grandkids actually made a lot of money out of gambling and what he was betting on was after the 2020 US election, there were a lot of people who thought Donald Trump was going to win and he was just betting against them. And he was betting thousands and thousands of dollars and made, can I say shitloads?
Vince (3m 6s):
That was probably a good bet.
Phil (3m 7s):
So I've got it. My first question, we're going back to basics here. What is an index?
Vince (3m 12s):
That's a really good question, because these things are sort of taken a bit of a life of their own. The whole, it really started as a way of answering the question, how did it go on the market? As long as we've been trading, whether it's wool or shares, we've always wanted to know that question. Go back to the 16th century and Shylock Merchant of Venice goes, what news on the Rialto? Right? How do we go on the market today? And so we created various ways of doing that. We started with, you know, did individual shares go up or down? Did more of them go up or down? Or did more of them go up than went down? So we then had the declines versus advances rule, and then when we developed a bit more sophisticated technology, you could squinting out, does it look mostly red or mostly green?
Vince (3m 58s):
And then we started to build indexes,
Phil (4m 2s):
Vince (4m 3s):
Or indices, even the Dow Jones', 1920s. 1920s. And that was really just a basket of stocks that whoever created it thought broadly represented the market. But as technology improved and we had the ability to process lots of data in real time, we started to move on to broader based indexes. So the S&P500 is 500 shares, unsurprisingly,
Phil (4m 30s):
Cuz the Dow Jones is only
Vince (4m 34s):
Phil (4m 35s):
31 Shares. Yeah.
Vince (4m 37s):
And they're very eclectic mix, and it's not cap weighted. So the big ones, the most popular ones are now capital, capital weighted so that the bigger, the bigger a proportion of the market a share is the bigger it's component of the indexes. And that's become a way of going, answering the question, how did it go in the market? And from there it became a measure of benchmarking. So if I'm managing a fund, did I, how did I go against the, the index or the benchmark?
Phil (5m 9s):
And here in Australia it's the ASX 200. Yeah. And
Vince (5m 13s):
It's the all ords. And then the S&P ASX 200 and 300
Phil (5m 20s):
And like, like you said, they're, they're weighted by capitalization. So when you're looking at the ASX 200, the vast weight of that index is the banks, the miners,
Vince (5m 31s):
Half of half of it is in the top 10. And then it becomes today a way of selecting stocks to put in a diversified pool. And that's where most people, I think, think about indexes as a, a tool for constructing a portfolio. And those three purposes require different things from an index. And picking the right one is, is the key to getting that right. Hmm. So if I'm trying to benchmark myself, I sort of need an index that reflects what I'm actually doing.
Vince (6m 11s):
Hmm. So is a broad index, like the ASX 200, which is largely a large cap finance and materials index, is that an appropriate measure? If I'm running a tech stock tech fund, probably not. And is that index the right thing for me? Which I guess we can sort of come back to, to later, but that's really what an index is, and you gotta make sure you're picking the right index for what you're doing.
Phil (6m 44s):
But in, in its most basic terms, if you are trying to pick your own shares to buy, you really need to benchmark it against, say, what you would get if you just put it into an a vanilla etf, ASX 200 etf, you don't really have to think about that. And unless, well, that assumes trying to outperform it.
Vince (7m 2s):
Well that assumes that your goal as an investor is to outperform the market, whatever the market might be. And to choose
Phil (7m 13s):
Whichever you choose
Vince (7m 14s):
To choose that as a goal. You've gotta do two things. You've gotta pick a market or you've gotta do three things. You've gotta pick a market, you've gotta do something different. And that different thing has to somehow relate to the goal that you're trying to achieve. So a goal to outperform a market is meaningless for a lot of people because what, what are they investing for? They're investing to achieve some goal, whether that's to retire, to start a business, to put their kids through school, to retire early, to have a holiday. All of those things have a, a timeframe and an amount of money they're prepared to allocate to it.
Vince (7m 57s):
And return is the balancing number. So I can choose to, I wanna outperform the market and for most people in Australia, the market means the ASX 200 or I can choose enough risk to achieve the return I need, or I can choose to maximize my return for any given level of risk. And there are three different objectives and only two of them will actually align with your goal. So the notion of outperforming a market whilst a useful benchmark if you're a fund manager is sort of academic in a consumer space.
Phil (8m 46s):
And, and We should just mention that most ETFs, just about any ETF is based on an index. And if anyone's interested in finding out a bit more, I did actually track down in episode 71 of the podcast, Simon Karaban. He's a good Sydney Greek boy who's working in Singapore and his job is creating indices. And it was actually better talking to him off air than when we went on air because he, the stuff that he was telling me off air was much more interesting than when he was being polite and well behaved. But there just seems to be some indexes, some indices are better than others. And as we know, some ETFs are created as marketing tools and it has to be based on an index and therefore the index is maybe, okay, it is measure measuring something.
Phil (9m 36s):
But whether that is useful to an individual investor is another story.
Vince (9m 41s):
But of course, ETFs and indexes were made for each other because the whole concept of an ETF is that you can exchange the assets held by the fund manager for interests in the fund, which means you've gotta have a public basket of what's in the fund. And if you are trying to run an active fund, you don't really wanna be giving away all of your positions in real time. Whereas an index being a publicly available basket of assets that's easy to hedge generally makes them ideal for ETFs. So the two sort of go hand in hand.
Vince (10m 24s):
Well of course there are unlisted index funds as well, but ETFs work really well with indexes.
Phil (10m 35s):
Now, in my hastily constructed introduction, I didn't mention that the point of this discussion is that we're going to be looking at the difference between active and index investing. So, and this is a very broad, when you start digging into it, this is very, very broad, but what's your summary of the difference?
Vince (10m 53s):
Well at the risk of cutting this very, very short, I would say that there is, is actually no such thing as passive. That choice of an index and indeed construction of index are both active decisions. And so I
Phil (11m 8s):
Vince you're doing my head in,
Vince (11m 9s):
I'd rather think of the word as being rules-based or index-based, that it's not actually a passive decision. And there is an committee that decides what's in the ASX 200. So it's not purely a mathematical construct. So by choosing the ASX 200, you are by definition saying, I wanna put half my money in the top 10, which means I'm taking a large capitalization position, I'm putting 27% of my money and financials, and I'm putting 24% of my money in materials. So half in the top 10, half in financials and materials.
Vince (11m 50s):
I'm also choosing a price to book of two times,
Phil (11m 54s):
Hang on, what's, what's price to book?
Vince (11m 55s):
So price to book that is the value of the shares relative to their assets in their accounts. And that's a measure.
Phil (12m 2s):
So if you, if you had to sell, sell off the whole of the AX 200, that's,
Vince (12m 4s):
Phil (12m 4s):
That's two times
Vince (12m 7s):
What the accountants think it's worth. It's not necessarily it's actual market range.
Phil (12m 11s):
A measure of sorts. Yeah.
Vince (12m 13s):
And the, the significance
Phil (12m 14s):
And the, sorry, you were gonna go
Vince (12m 16s):
PE of 12 to 13. So the consequence of that is it's large cap tilted, it's financials tilted, it's materials tilted, it's value tilted by a relatively low price to book by world standards and a relatively modest PE by world standards. On the other hand, S&P500, only 27% are in the top 10, 25% detects in tech and only 13% in financials and as little as two and a half percent in materials. But it's got a price to book of 3.8 and a P of 20. So that's by definition a less large cap tilt and a more growth tilt.
Vince (13m 0s):
Now those two things will give you completely different results. So if you go back to your three factor pharma French model, you know, you got market size and value as your three big drivers, it returns, well those two indexes have fundamentally different factor exposure. Now that's not an either or, but it's just saying that the, the decision to choose the ASX 200 as your index, you are actually making a active decision to be invested in financials. Now does that fit what you're investing goal is?
Vince (13m 41s):
That's a completely different question. And just as much on the bond side, you know, you view by the Bloomberg Ausbond composite, which is what many of the big bond funds track, well, 70% invested in triple A. So that's really good fulfilling the risk-free component of your,
Phil (13m 60s):
They're they're government bond. So
Vince (14m 2s):
They're primarily commonwealth government.
Phil (14m 3s):
Yeah, yeah, yeah.
Vince (14m 4s):
But 25% of it is in the seven to 10 year maturity. So you are getting an effective duration of five and a half years, which means you're gonna have a particular sensitivity to risers and falls and interest rates. Is that what you want?
Phil (14m 20s):
As anyone who's invested in bonds over the last years has noticed.
Vince (14m 23s):
So you know, if I'm looking for a solution to the risk-free component in my portfolio, I'm as an Australian investor, I'm gonna be looking for largely Australian government local currency bonds. But is 5.4 used the right answer for my duration? That's an active decision. So
Phil (14m 44s):
I didn't know we were gonna get into bonds here, but, well there's so many questions to do with that, but yeah, but it's all to do with how long you're going to behold the bond for, isn't it? So the longer
Vince (14m 55s):
That's duration is, so just as for shares, you get paid for market size and value, with bonds you get paid for duration and credit. The longer the duration, the higher you should expect a return. And the lower the credit the higher,
Phil (15m 11s):
Unless you get an inverted yield curve, which is when it goes. Yeah.
Vince (15m 13s):
So the point of all of that without laboring it too much is that choosing an index is an active decision. So I'd rather try to think about this in the context of is it rules based or is it research-based?
Phil (15m 27s):
Vince (15m 27s):
And a rules-based approach gives you a few, few things. You know, it gives you fairly good certainty of what you are actually investing in. So if your asset allocation decision says, I want Aussie large cap, well you go and buy IOZ or A200 or VAS, that's what you're gonna get. And you know precisely what it's invested in and it's low cost. But the consequences is you are heavily invested in financials, value materials, the large cap.
Phil (16m 2s):
Well let, let's get then though, to what we'd be traditionally looking at as active. And you said it's more of a research based. Is that what, how you would more refined the definition?
Vince (16m 15s):
Phil (16m 16s):
I'd use it what we would normally talk about as being active
Vince (16m 19s):
Yeah. So I think by active you making stock selection decisions in order to achieve a particular goal. And those decisions are made generally by humans. And humans cost money, often a lot of money. And so the cost of making that decision is more expensive than the cost of paying s and p their license fee and following the rules. And so you've gotta say, well, why would I do that? When most of the research says that the average manager doesn't outperform on average when you take into account those fees, and the answer is if you wanna achieve something different.
Vince (17m 4s):
So in order to get something different that's different enough to support the fees and costs, you have to do something materially different. And the research will tell you that smaller managers with high conviction positions, we talk about an active share. So how different from the market is their asset selection? They're generally small numbers of positions, maybe 13 to 30 positions. And they are generally managers with large proportions of the manager investing in the fund.
Vince (17m 44s):
So in an Australian context, something like PM capital where Paul and his team own a big chunk of the fund and that, I can't remember what the rule is, but they have some rule for their team about what percentage of your net worth you have to have invested in the company funds. And those sort of funds are the ones that tend to deliver return. The downside is you've gotta find them when they're small and that comes with a whole bunch of other risks and
Phil (18m 14s):
And is that a managed fund?
Vince (18m 17s):
Yeah. So Paul Moore runs a called PM Capital. He's been running, he was at BT in the glory days when Kerry Nielsen was
Phil (18m 25s):
Oh, hear about, I always hear about the nineties of bt. No, this is eighties.
Vince (18m 29s):
Oh, eighties, eighties. And he set up his own business in mid nineties. I'm saying it's definitely nineties, I think mid nineties. Yeah. This is not a pitch for Paul, but an example of a high conviction fund where they're doing something different. So if you are looking for an active manager and they use words like overweight or tilt, you are probably buying a closet index and it's unlikely to ever create something materially different. And the point of, to my mind of doing active is to get something different.
Phil (19m 6s):
Well, most people would say more
Vince (19m 8s):
Phil (19m 8s):
Vince (19m 9s):
Yeah, I, I'm not sure that more is necessarily the right objective here.
Phil (19m 13s):
I know, I understand that completely. And I, I think that's one of the things that, I mean, there are actively managed ETFs, there's actively managed funds. So we just should use, just to find the base term of fund. Yes. A fund is just a pool of financial resources, which an ETF provider or a fund manager will allocate according to the mandate. And for example, just just to look at it simply and just trying to break it down, I'm talking totally theoretically here, there might be an etf, for example, that wants to maximize dividends. Hmm. So that there is more of an income stream for investors. So they're not looking necessarily for capital growth, but they're looking for more dividends, more cash flow, more of a steady cash flow.
Phil (19m 60s):
And that's a form of active management, isn't it?
Vince (20m 2s):
It is. And I can set up a set of rules that say if my yield is greater than 1.2 times the market average, I will include this and I will use this weighting. So that allows me to create an index. I could create an index of companies whose CEO is called Phil. How useful that is, is another matter. But it's simply a set,
Phil (20m 28s):
Set theory. Now
Vince (20m 29s):
A set of rules that dictates what asset you put in that fund. Many of them follow existing indexes. So if you are an s and p 200 ASX 200 fund, you buy what s and p say should be in your fund, and they publish the list every quarter where they add new ones and delete old ones. That decision as to which ones get out and which ones get deleted is done by real people. And it's not.
Phil (21m 3s):
So the ASX 200 is not fixed.
Vince (21m 5s):
Phil (21m 6s):
Coming every quarter. Every quarter, there's companies coming in and then leaving like relegation. It's,
Vince (21m 11s):
Yeah, it's like Premier
Phil (21m 13s):
And which we should have here in Australia as well in the NRL and the VFL.
Vince (21m 18s):
That's right. And the, so that's not a, that's not a purely mathematical question. There's a committee that meets and goes, well, based on our applying these rules and our philosophy and our biases, we'll add these three in and take these three out. It is closely related to market cap, but it also takes into account things like liquidity, how much is owned by Cornerstone shareholders and a few other points, but it, they then publish the rules and that's what you buy in your ASX 200 fund. On the other hand, you can get actively managed indexes like the Wilder Hill, what's it called now?
Vince (22m 1s):
The Bloomberg Wilder Hill New Energy Index, which is a actively managed index of green energy companies, green companies. And every quarter they publish the new lists. But it's sort of like a virtual fund where they're man creating this index, which you can then buy funds and ETFs that track. Yeah. The fact that it's an index doesn't mean that it's a market cap based index or that it's entirely rule based. But what you do know is that if you are buying a fund that tracks it using full replication, that is, they actually go and buy the stuff, then you know that's what you're getting.
Vince (22m 47s):
And the manager is kept honest by their tracking error. So you don't run the risk that you get style creep. So if you are investing an active fund, let's say it's supposed to be a large cap value based fund, well in the long periods of time when value underperforms, even though in theory it should outperform over time and it does, it does go for long periods of time where it underperforms. So is your manager gonna be tempted to slip, get, you know, pop a little bit of growth in to spice up the returns because they're incentivized not to have the investors pull their money out because they get paid based on assets under management.
Vince (23m 33s):
So the advantage of a rules-based fund is that you avoid style creep and you get pure transparency. And those two are highly valuable attributes of a fund that should never be underestimated.
Phil (23m 49s):
So investors, if they're looking for access to what we're broadly defining is a little bit more active than ASX 200 tracking etf. But if they want to have some more active management, what are the ways of finding, I mean there's ETFs and managed funds and we should not forget LICs listed investment investment companies.
Vince (24m 10s):
And of course you've got actually gone buy them. Yes, that's right. I, if you had a million and a half dollars, you could replicate the ASX 200. That's the minimum you need to buy a marketable parcel.
Phil (24m 20s):
Sorry, how much is that?
Vince (24m 21s):
A million and a half.
Phil (24m 22s):
Oh, okay. Yeah, yeah.
Vince (24m 23s):
So if you were to buy a minimum tradable parcel of the smallest member of the ASX 200 and then kept going, they kept, you need a million and a half by the time you get to buy, get the whole thing. And that's probably hopelessly inefficient because of your trading costs. So what do you do? You either buy a subset of those Yep. And hope that you've got it reasonably right. Or you go and buy a pooled investment
Chloe (24m 47s):
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Phil (25m 1s):
And, and that that's part of the thinking behind, I know with some LICs is that why do you wanna own all the banks and why do you wanna own all the resource companies? And this is the place where sometimes active decision making can help to produce either similar or better returns or better outcomes depending on what you have.
Vince (25m 28s):
You can, I mean, only two of the banks have outperformed the ASX 200 over the last 20 years. Macquarie, Macquarie and C cba. Yeah,
Phil (25m 36s):
I've been looking at Macquarie, I just was looking at the cage of the compounding annual growth rate of Macquarie Bank for like 20 years and something like 20%. I mean that's outperforming significantly the benchmark. I'm not saying, you know, we're not recommending that anyone goes out and buys Macquarie Bank.
Vince (25m 53s):
Well it was $3.50 when I bought my first parcel in 95 before it was listed. Yep. And today it's 200 and something,
Phil (26m 3s):
176. I think
Vince (26m 4s):
they didn't they crack 200 recently
Phil (26m 7s):
It did, but it's dropped off a little bit, I think of the banking stuff in America is affected a little bit.
Vince (26m 12s):
So Yeah. So they're the only two.
Phil (26m 13s):
And the other one would be cba.
Vince (26m 16s):
Yeah, CBA and Macquarie are the only two over five and 10 years. Yeah. They've all underperformed over one, three and five. One, one and three. Despite making up a quarter of the index, you could probably make a good living out of trading pairs of banks like picking two banks and trading in and out of them. My days are,
Phil (26m 36s):
Don't try this at home.
Vince (26m 38s):
My days o