The switch from my OEIC portfolio to my ETF one - one year on

ivormonee

For quite a few years I held all my investments in OEIC and unit trust form on a platform that was "free" (pre-RDR) and then converted its charging structure to a percentage based fee based on assets held (post-RDR). All my funds, around 25, were of the actively managed flavour. A year ago I decided to do a bit of research to learn a bit more about investing. I (think) I learnt that:

(1) actively managed funds generally (much more often than not) fail to beat their respective indecies, (2) pre-RDR platform fees were not "free" but in fact each fund had a charge of close to between 1.5% to 2.0% (which you never saw or properly understood or was able to quantify in any meaningful way, (3) post-RDR fees on a platform of 0.3% to 0.45% didn't seem that bad and neither (at the time) did actively manged fund fees of around 0.75% to 1.0%.

My conclusions were arrived at quite naturally, and these were that, passive (index tracking funds) must be the way to go, given their performance compared to actively managed counterparts over the long term (ie. several years or more); a balanced and diversified portfolio will (should) reduce volatility; actively managed funds are beaten on price by index trackers; and holding ETFs cuts down platform fees from 0.3% - 0.45% down to 0.0% (ie. zero, if you choose the right platform , of which there is a handful).

Given the above, I moved to a new platform that didn't charge for ETFs and transferred into them from the previous holdings in actively managed OEICs and unit trusts. The potential saving from this alone I calculated would be quite sizable (approx. 1.0%).

My (new) 60/40 portfolio over the year is up by approx. 6%. I've calculated today what my portfolio would have been worth if I'd left it in its previous incarnation and, that figure is 17%; the difference (loss) is a four figure sum and the discovery of this was a shocking revelation.

I then embarked on a mission to understand what has caused this. After all, the expectation was that the portfolio would be better off not worse of, and by such a large amount. Part of the reason seems to be timing. For example, I held a European fund which, at the time of the switch a year ago, was down over one year by 2% whereas the benchmark was up 16% (so much for active management!). The European ETF I switched into (a year ago) is up by 9% whereas that old OEIC is now up 23% over the year! There's a bunch of other funds that have a similar story. Somehow the timing wasn't right, and it's cost me dearly.

There are other contributory factors. One is that I had to sell a couple of funds in order for the transfer to take place as the new platform did not have those particular funds. By the time the transfer completed prices had gone up substantially, adding to the loss. Being out of the market was a huge risk and worked against me.

Another factor was a change in asset allocation. I added a largish component in commodities (away from equities) to increase the diversification of the portfolio. Whilst equities have had a boom year my commodities ETFs have suffered an average loss of 11%! That too worked against me.

We're almost at the end of the year and I can't help feeling that, despite all the detailed research and education I involved myself with a year ago, taking the plunge for what must (should) have been for the better ending up being a very costly affair. Is there a lesson to be learnt? I've no idea. Maybe it's that, despite all the effort, things just don't always work out the way you expect!

aberlyfid_2000

thank you for sharing your experienance and the background to your moves from active and passive.

a return of 6% for the year isn't bad, and is remarkably close to the vanguard lifestrategy 40% 6.83 YTD return.

besides the relative poor performance of commodities, its possible that timing, sector allocations, and more importantly currency risk could have impact - many funds or sub funds hedge out the fx exposure: sterling is up circa 10% on the year, but the hedge in a GBP hedged product would wipe these gains out.

Can you share the details of the european etf and the oeic it replaced?

talexuser

At least you are still 6% up on the year and not made a loss. Next year the tables may be turned the other way we don't know. A lot of my increase in active funds is due to devaluation after the referendum, that may not be repeated unless there is a really bad negotiation panic, and if it is, may just be even more inflation to follow. I stuck with active funds for over 20 years and only in the past few years added a few world sector trackers. They will never match the best active funds, and it may be a mistake to compare apples to oranges and expect them to. But having the luck to choose and stick with the good funds is part of the punt you take with active.

bowlhead99

aberlyfid_2000 wrote: »

and more importantly currency risk could have impact - many funds or sub funds hedge out the fx exposure: sterling is up circa 10% on the year, but the hedge in a GBP hedged product would wipe these gains out.

Not sure if it's just the way you're explaining it, but just in case..

Say you had two Microsoft shares about a year ago valued at $62 each. You could buy them both for $124 and the $124 would be equivalent to £100 (£1= $1.24).

After a year, imagining the MSFT shares are still worth $62 each - your dollar portfolio is still worth $124. But because sterling is up on the year, $124 of assets is now worth less than £100, because dollars are relatively less valuable. Now you have to pay $134 to get £100. So your $124 of Microsoft shares would only be worth £92-93. In order to not lose value for you as a sterling investor, the Microsoft stock would magically have to be worth 8% more dollars.

If the fund had hedged out the currency risk, the drop in value due to dollars devaluing against sterling would have been mostly cancelled out by the gains made on the hedge (less hedging costs). So the loss would be wiped out. Whereas a fund or a tracker which didn't try to hedge the gains or losses, would have made a loss.

So, when you say "the hedge would have wiped the gains out"... there weren't any FX gains to wipe out in the unhedged fund. There was only FX losses. Which an active fund that hedged the FX, or a passive fund that hedged the FX, could have covered, but an active fund that didn't hedge the FX, or a passive fund that didn't hedge the FX, would have suffered.

You're right of course that the hedge would aim to have the effect of wiping out the gains that The Pound made; but in a year like this one, that has the effect of wiping out one's investment FX losses Maybe I'm just misreading what you said as I wait for this taxi to deliver me to a Christmas Eve pint vendor.

In real life, actually Microsoft didn't stay at $62 per share, it rose to $85.5 between last January and Friday. The above is just theoretical.

In reality, relatively few active (or tracker) managers hedge foreign exchange exposure as a matter of course. One of the reasons investors want exposure to overseas assets is to take exposure to all the currencies around the world rather than solely their own. When you say "many" funds or sub funds hedge it out: yes you can find many if you define 'many' as "more than the occasional one or two", but there are many many more that don't attempt to hedge whatsoever.

Linton

Perhaps there are more important considerations when choosing investments than low charges.

aberlyfid_2000

thanks for the example bowlhead - i trying to emphasise the importance of the fx hedged or not status as being the another driver behind the different returns that the OP is seeing. Your example is correct mine would be right if i had said the pound had fallen 10% - so go for hedges when the pound is weak.

hedged products are more common than you think, in terms of size anyway. most of the subcomponents of the VG LS are hedged. i'm not a fan of these things as their a somewhat self defeating, confusing and downright inaccurate means of hedging fx risk.

bowlhead99

aberlyfid_2000 wrote: »

hedged products are more common than you think, in terms of size anyway. most of the subcomponents of the VG LS are hedged.

In terms of size (i.e. by value?) most of the subcomponents of the Vanguard Lifestrategy are unhedged?

At least, mostly unhedged if we are talking about the 60% equity version which would accord with OP's comment about having a 60% equity / 40% bond split.

The equities are not hedged at all, only some of the bonds;
Only 40% of the holdings are bonds;
Only two thirds of those bonds are held through index funds which have an international component;
Not all of the international component of those funds is non sterling;
Only the non-sterling element is hedged.

The reason people want to mix bonds into an equities portfolio to make a mixed-asset portfolio product such as VLS60 is to take the edge off the high volatility offered by global equity markets and add something that can have negative correlation to equities performance combined with some stability. A UK bond or a mix of foreign bonds hedged to sterling can offer that. You are already getting plenty of overseas currency exposure through the globally diversified equities and if you want more exposure to the currency component of the ups and downs of foreign assets, you could always go up to the higher risk products such as 80 - 100% equity.

Personally I wouldn't hedge out all the FX on my bonds but if it is true for most casual investors that bonds are added to the portfolio for stability / caution / low volatility then fx-hedging them is reasonably sensible. If the investor's aim was to take exposure in unhedged US dollars to US dollar treasuries and corporate bonds, then they probably would not want Vanguard to buy those exposures and immediately hedge the currency piece out. However, investors are buying the product, so what they are doing must be acceptable to people.

You mention it is downright confusing and inaccurate. I'm not sure what's confusing about it. All hedging is going to involve accepting some costs and imperfections but for background, Vanguard claim they don't generally carry forward any material over-hedges from month to month and won't permit overhedged positions in excess of 105% of NAV.

aberlyfid_2000

the inaccuracy is that the hedged amounts/ratios are very crudely set.

in your example, MS is worth $62. therefore $62 will get hedged.

in reality, MS does closer to 20% (for arguements sake) of its business in the UK, so you will be overhedged by 20%.


your example, following a 10% gain in stirling, all else being equal, MS' value would go up 2% to $63.2. This 2% gain is driven by fx, even though you supposedly hedged-out fx risk, hence the confusion.

bowlhead99

Well, in the example you used of Vanguard Lifestrategy's bond index, the fund manager is hedging the capital and income returns from financial instruments which are bonds. In such a situation the 'underlying' source of assets or profits are not so relevant because the bond issuers have promised to deliver a known fixed return in a specific currency, which is what's being hedged. So, not too tricky to calculate the hedging and keep it at a level that's broadly efficient.

In something like VLS60 they are not doing equity hedging anyway. But if you take an example of a find that invests in the US market and creates a GBP-hedged class: they are *not* trying to assess the portions of underlying drivers of Microsoft's equities' fair market valuation (revenue, costs, capex etc) to pick apart what direction to hedge to "eliminate FX risk".

The goal of a fund is not to try remove all the "risk" of what happens within the business. If they are telling investors they've hedged the returns, they mean they will aim for you to get the same sort of percentage return on your own currency that an investor in the base currency of the asset would have got, notwithstanding that your currency has strengthened or weakened.

So if the S&P500 or Nikkei goes up 10%, and they say they'll hedge the currency risk, they mean for you to get close to 10% on your GBP investment in the fund even if dollars or yen Vs GBP has changed. They don't mean you will get the return you would have got if somehow exchange rates in the global economy could have been prevented from changing. That might be a quite different number.

aberlyfid_2000

i mentioned that hedging is confusing, inaccurate and self-defeating. By citing equities, i have shown the first two.

Bonds addresses the third "self-defeating" aspect. The whole arguement of holding foreign bonds is to gain fx exposure. Hedging that out means you will get very similar returns as holding domestic bonds.

therefore, with the level of hedging and unhedging going on in the LS60, it is difficult to know what is going on and why. we can be certain that it is, not by a long shot, a passive product, it makes some very active decisions.

bowlhead99

aberlyfid_2000 wrote: »

i mentioned that hedging is confusing, inaccurate and self-defeating. By citing equities, i have shown the first two.

You 'cited' equities by showing how a certain type of hedging on a certain type of asset wouldn't give the result you personally might have wanted, but didn't really give any real life examples of which funds you're talking about and how those fund managers in particular do it or say they do it or whether investors buying their product want what the managers do, or understand it.

So to me that doesn't mean you've 'shown' that it's confusing and inaccurate, merely that you are confused by it and don't think it's accurate enough for what you are trying to do, which is not necessarily what the fund manager is trying to do, nor what his investors are looking for him to achieve for them.

In other words, perhaps the process works how it's supposed to work but maybe you misunderstand what is trying to be achieved.

Bonds addresses the third "self-defeating" aspect. The whole arguement of holding foreign bonds is to gain fx exposure. Hedging that out means you will get very similar returns as holding domestic bonds.

Whose whole argument for holding foreign bonds is to gain fx exposure? Yours? Or the investment community at large?

Why will you get very similar returns as holding domestic bonds by holding foreign ones and hedging out the currency rate movement, if for example:

- the foreign bonds are paying different interest rates

- or have a different mix of credit quality

- or those countries' bond markets have different relative strength to their equity markets due to being at a different part of their economic cycle

- or the markets deliver different levels of return for their price due to being an underdeveloped market or an emerging economy.

- or the home market or foreign market goes through some major economic event for better or worse causing a big valuation or yield swing in one territory that isn't felt to the same extent in the other?

Once you have hedged away the differences that come from actual fx rate swings in your currency vs the borrowing currency over the holding period there seems to be plenty of diversity to round out your portfolio by including foreign bonds among your asset classes.

If you want the fx risks as well as the other characteristics then, obviously, don't try to hedge the fx away. But if you are seeing all foreign bonds as, "just the same as domestic bonds but with some fx risk" you are probably missing a trick.

Say you hold Japanese treasuries, investment-grade credit and high yield, and UK treasuries and investment-grade credit and high yield. Then we have a brexit and the Japanese have another change of government and a bunch of other different domestic and world economic events occur, and hit our two nations quite differently. Are you saying that once you adjust for currency translation, the returns of the japanese bond portfolio will have delivered the exact same as the returns of the UK bond portfolio, with no differences in timing or performance? That seems either optimistic or naive.

with the level of hedging and unhedging going on in the LS60, it is difficult to know what is going on and why. we can be certain that it is, not by a long shot, a passive product, it makes some very active decisions.

Anyone creating a fund-of-funds product to solve a retail investor's asset allocation problem by giving them the chance to invest in a professionally-constructed collection of underlying funds, is conducting some 'active' management when he actively makes decisions about what will go in the fund in what proportion. That's true whether the underlying funds are themselves index-driven or active.

That is inevitable because the 'total market' of $x trillion fixed interest securties and $y trillion company equities and $z trillion other things is not necessarily all investible, liquid or - most importantly - likely to meet the needs of a typical retail investor who shows up wanting to deploy his life savings for some particular goal.

Vanguard don't say "this is a totally passive product, we don't make decisions about what you might want, it all comes off some big magic index with no user intervention and is all out of our control". Of course they take a management fee to construct, monitor and maintain it. They tell you what is in it, in case you'd like to buy it. The portfolio funds within it each aim to follow an index which has been bought in from somewhere else. Whether that's an equities index, bond index, hedged bond index, or whatever. The allocations between major asset classes are relatively rigid though they float around a bit once you get down to what's inside the equities bit and what's inside the bonds bit.

As a casual investor, you can decide you know enough / as much as you want to, about what they are doing and why, and buy it... or you can decide you don't have enough knowledge to work out what they are doing and why, so you won't invest. I expect they have enough customers in the former camp to not be desperate enough to need to win over more from the latter camp, and so are not going to publish all their financial models and proprietary research that led to the specific decisions to balance the fund to a specific allocation on a given day, just so people like you can argue with them about why it is that they should not try to hedge any fx impacts on the bond holdings.

In summary, I don't believe all hedging is confusing or inaccurate or self-defeating. However, you're welcome to believe that. Merry Christmas.