A family of funds associated with some of the world’s most famous economists has created a buzz in the market. But the funds are sold without upfront sales charges and do not pay trailers, which does not suit the business model of most local distributors.
Financial advisers often say it is hard to find actively managed funds that consistently beat their benchmarks. Finding one that does so without high costs is even harder. That is why a growing number have been gravitating towards exchange-traded funds (ETFs) or passively managed funds that simply aim to track a market index. In effect, these funds do not aim to achieve “excess returns”, or what is commonly known as alpha. Instead, they aim to match the market’s beta at the lowest possible cost.
Now, some local financial advisers have been talking about a range of funds run by a firm with links to some of the world’s leading financial minds that aims to consistently generate alpha in a cost-effective manner. The firm is US-based Dimensional Fund Advisors, which opened an office in Singapore in January 2013 to broaden its global footprint and serve a region with fast-rising levels of wealth.
Dimensional is associated with Nobel laureates such as Eugene Fama and Robert Merton as well as distinguished academic Kenneth French, who has collaborated with Fama. Both Fama and French are members of Dimensional’s board of directors; Merton provides consulting services to the firm. The firm initially tapped the institutional market from its Singa pore offices. In August, it began making its funds available to individual high-net-worth investors.
Aw Choon Hui, deputy CEO of GYC Financial Advisors, says the key differentiator of Dimensional is its approach to investing in equity markets, which incorporates four key principles. “First, they believe there is an equity premium for stocks over bonds; so, stocks deliver a higher return than bonds over time. Second, there is a small-cap premium such that smaller companies will outperform larger ones — these very logical ideas are well-researched and proven,” says Aw.
Two other fundamental principles are also applied by Dimensional in the construction of its portfolios. These are the concepts of capturing the market premiums for relative value and strong profitability in companies. “Their research has also established that buying cheap value stocks will deliver higher returns than more expensive growth stocks while a company with high profitability will naturally outperform low-profitability companies,” adds Aw.
Taken together, the four types of market premiums comprise what is described as the “dimensions” of expected higher returns that can be harvested from equity markets. Joel Teasdel, vice-president of financial adviser services at the firm’s Singapore office, says that is how the firm came to be named Dimensional.
“We provide a low-cost and more scientific approach to investing,” says Teasdel. “We work mainly with advisers and look for those that are fee-based, where there is no conflict of interest in terms of giving clients good advice — that is the No 1 priority for us.”
The key reason Dimensional chooses to work only with fee-based advisers is that the fund management firm is not in favour of upfront sales charges nor does it pay its partners annual trailer fees. Fund distributors in Singapore generally charge an upfront sales fee of as much as 5%, and also receive a substantial chunk of the management fee charged by the fund manager every year.
Therefore, distributors that work with Dimensional have to earn the bulk of their income from dispensing professional advice rather than selling financial products. To be sure, that narrows the market for Dimensional funds significantly. But the company says it is committed to its business model for the benefit of investors.
“We want to have only relationships with advisers that act in a fiduciary capacity and work in the best interests of their clients. We are very passionate about ensuing that investors get a good outcome. So, advisers who work with us tend to be those that have business models that are not based solely on selling products to people,” Teasdel explains.
The idea of providing fee-based advice has been talked about since the Financial Advisers Act was introduced in 2002, but the industry is still heavily reliant on sales commissions. In addition, changing old mindsets remains tough, some players say. “I have been in the business since the financial advisory industry started, and very few things have changed,” says Christopher Tan, CEO of Providend, one of the few players that relies on advisory fees rather than commissions. Providend is also one of the distributors of Dimensional funds.
Tan adds, “Most people are still commission-based and many still sell funds with sales charges, and they still take trailing fees. But if we want the best for our clients, we shouldn’t be taking sales charges, because it is not just a matter of eating into the investments but also because of the potential for conflict of interest.”
Tan is referring to the incentive that sales charges provide for advisers to churn the portfolios of their clients to generate fees for themselves. That can happen because, each time a client switches from one fund to another or makes an investment in a new fund, the adviser benefits from a portion of the sales charge that is shared between him and the firm he represents. Churning portfolios for fee income effectively shortchanges investors and dilutes the return investors would otherwise earn from the fund.
Low costs vital amid low returns
What do these practices cost investors? How low could costs be if fund managers were not forced to pay distributors? Comparing the cost of investing in Dimensional with that of other funds in the market provides useful insight.
Equity funds managed by Dimensional charge management fees of about 30 basis points a year. Their total expense ratios (TERs), which include the management fee and miscellaneous expenses, are upwards of 38bps. By comparison, the average TER of wellknown actively managed equity funds in the market is 180bps. In effect, Dimensional’s business model of not paying fees to distributors puts the annual performance of its equity funds about 140bps ahead of other funds even before the race begins.
A persistent drag of 140bps a year on performance could become even more significant in the years ahead as the soft economic growth rates and rising interest rates weigh on investment returns.
Highly regarded institutions such as Singapore’s GIC and the McKinsey Global Institute have been warning that the returns from equity investing are likely to decline in the years ahead compared with the gains of previous decades. The annualised real return from a portfolio of global equities is projected to decline from 8% to 9% previously to perhaps 5% to 6% in the eyes of these experts. It means that managing portfolios at low costs will be vitally important to investors if their returns are not to be eaten away unduly by high expenses and other factors.
“With a return environment that is likely to be lower, costs will be very important,” Tan points out. “The mindset of advisers will have to change and they have to first start thinking of what is best for the clients, because if they don’t, it will be very hard to deliver the returns that clients need.”
So, are Dimensional’s funds able to generate appropriate returns? Are the returns reliable?
GYC’s Aw says that, in the case of an equity-blend portfolio comprising the MSCI World (70%) and MSCI Emerging Markets (30%) indices, the adoption of Dimensional’s core principles has been proven to generate annualised returns of some 1.6 percentage points on top of market beta since 2002. “The individual composition or building blocks of Dimensional’s funds is the thing that makes the difference to returns,” Aw explains.
He adds that Dimensional’s funds are good examples of what he describes as “better beta” funds for their ability to generate excess returns at virtually the same level of risk as the general market. “They fight for every basis point and provide a better return for the same amount of risk, which is why we want to have them in our portfolios.”
Dimensional’s policy of “better beta” at low cost also fits in with GYC’s expectation that the industry in Singapore will move towards a fee-based model of financial advice, where clients compensate advisers for dispensing advice and managing portfolios instead of paying product charges every time a transaction takes place. “The signal from [the Monetary Authority of Singapore] is clear and we also cannot ignore worldwide trends that are pointing towards having no sales charges or commissions,” Aw says.
Tan of Providend, which already practises a feebased model of advice, welcomes the entry of Dimensional to the Singapore market. The distribution of its funds is currently restricted, however, to the “Accredited Investor” (AI) segment, for investors that meet pre-set criteria on income levels or net worth and are prepared to accept higher risks. This condition limits the pool of clients who can benefit from the low-cost actively managed strategies of Dimensional.
“If you are not an AI client, we use ETFs to express your market position,” says Tan. “From the firm’s perspective, it is less easy to manage ETF orders operationally compared with passing an order to a fund manager, as the orders have to be queued at an exchange. But clients will still get whatever they should have at the market price of the ETFs.”
Teasdel says Dimensional is happy to limit its products to the AI market for now because the firm has just launched its offerings to individual investors. “It is our starting point into the Singapore wealth management market and, if we’re successful at it, there may be opportunities to play a bigger role. But, at this point in time, we are just getting started,” he stresses.
Starting out with the AI market makes sense from a business standpoint, according to industry watchers. Not only are individual investment amounts likely to be larger than in the retail segment of the market, but the compliance standards are less stringent and not as costly. Fund distributors that serve the retail segment of the market are also less likely to take on a family of funds that are not sold with hefty upfront charges and annual trailers, industry watchers say.
David Mok, head of fund management at IPP Financial Advisers, which operates a compensation model based on asset-based fees and commissions, does not believe that Dimensional’s funds are that unique. Mok says there are other funds available in the market that can deliver similar outcomes for investors despite higher costs.
“Every fund house will say they are different, and I respect that,” Mok tells Personal Wealth. “Dimensional does have some great names behind it, but if you pit it against some others, it is not exceptional. Even though other guys carry higher costs, some are also able to maintain a good performance.” He emphasises that he has nothing against Dimensional funds, though. “Dimensional has a good story to tell, and investors will not be hard done by getting into their funds. But investors may also be fine by getting into other funds.”
Indeed, as long as these other funds make money, Dimensional could find it tough to gain traction among financial advisers in Singapore. Individual advisers construct portfolios for their clients using their professional discretion, which is limited by rules requiring the selected funds to be on an approved list and match the risk profile of the client.
Providend’s Tan points out that the more expensive actively managed funds continue to thrive even in large developed markets. “If we take any guidance from more developed markets like the US or UK, there is a sizeable [percentage] of advisers out there who will continue to do the more costly active strategies,” he observes.
It is only when investors become more discerning about costs, perhaps in the face of reduced market returns for an extended period of time, that things will change.
This article appeared in the Personal Wealth of Issue 753 (Nov 7) of The Edge Singapore.