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.

In this episode I'm joined by Vince Scully, chief sherpa at Life Sherpa. When I asked about the difference between active and passive he said:

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.

Remember, markets and economies evolve, and what worked in the past may not work in the future. Regularly reviewing your investment strategy can help ensure it's still appropriate for your goals. If you need help figuring out your strategy, Life Sherpa can give you the guidance you need. Book a free consultation with them here.

Read the full article to learn more.

TRANSCRIPT FOLLOWS AFTER THIS BRIEF MESSAGE

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EPISODE TRANSCRIPT

Chloe (1s):

Shares for beginners. Phil Muscatello and Fin Pods are authorized reps of Money Sherpa. The information in this podcast is general in nature and doesn't take into account your personal situation.

Vince (12s):

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.

Phil (49s):

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):

Indices

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):

31 shares

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):

Well

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):

Hmm.

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):

I think

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):

They

Phil (19m 8s):

Want return.

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):

There's companies

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 of doing that are well over, but I used to do it quite regularly.

Phil (26m 41s):

Anyway, So getting back to the question, so,

Vince (26m 44s):

So getting back to, yeah, sorry, getting back to your question.

Phil (26m 45s):

Yeah. With what's the vehicle and how can people start thinking, I mean it, it's, we're talking a guess here as broad approaches.

Vince (26m 52s):

So you really got, if you ignore the buy everything yourself thing, you really got managed funds, LICs or listed investment companies or ETFs and all three of those can be active or indexed. The traditional approach was managed funds. They offer the great advantages that you are always gonna buy or sell at net asset value, but you do it once a day or in some cases once a month or once a quarter. Yeah. But generally end of close of business. So there's never a gap between what you pay and what you get. The downside was they used to be bought by filling in the form at the back of a PDFs and mailing it in with a cheque, which is, hasn't got all that much better with technology,

Phil (27m 39s):

Although there's Mfunds isn't there? Right,

Vince (27m 43s):

Yeah. They really haven't taken off as much. Now perhaps that's because of the growth of ETFs at the same time that maybe they'd missed the boat on that one. And so we got LICs or listed investment companies or listed trusts in the uk. So the point of a listed investment was that you could buy and sell it on the stock market, very efficient even when you had to mail in your, your certificate or your stock broker held it. But the disadvantage was that the price dependent on the supplier demand of the investment itself. So a manager that was perceived to be hot or good would often trade at a premium to the underlying assets.

Vince (28m 30s):

These

Phil (28m 31s):

These are LICs.

Vince (28m 32s):

LICs. Yeah. And so that meant that you were paying a dollar 10 for a dollar worth of assets return, as long as that discount or premium doesn't change, you are indifferent. But it adds a complexity that not only do I have to look at what's happening to the loan portfolio, but I've gotta look at what's happening to this premium or discount.

Phil (28m 51s):

And the opposite happens as well, doesn't it? That there are many that will be trading at a discount. Yeah, absolutely. Net asset.

Vince (28m 57s):

Yeah. So a management's out of favor, they'll trade at a discount. So the ETF was designed to solve that difference that you had the simplicity, but logistical complexity of unlisted funds and the simplicity of buying and selling listed companies, but the price discount premium problem. So ETFs were designed to solve that problem and they solved that problem by being able to create or destroy units to match the supply demand problem. So if there's a greater demand for IOZ, then there is supply, BlackRock can create more and the market makers get to actually exchange the physical underlying basket of shares for units in the fund.

Vince (29m 46s):

So if the fund is trading at more than the value of the underlying assets, people will buy units and say, give me the basket please and vice versa. So that keeps the two fairly closely matched.

Phil (29m 59s):

And that's, and that's what's called open-ended, isn't it?

Vince (30m 2s):

Yeah. So it's open-ended because you can add or subtract units. And the other thing that it solves is, and this is largely a, a legal tax quirk rather than a a design, is that the creation and destruction of units doesn't create a C G T or capital gains tax event in the fund. So as an investor in an etf, I'm not exposed to the behavior of the other investors, firstly because most of them are traded on the secondary market. And secondly, when they are created or destroyed, there is no C G T event.

Vince (30m 42s):

Whereas in a unlisted fund, if there's more redemptions than there are contributions, the manager has to sell the underlying assets, realize again, or a loss and it gets passed onto all members. Now this is really only a benefit or problem depending on which side of the coin you're on, where a fund is shrinking net net shrinking because the growth, so creating a new, new unit buy more assets, doesn't create a a problem, it's only the sale that creates the problem. So in an unlisted fund, I'm exposed to the behavior of my fellow investors, whereas an ETF I'm not.

Vince (31m 24s):

On the other hand, you know, because it's traded all day every day, the price is not just a single daily price. So it looks more volatile. And this is why Jack Bogle, you know, the founder of Vanguard was a very reluctant entrant into the ETF market. You look at Vanguard today and it's a huge player, but Jack was totally opposed to this in the early days. He was dragged kicking and screaming into this.

Phil (31m 50s):

Yeah. Even though he is creditors as being the, the father of ETF who,

Vince (31m 54s):

Well the father of the index index I think, and and people do today, sort of treat them as synonyms. They do, but they're not really, but Jack was not a fan of the ETF because he felt people would use it as trading and trading in his mind was evil. Whereas the managed fund sort of, you couldn't intraday trade it. Yep. And so that was his reluctance to, to move into ETFs. But today for many people, ETF equals index fund and vice versa, which is not quite true. Most ETFs are index based, but not all index funds are ETFs.

Vince (32m 34s):

There is a place for each of those, but there are some tax efficiencies of an ETF and there are certainly trading and access to information benefits. So you can use a, a tool like share site and it knows the price every minute. So you can open the app and see your price maybe with a 20 minute delay, I think

Phil (32m 57s):

20 minute, I think it is 15, 20, something like that.

Vince (32m 60s):

Whereas with the ETF with the managed fund or unlisted fund, you end up with that end of day price.

Phil (33m 7s):

We've sort of spoken briefly about the fees associated with each approach, but the more humans involved, the more it costs. Yeah. Is that what it comes down to?

Vince (33m 15s):

That's broadly That if you, if you want Porsche driving private school, educating their kids managers

Phil (33m 20s):

Wearing their old school ties,

Vince (33m 22s):

I think people have sort of given up on the old school tie, but that just costs money and may or may not add value, but it's certainly a way of getting a different result. Mm. So all comes back to your objective, but on average you would say that the typical indexed fund is cheaper than the typical active managed fund. Some of that. And

Phil (33m 50s):

That's just, that's just one consideration to it is taken in it as well because you, you have to weigh that against the, the value that might be added by active management.

Vince (33m 58s):

Yeah. And one of the things that I always come back to when people ask me should I buy index funds or active funds? And well that's a bit like walking into a bottle shop and say, 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 wanna full body Sharons, you probably don't wanna be drinking out of a 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. And if what you wanna drink is something that, well in this case, if, let's say I want to invest in large cap value stocks in the Australian market, well an ASX 200 indexed fund is probably the right answer.

Vince (34m 52s):

And then you need to ask yourself, well do I buy an unlisted fund? Which can make management easier if you insert circumstances or do I wanna buy an ETF which I can buy online at the tap of a pen or

Phil (35m 7s):

I

Vince (35m 7s):

Or indeed an LIC? That's the decision you need to make. And once you've made the decision that you, that's what you want, then yeah, fees matter. But you should only look at fees once you're sure you're comparing like with like,

Phil (35m 21s):

And so are the factors that you should consider, are they the usual sort of things you hear when you talk to a financial advisor about where you are in life, what your goals are?

Vince (35m 32s):

Absolutely. Yeah. So that's what comes, so step number, the difference that you are gonna make is the quality of your decisions and your decisions will be better if they align with a real life goal. And that will make a much bigger difference to whether you buy, you know, eight basis points or 20 basis points. Now I know all the software bros on the five groups and red are gonna shoot me down for that. But this is the difference between theory and reality that, you know, one of the most important things is, is it a portfolio that you're gonna state the course and if it's not, you'll never realize the theoretical higher return.

Vince (36m 18s):

So get your ass allocation right first. And that's based on goals, risk profile, time horizon, your

Phil (36m 26s):

Own knowledge as well, what you've been exposed to. Well

Vince (36m 30s):

Exactly your familiarity can be important. But you know, let's not get too hung up on recency bias and all those other biases. You know, why do people buy rental properties in their or investment properties in their same neighborhood as you feel like they know it but you're not getting diversification. So what do you want? Do you want familiarity or do you want the diversification? And then how am I gonna achieve that Allocation? Allocation at its broader sense is, you know, bonds are shares, but within each of those markets you've got various things you look at. So we talk briefly about bonds. I know this is called shares for beginners, but they're the easy ones. I

Phil (37m 8s):

Go on about fixed income. So let's deal, it's so, it's so big. The market is so big and has such an influence on equity markets that it's worth,

Vince (37m 17s):

But there's sort of, there's two things I'm buying when I buy a bond fund for my duration and credit and there there's two things I get paid for. So I need to make a decision as to why am I buying these bonds? And for many people, bond allocation is about ballast, it's about smoothing your returns and therefore you, if you live in a developed market, you wanna be buying local currency, highly rated, mostly government bonds. Investible index that aligns with that in Australia is the Bloomberg OS bond index. And so you can go and buy I A F is the the big one

Phil (37m 54s):

And with shares you own them with bonds, you loan them. That's right. You can own it or own it. We'll be returning to our guests in a moment after this brief message. Investing in shares can be fun, but the paperwork isn't. My investing's been transformed since using Sharesight, the best portfolio tracking tool in Australia and New Zealand. My portfolios are on share sight and whenever I buy or sell, they're automatically recorded. I can see the dividends I'm receiving and the Franking credits and it helps me to work out my asset allocation. Sharesight are extending a special offer to listeners of this podcast. Four months free on an annual premium plan, there's a seven day free trial where you can experience the full power of sharesight portfolio management, go to sharesight.com/shares for beginners and sign up now for a free trial before taking advantage of four free months.

Phil (38m 46s):

That's sharesight.com/shares for beginners.

Vince (38m 48s):

So that's, if I'm treating, if I want bonds for ballast, then I'm looking for local currency highly rated so that it's as close to a risk-free as I can get. If I want bonds for income, I now need to start looking offshore to get diversification and enough exposure to credit. So they're the two things you can focus on in terms of bonds, duration and credit. When it comes to shares, it's a little bit more complicated. So you've got geography, so market, you know, do I buy Australian? Do I buy US, do I buy European, do I buy emerging markets?

Vince (39m 28s):

Do I buy size? Do I buy big ones or small ones? Medium size ones. Do I buy value or growth? So am I looking for shares that are likely to deliver greater returns? I, I mean value, the value premium, the size premium, both of those will give me a higher expected return. You're not always gonna get it. Last years been particularly unkind to small caps just as they led the growth up, they've led the fall down value was looking out of fashion when the big tech companies were driving most of the returns in the US market, but they're the factors that drive the returns.

Vince (40m 8s):

So which one of these do I want? And then do I focus on the, in technical terms, the lower beta stocks, which is the stuff that moves around less than the market. So real, real estate and infrastructure are the main players there, which behave a little bit more like real assets. That is, you know, they linked to G D P, they're inflation hedged generally less volatile so they can behave a little like a bond giving you a little bit more stability without giving up too much return. So how I mix all of those is my asset allocation. And then I've got inside having done that, well what, what am I gonna do?

Vince (40m 51s):

So the big large cap value basics 200, it's pretty easy in the s and p 500 when I move outside that I'm probably looking at MSCI or an FSE Russell. Not all those index are created equal, but that's my decision as allocation then is there an index that tracks that particular allocation? And if there is, then what fund will track that and do they actually track it? So what's their tracking error? Do they actually replicate it? Do they sample it? Bond funds are typically sampled because there's so many and you can't hold them all.

Vince (41m 33s):

But share funds should generally be fully replicated and that's my decision. And then once I've got that, I need to focus on rebalancing and making sure these indexes don't change their characteristic. So when you know MSCI gradually brought China into the World index from 2018, there was like stuff all China in there, whereas now it's not six, 7% I think, I can't remember. But that changed the nature of what you're buying. So if you don't wanna be in China, then maybe it's time to pick a new index. And that's the challenge for most people that the Redditers in this will go, oh, all you need is is Vanguard and all you need is VAS and VGS, VAS and VTI.

Vince (42m 19s):

Nothing could be further from the truth. The thought that there is a single right answer for everybody and that higher returns are by definition better returns is just nonsense. Probably a very unpopular view. But just because the ASX 200 is the highest performing stock market in the world over the last 120 years. Is it? Yeah.

Phil (42m 50s):

Oh okay.

Vince (42m 51s):

Follow very close by the Johannesburg one doesn't mean that you should put everything on the AETFSX 200. If there was the possibility of that answer then everyone should just buy a global fund and enough local government bonds as in local currency issued by your local government, national government of the country you live in. And that's all we'd ever need.

Phil (43m 14s):

Well it's funny you say that because you know, I see here are other examples and some, some people say, okay, you get an A S X 200 ETF, then you get a A world index X Australia with no Australian companies in it and then maybe you get an s and p 500. You know, there's all ways of different of slicing and dicing this. And I was speaking to Dave Gow from Strong Money Australia, he's got one ETF and it's basically the top 100 companies in the world. Geographic agnostic, I guess, you know, as again, we're not recommending anything, but these are the kind of factors that you've gotta keep in mind,

Vince (43m 49s):

Isn't it? That's right. And and

Phil (43m 50s):

About what you want. Yeah,

Vince (43m 50s):

I mean if it weren't for currency and taxes, that two fund model could very well work. I mean that's based on the theory that well that's how the rest the world invests as an aggregate. So it's good enough, the world is good enough for me. And so all I need is a global equities and a local high rated bond and I just mixed the two depending on my age. Problem with that is everyone in the market's not playing the same game as you are. So we talked about mandates earlier. So if I'm an equities manager and I've got an Australian large cap mandate, I've gotta invest in Australian large cap equities. Whether or not I think they're a good investment because that's what I'm being paid to do.

Vince (44m 36s):

The aggregate investment in the market is an aggregate of a whole bunch of people playing different games and their game is not necessarily your game. So just because 60% of the world's equities are invested in the US doesn't mean that that's the right answer for you. It might be, but this simplistic notion that I go, I mean Lars Croyer wrote a whole book about this saying these are the only two funds you'll ever need. Now he wrote it from a UK perspective where the UK's a bigger part of the world than we are. But even still, yeah, if it weren't for taxes and currencies maybe, but actually we live in a world of currencies and taxes and local regulations and Australian investor is likely to benefit from having more Australian shares in their portfolio than the 2% they represent of the world's

Phil (45m 28s):

In terms of active management. If you want to invest in small caps, small medium cap companies, you could go out and try and find these companies all by yourself. But there are, this is somewhere that you really do need active management. That's right.

Vince (45m 43s):

I mean for two reasons. One, certainly in Australia there isn't a small cap index that you can trade. The small odds, which is really numbers 200 to 300 are still relatively large cap companies by, you know, relative to the other ones. That's a good reason why you should or need to go active if there isn't an index that aligns with your investment goal. Small caps is a perfectly good example. So here at Life Sherpa we use two microcap managers. We use OC and Ausbil. Yeah, they have clearly added massive value to the portfolios.

Vince (46m 23s):

Is that because where gurus are picking funds? Well it's largely a factor play. So it's a, you are investing in small cap value and so a manager can add real value. So the trick is how to identify the manager and how to identify the right mandate. But they're, you know, they, they've delivered 50% annual returns in the period leading up to just early, remember that big bounce after the initial covid? Well they delivered 50% in that year. Like it's massive return. They're down 20% in the last 12 months. So you've gotta have a bit of a stomach to

Phil (47m 5s):

Well that's right. I mean you gotta look at what it was like in, in that time and if people were brave enough to get in right at the the bottom, they could have made good gains but then hanging onto them through 2022. Yeah,

Vince (47m 15s):

And so that's why difficult thing, that's why you don't punt everything on, on black or red. So together they make up about 10, 15% of the growth portfolio. But that's where one of the areas where managers add a lot of value. Other areas where there isn't an appropriate index is private equity. So where do I, how do I invest in private equity? There isn't an index. So what do I do? I've got a by definition, higher active manager, emerging markets, there's a lot of evidence that active managers add value, certainly on a global basis where you can underweight or overweight regions.

Vince (47m 56s):

China's probably a good place to be underweight if you're going to go into specific themes or sectors. You know, if you want a healthcare fund, you probably need something. You understand something about healthcare that

Phil (48m 11s):

Any, any specialization.

Vince (48m 12s):

Yeah, so they're semiconductors, they're all places. Yeah. Now whether you should be investing in a sector or not is a separate question. Yeah. But if you've made the decision to invest in healthcare, you can probably find a manager who adds value in certain markets. You may need an extra manager if you are looking for something different. So if you, if you're not happy with a five year duration on your Aussie bond allocation, well you can't invest in index. So you've gotta go active. And that's a decision to take a view on duration. So if I've got a view that bond rates are heading down or up, sorry, bond rates are heading up, then I probably don't wanna be long duration.

Vince (48m 60s):

So what am I trying to do? And then if you want a, a manager that's taking a stock specific position, so some of the long short funds where they might say, well we are gonna trade the difference between these two Aussie banks and these two Aussie banks. So they're not exposed to the market as a whole, they're taking an absolute return focus and they're taking a view that this pair will outperform that pair. And I don't really care what the market's doing, very specialized, but that's where you can add value. So is there an index that reflects what you want? B, is it tradable and C is there a fund that matches it and they're the the thought processes you need to go through.

Phil (49m 48s):

So if listeners are interested in what Life Sherpa has to offer in terms of spiritual guidance in these matters, what happens when they ring Life Sherpa in terms of getting in?

Vince (49m 58s):

I mean you'll get just talk, you'll get to talk to a real advisor who'll help you align your values with your portfolio. We are generally an indexed house, so we generally believe that markets are more or less efficient. And even if they're not efficient, they behave as if they were most of the time. So we would generally only go active where there's clear evidence that there is value. And that's certainly in places like emerging markets. And that the most important decision you can make is asset allocation to siding on an asset allocation is important.

Vince (50m 39s):

Then actually getting what you think you're buying is important. So multi-asset funds are generally problematic in that sense and why indexes are often important because you know precisely what you're getting. And generally we would avoid bads and fashions as, as Jack Bogle would call them, because there's a real science in trying to differentiate between a fad and a trend. You often, the funds that track these trends come too late for students of history. If you go back to 1999 and look at the number of tech funds that were created in 1999 and have few of them were still there in 2002.

Vince (51m 21s):

So is it a fashion a fad or is it a genuine trend? And do you think that you or this manager are smarter than the average bear? And fees matter

Phil (51m 34s):

And fees matter. Vince Scully, thanks very much for coming on today.

Vince (51m 40s):

Thanks for having me Phil.

Chloe (51m 42s):

Thanks for listening to Shares for Beginners. You can find more@sharesforbeginners.com. If you enjoy listening, please take a moment to rate a review in your podcast player or tell a friend who might want to learn more about investing for their future.

Any advice in this blog post is general financial advice only and does not take into account your objectives, financial situation or needs. Because of that, you should consider if the advice is appropriate to you and your needs before acting on the information. If you do choose to buy a financial product read the PDS and TMD and obtain appropriate financial advice tailored to your needs. Finpods Pty Ltd & Philip Muscatello are authorised representatives of MoneySherpa Pty Ltd which holds financial services licence 451289. Here's a link to our Financial Services Guide.