vanguard denmark - uk vs euro area · 2015-05-18 · 13 the investment outlook from oil to interest...

UK vs euro area

A Vanguard wealth briefing

The UK has been a surprise economic success, with growth at the head of the G7. The euro area has been bogged down with fractious policy and heavy debt.

Why the contrast? Is it temporary or structural? What are the implications for investment portfolios?

This document is directed at professional investors and should not be distributed to, or relied upon by retail investors. The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

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A Vanguard wealth briefing 3

Contents Contributors

4 Relative valueThe UK has had the advantage of speed and flexibility, but the euro area is making the right moves

5 The oak and the willowDespite its more flexible structural characteristics, the UK is struggling to regain momentum in productivity

6 UK vs EuropeThe story in pictures

8 Reading the runesThe UK has recently had better economic outcomes than the euro area, the explanation for market returns is a little more complex

9 Breaking the bankThe Bank of England seems unsure if it should raise rates or cut them, leaving investors increasingly confused

10 Good behaviourWhy investors need to learn to counter behavioural biases

12 Keeping control Passive investing and ETFs are growing rapidly, reflecting demand for low-cost products

13 The investment outlookFrom oil to interest rates, the key themes investors should be watching

14 Sales and contacts

Biola Babawale is an economist in Vanguard’s Investment Strategy Group, where she provides analysis of economics, markets, and portfolio construction. She was previously at Oxford Economics. Biola has an M.Sc. from the University College London, and a B.Sc. Hons from the University of Warwick. She also studied economics for one year at Sciences Po in Paris.

F. William McNabb III is chairman and chief executive officer of Vanguard. Bill joined Vanguard in 1986, became chief executive officer in 2008, and chairman of the board of directors and the board of trustees in 2009. Bill serves as the chairman of the Investment Company Institute. He earned an A.B. at Dartmouth College and an M.B.A. at The Wharton School.

Todd Schlanger is an investment analyst in Vanguard’s Investment Strategy Group, where his responsibilities include research on the capital markets, portfolio construction and design, and investment market commentary. Todd earned a B.S. in business administration from The University of Scranton. He is a CFA charterholder.

Janine Menasakanian manages Vanguard’s relationships with global banks, asset managers, wealth managers, major distribution companies and wrap platforms. She joined Vanguard in 2011 and has over 20 years’ industry experience.

Peter Westaway is chief economist and head of the Investment Strategy Group for Vanguard in Europe. Peter was previously chief economist, Europe, for Nomura International and a senior official at the Bank of England. He earned a Ph.D. in economics and an M.Phil. in control engineering and operational research from the University of Cambridge, and a B.Sc. in mathematics and economics from the University of York. He is a visiting professor at Queen Mary University of London.

Additional research by Savas Kesidis and Georgina Yarwood

4 A Vanguard wealth briefing

The narrative of the recent relative performance of the UK and the euro area would appear to be simple. The UK economy is prospering, enjoying the best growth in the G7, having successfully navigated the global financial crisis. By contrast, the euro area has been struggling to achieve respectable growth rates, held back by the rigours of adjustment within a monetary union and the years of postponing necessary structural reforms.

In our view, differences in monetary and fiscal policy have played a large role in the recent growth performance. Policy changes over the next few months might cause the euro area growth to improve and UK growth to fall back.

Going back to the 2008 financial crisis, the initial fall in GDP in the UK was larger than in the euro area (6% versus 5%). Recovery in the UK was slower than in the euro area, lagging until early 2012, when euro area activity fell back due to the sovereign debt crisis. Since then, the contrast has been stark. With a persistent growth advantage of over a percentage point each year, UK GDP is now some 4% above its pre-crisis peak while the euro area’s is still more than 1% below it.

Monetary and fiscal policy have both played a significant role in explaining the differential. The Bank of England supported UK growth by providing an earlier and stronger monetary stimulus than the European Central Bank, not only by cutting interest rates further but by expanding its balance sheet, initially providing liquidity support and from late 2011 through quantitative easing. By contrast, the ECB was much slower to engage in asset purchases, waiting until inflation moved into negative territory early this year before launching full-blown QE.

An obvious symptom of the easier monetary conditions in the UK was the lower level of real interest rates since 2008 compared to the euro area. Credit conditions, as measured by observed bank lending, were also easier in the UK. For example, policy measures to stimulate borrowing in the housing market (such as the Help to Buy scheme) supported UK household spending in 2012-13, whereas balance sheet retrenchment in Europe continued to act as a drag on lending in the euro area. This was especially significant given the pre-eminent role of bank financing in the euro area as a transmission mechanism, that is, as a conduit for carrying monetary policy into the real economy. In the last year, we have seen positive signs that net bank lending is picking up in the UK, but it is still acting as a drag on growth in the euro area.

Fiscal policy has also contributed to the UK-euro area growth differential. Focusing on the cyclically adjusted fiscal balance, it can be seen that UK fiscal policy was more aggressively stimulative when the crisis hit in 2008 and has been less contractionary in the years since. In particular, since 2012, UK fiscal policy has not been as restrictive as originally planned, and this has provided additional impetus to UK economic growth.

To understand whether the UK will be able to sustain its advantage, it is instructive to examine how these same policy factors are likely to evolve in the years ahead.

• On monetary policy, the ECB are undertaking an ongoing asset purchase programme of €60bn per month which will amount to an additional €1.2trn by September 2016. This has already led to substantial falls in sovereign yields and a large fall in the euro which should act as a major stimulus to the euro area economy and which is already showing up in the real data. By contrast, the Bank of England is beginning to consider raising interest rates, most likely in early 2016.

• On fiscal policy, most of the necessary fiscal consolidation has been carried out in the euro area, neutralising what has until recently been a drag on growth. The UK government, however, still needs to undertake further fiscal austerity which is likely to add as a new drag on growth in the years ahead.

This suggests, in our view, that euro area growth is likely to move closer to the UK’s in the next two years, though it is unlikely to overtake the UK as things stand.

Peter Westaway

Relative value

UK v euro area

The UK has had the advantage of speed and flexibility, but the euro area is making the right moves

Source: Vanguard calculations based on data from IMF Fiscal Monitor

United Kingdom Euro Area United Kingdom (Forecast) Euro Area (Forecast)

% P

oten

tial G

DP

2007 2009 2012 2013 2014 2015 2016 2017 20182008 20192010 2011

4

2

1

0

-1

-2

-3

-4

3

That sinking feelingChange in General Government Cyclically Adjusted Primary Balance


The oak and the willow

The UK is leading the G7 pack in terms of growth. This in itself has a ‘feel-good’ factor, enough that George Osborne thought it worth mentioning in his last Budget speech. But is it anything more than a short-term fillip? What are the real prospects for the UK and the euro area in the medium term?

It is worth reminding ourselves that despite the perception that the UK’s economy is structurally sounder than that of the euro area, GDP per head in the UK is actually lower than in the euro area as a whole. This divergence is largely driven by lower levels of UK productivity per worker. Of course, there is considerable heterogeneity within Europe, so that while the UK’s productivity is some 10 and 20% below that of France and Germany, it is ahead of most others, in particular most of the periphery countries of southern Europe.

It is a subject beyond the scope of this note to disentangle the underlying causes of these productivity differences across Europe, but some interesting comparators are the number of patent applications per head and the proportion of GDP spent on research and development. Both are plausible indicators of the ability of an economy to invest in the cutting edge technologies that are likely to be closely correlated with higher productivity. The UK falls behind these metrics relative to France and Germany, though it is ahead of other large European economies.

While the measurement of productivity levels is subject to difficulties, it is worthwhile to compare key elements in the composition of growth, population, productivity and changes in participation (including changes in unemployment).

In the years from 1990 up to the financial crisis, UK growth was around 0.5% higher than the euro area, which can mainly be explained by strong productivity growth

(defined on a per hour basis) of around 2.5% per annum. Since the crisis, UK growth while weak has exceeded that of the euro area more because of a strong recent contribution from population growth, while productivity has made virtually no contribution. The euro area by contrast has had positive productivity growth but has been held back by rising unemployment.

Looking forward, most official estimates suggest that UK growth is likely to be stronger than the euro area over the next 5-10 years due to higher population growth and productivity improvements (1.1% per annum in the UK versus 0.8% in the euro area). By contrast, euro area growth is likely to be boosted over the same period by a gradual recovery in unemployment levels.

Any estimate over such a long time horizon is bound to be uncertain. The recent so-called ‘productivity puzzle’ in the UK makes it difficult to be confident about future projections (are we entering a new age of weak performance, as Japan did in the 90s, or are we in for a period of catch-up?). There is also uncertainty around immigration policies which could reduce population growth as a source of expanding activity.

If living standards are lower and recent productivity growth is so poor, why is the

UK perceived to have performed so much more strongly than the euro area in terms of structural reform? The reason is that the UK economy has made much more progress in terms of structural flexibility, a legacy of the painful reforms that took place in the UK during the 1980s, but much more patchily in Europe. Germany is a partial exception, where the process of reunification helped to modernise labour market institutions.

Elsewhere in Europe, the need for structural reform is still apparent. This allows UK product and labour markets to respond more quickly and dynamically to economic shocks. One obvious manifestation of this type of structural flexibility is the natural level of unemployment which remains stubbornly high across much of Europe, but appears to be much lower in the UK, allowing headline unemployment to fall in the last two years.

Overall then, the superior labour market performance in the UK relative to the euro area is encouraging but it would be complacent to assume that the structural characteristics of the UK economy are generally superior. There is room for improvement on both sides of the Channel.

Vanguard calculations based on figures from Eurostat and Office for National Statistics

Peter Westaway

UK v euro area

Despite its more flexible structural characteristics, the UK is struggling to regain momentum in productivity

Vanishing pointComponenets of GDP: UK productivity has been negative

Source: Macrobond

Labour productivity Population Participation GDP growth

Euro Area United Kingdom

1999 to 2007 2008 to 2013 Forecast

Euro Area United Kingdom Euro Area United Kingdom

3.5%

1.5

1.0

0.5

0

-0.5

-1.0

-1.5

2.5

3.0

2.0


UK vs euro area

The story in pictures

Dash for growth

In terms of headline GDP growth, the UK has outstripped the euro area since the onslaught of the sovereign debt crisis in 2011/12.

Fuelling the fire

The UK was able to exploit its independence, pushing interest rates down to historic lows (negative in real terms), while pouring money into the financial system through quantitative easing.

Productivity puzzle

Economists and monetary authorities have been perplexed as to why UK productivity growth has been negative since the financial crisis. Historically, recovery from recession is driven by productivity increases, as is clearly happening in the US and the euro area.

Cost of labour

Possibly reflecting the poor recovery in productivity, UK unit labour costs are among the highest in the big five EU economies.

Since late 2013, UK bank lending has been positive, while in the euro area it continues to contract.

UK vs Euro Area GDP Growth (index to Jan 2008)

United Kingdom Euro Area

Inde

x Ja

n 20

08=

100

05 06 07 08 09 10 11 12 13 14

106

102

100

98

96

94

92

90

104

Source: Eurostat, ONS

Real vs Nominal interest rates

United KingdomUnited Kingdom real interest rate

05 06 07 08 09 10 11 12 13 14 15

6%

2

0

-2

-4

-6

4

Euro Area Euro Area real interest rate

Source: Bank of England, ECB, ONS

Central bank balance sheets

Bank of EnglandEuropean Central Bank

Tota

l ass

ets

(% o

f 20

08 G

DP

)

Ind

ex (J

an 2

008=

100)

07 08 09 10 11 12 13 14 1615

700

600

400

300

200

100

0

500

Forecast balance sheet expansion under QE

Lehman Collapse

Source: Bank of England, ECB

Private sector lending

United Kingdom Euro Area

% y

/y

05 06 07 08 09 10 11 12 13 14

14

12

10

6

4

2

0

-2

-4

-6

8

Source: ECB, ONS

Current price GDP per hour worked relative to UK=100

US Germany France Italy

Inde

x

90 94 98 02 06 10

140135130125120

1101051009590

115

Source: OECD, ONS

Nominal unit labour costs

Sha

re o

f G

erm

an U

LC

95 97 99 01 03 05 07 09 11 13

1.2

1.15

1.1

1

0.95

0.9

0.85

0.8

0.75

0.7

1.05

United Kingdom France Italy Spain

Source: Eurostat


Knowledge economy

Patent applications and spending on research and development (R&D) shed some light on investment in new technology and give an indication of business confidence into the medium term On both counts, the UK lags Germany and France.

Bottom line

Over the past two cycles, US dollar and euro denominated investment grade corporate bonds, when hedged back to sterling, have outperformed. Unhedged euro denominated bonds have lagged only slightly.

In equity markets, the US has spiked ahead over the past year, but the euro area has held its own other than in the sharp drops during the sovereign debt crisis in 2011/12.

Employment protection, however, is limited and the overall tax burden is low relative to EU partners.

United Kingdom France Italy Spain Germany

Total intramural R&D expenditure

% U

S R

&D

Exp

endi

ture

90 96 989492 00 1008060402 12

35%

20

25

30

10

5

0

15

Source: Eurostat

Strictness of employment regulation

Inde

x

90 95 00 05 10

4

3.5

2.5

2

1.5

1

0.5

0

3


Source: OECD


Average tax wedge

% la

bour

cos

ts

00 04030201 0605 121110090807 13

45

39

41

43

35

33

31

29

27

25

37

Source: OECD

United Kingdom Euro Area Euro Area (Hedged) United States

Corporate bond returns

Inde

x (J

an 2

000

= 1

00)

00 06 080402 10 1412

400

300

250

200

150

100

350

Source: Macrobond

United Kingdom United States EMU

Equity returns

00 06 080402 10 1412

250

150

100

50

0

200

Source: Macrobond

Inde

x (J

an 2

000

= 1

00)


90 96 989492 00 1008060402 12

90%

60

70

80

40

30

20

10

0

50

Source: Eurostat

Patent applications to the EPO% US Patent Applications


Reading the runes

currency union, with German 10-year yields flirting with the zero for the first time.

Looking at cumulative returns on investment-grade bonds since October 2007, UK bonds returned an annualised 7%, 6.5% for sterling-hedged euro area bonds (6.1% in local currency) and 6.6% for sterling-hedged US bonds (5% in local currency). Relatively speaking, fixed income investors in the euro area initially earned lower returns than investors in the UK or US due to the slower start to QE by the ECB, higher credit risk associated with the sovereign crisis, and the euro area’s lower duration relative to the UK.

The landscape for euro area bonds may already be changing, however, as the sovereign debt crisis continues to abate, the ECB becomes more simulative, and interest rate increases loom on the horizon for in the UK and the US. However, practically speaking, returns for developed market bonds will be low across the board for some time.

it was the most undervalued of the three markets, moved to on par with US equities in 2013, and recently spiked due to the effects of QE.

Fixed income markets have been among the most keenly observed bellwethers in recent years. Even through the financial crisis of 2008-9, spreads between developed-market 10-year bond yields stayed relatively low. But the euro area sovereign debt crisis from early 2010 caused yields on European periphery bonds such as Italy and Spain to widen significantly as investors speculated on the break-up of the currency union. At the same time, yields on core European countries (Germany, France) and other developed markets (UK, US) fell to historically low levels between 1-2%.

This divergence in yields began to close after mid-2012 as the survival of the euro became more certain, but since mid-2013, as it became apparent that the ECB would engage in QE, bond yields plummeted to unprecedentedly low levels across the

The UK has had the lead in economic growth relative to the euro area, but there is never a simple correlation between the economy and financial markets

In the 12 months following the market peak in October, 2007, equities in the UK and euro area fell by around 45% relative to a fall of around 35% for the US market. Since then, relative performance has continued to strongly favour the US and to a lesser extent the UK. In total, UK equities have rebound by more than 150% compared to around 130% for equities in the euro area.

Some of this can be explained by differing factor exposures (for example, UK equities favour value stocks which have performed well post-crisis), but it is clear that the US recovery has been stronger (just as economic growth has been). This has been especially true since early 2011 as the sovereign debt crisis unfolded in Europe and all three markets suffered setbacks, particularly euro area equities, which underperformed by more than 20%. The gap started to close with stronger relative performance for the euro area from mid-2012, following European Central Bank president Mario Draghi’s ‘whatever it takes’ speech, and more recently as a result of the ECB’s quantitative easing.

Movements in equity markets are interesting, but it is potentially more important to understand movements in valuations because of what they might tell us about future returns. On that basis, the analysis of PE ratios in the euro area is rather different because their higher absolute values are more a reflection of low earnings (although, again, we need to be conscious of comparing stock market indices with differing composition). The valuation landscape has also changed markedly for the euro area. In early 2011,

Peter Westaway

UK v euro area

The UK has recently had better economic outcomes than the euro area, the explanation for market returns is a little more complex

Price to earnings

Source: Macrobond

0

5

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20152014

10

15

20

25

30

35

40

United Kingdom United States EMU

Valuations in the euro area have increased post-QE, but it is noteworthy that current levels are still well below what we saw in the US markets leading up to the technology stock bear market


Biola Babawale

Breaking the bank

Will UK interest rates rise or fall? Those with their hands on the lever seem hard-pressed to make up their minds, and there is some confusion as to what the message is coming out of Threadneedle Street.

Less than a year ago we were told rates might rise toward the end of last year. Now there are even murmurs of a cut. We were told unemployment was key, now we’re told it is economic ‘slack’.

In March 2015 it was exactly six years since the Bank of England cut its base rate to the historic low of 0.5%. The world has changed. The economy has revived. The FTSE World Index has risen 187%. But the base rate has languished.

When current governor Mark Carney first introduced forward guidance in mid-2013, the central tenet was that rates were unlikely to rise until unemployment fell below 7%, a seemingly safe bet as this was not expected to happen until late 2016. In January 2014 it was 6.9%. In December 2014 it was 5.8%.

But instead of triggering an increase in rates, we seem further from a rise now than at any time since the end of the financial crisis. The likelihood of the base rate being cut is of course marginal. But it was discussed at a recent Bank press conference as a possibility in the event of continued weak wage growth and negligible inflation – a fair description of where we are now. Inflation fell to 0.3% in January, well below the Bank’s 2% target.

There are two important factors currently affecting UK inflation. Global oil prices are in a slough, below $50 a barrel as of mid-March and with US inventories as high as they have been in 80 years. The structure of UK retailing is altering, rapidly and

significantly, with once all-dominant mid-market players grappling with a fierce attack from discounters.

The critical issue, though, is not what has happened or even what is happening now, but what do people making buying or investment decisions think will happen in the future? What in aggregate are UK inflation expectations?

Bank officials underline that the oil price and supermarket discount wars are likely to be temporary factors, their effects diminishing through the course of this year. Far from being on the brink of a spiral of deflation, the UK is likely to benefit from a short-lived, virtuous period when prices for essential goods decline. The key impact will not be to frustrate spending but to free up income, potentially increasing spending among a population whose real incomes have been ground down over several years of fiscal austerity, weak growth and the inflationary effects of quantitative easing.

If spending and investment were to pick up as disposable income rose due to lower costs, it would add fuel to an economy that has been growing at pace. The fourth quarter of 2014 was the eighth straight quarter of rising UK GDP, all but one at a rate above 0.5%.

You can see why the Bank might not know whether to raise or cut, and why its messaging might seem confused. It is in this context that it has moved to the idea that the key indicator for monetary policy should be economic ‘slack’. The concept of slack, or spare capacity, is somewhat vague. It is especially difficult to measure or predict in an economy as open and globalised as the UK, where net inward migration remains high.

As in other developed economies, UK headline employment figures can be especially crude. Participation in the UK has fallen and remained weak relative to historic recoveries. Those who do have work are too often under-employed. Surveys show that many workers would like better quality terms, data supported by widespread

anecdotal evidence of zero-hour contracts and no-pay internships. Many would like more hours, and many work in jobs that are low-skilled relative to their qualifications.

These issues are hard to quantify. As a proxy, the Bank will focus on productivity. If productivity fails to pick up, it would indicate that the economy is less likely to grow by producing more goods and services using current levels of labour and capital. This would in turn imply that inflation was likely to rise. Improving productivity, by contrast, would imply lower inflation.

What will happen? There is an outside chance that inflation will rise faster than expected. If a future government were to increase fiscal austerity by raising indirect taxes and such sources of public sector income as tuition fees, this would, somewhat perversely, put upward pressure on prices.

Bond markets are pricing in a rate rise in the latter half of 2016. Whatever the timing, the lift will be gradual. The new normal for UK interest rates is likely to sit at around 3-4%, substantially below the 5% judged to be the appropriate average from the late 1990s to the financial crisis.

The Bank of England seems unsure if it should raise rates or cut them, leaving investors increasingly confused

Between the linesUnemployment has fallen far faster than expected

Q32013 2014 2015 2016

Q4 Q1 Q2 Q3 Q4Q1 Q2 Q3 Q4 Q1 Q2 Q3

8.5

8.0

7.5

7.0

6.5

6.0

5.5

5.0

Source: Bloomberg

BoE August 2013 forecast

Actual unemployment rate


Good behaviour

Todd Schlanger

A wealth manager can add significant value to their client relationships by helping clients acknowledge and overcome behavioural biases. Academic studies have suggested that behavioural coaching can add between 100 and 200 basis points per annum to a client’s performance1, and our own research suggests advisers can add 150 basis points on average2. A simple way of illustrating how investor behaviour can impact the returns on an investment portfolio is to look at the difference between the returns generated by funds and the returns experienced by investors in those funds, as we’ve shown below. This figure shows that investors generally subtract value through their investment decision-making behaviour.

Cognitive and emotional

So what are the most common behavioural biases, and what can wealth managers do to help mitigate them? Behavioural biases can be divided into two categories: cognitive and emotional. Cognitive biases have to do with errors of perception, memory, judgement or reasoning. There are many examples, but among the most pertinent for investors are:

• Confirmation bias – the tendency to seek out evidence that supports one’s existing view and overlook evidence to the contrary;

• Framing – people are prone to drawing different conclusions from the same information, depending on how that information is presented; and

• Gambler’s fallacy – the belief that future outcomes are influenced by past events.

Emotional biases, meanwhile, are based around the tendency to believe in things that give us a good feeling and disbelieve things that make us feel uncomfortable. These include:

• Loss aversion – the fact that most people dislike losing money more than they enjoy making money;

• Overconfidence – a misplaced belief that investors can influence the markets, for example; and

• Self-control – failure to act in our own interest by remaining committed to the investment plan over time, for example.

Cognitive biases are based on logical errors and this makes them easier for wealth managers to address via rational argument than emotional biases, which can have a more detrimental effect.

Why investors need to learn to counter behavioural biases

Investor returns versus fund returns: ten years ending 31 December 2013

Sources: Vanguard calculations, based on data from Morningstar, Inc. Figure displays the difference between the investor and fund returns, as defined by the asset-weighted average in each category. Investor returns are calculated as the internal rate of return that sets the beginning and ending fund assets equal, given the interim cash flows. Market returns are the asset-weighted average fund return. Both are derived from aggregate flows data for funds domiciled in the UK, with asset classes defined as in Westaway et al (2014). Returns are in GBP, net of fees, with income reinvested.

0.5%

0

-0.5

-1.0

-1.5

-2.0

-2.5USD

diversified bonds

United States equity

United Kingdom equity

Global equityGlobal bonds

Eurozone equity GBP diversified

European equity

EUR diversified Emerging market equity


But a good wealth manager can make an impact on both sides of the ledger. Here are a few examples:

Help clients see the whole picture

Confirmation bias is a common investment blunder. Once a client makes an investment, he or she will then have a tendency to notice good news about that investment and overlook any information that calls the investment into question.

Wealth managers can help their clients to address this bias by encouraging them to focus on data, to seek out contrary views and to record the impact of their investment decision-making over time.

How information is framed can make the difference

Framing is an interesting and topical bias. The FCA recently conducted an experiment on this bias and how it can influence product choice at retirement3. Among other things, they found that the way the information was presented had a significant impact on an investor’s likelihood to choose an annuity for retirement income.

One approach to deal with framing is to start the discussion from the direction that would most benefit the client. For example, for clients with an aversion to diversifying their portfolios abroad, it could be helpful to start the discussion from the perspective of the benefits of a global portfolio. This is likely to result in a portfolio with a lower home bias, resulting in better diversification.

Using one bias to counter another

Framing also provides an opportunity to counter one bias with another. For example, loss averse clients with more conservative asset allocations than their required return may be more likely to increase equity exposure if their wealth manager framed the discussion around short-fall risk (the risk of not meeting their goals) than equity market risk.

Emotional biases and keeping your clients on course

Reminding clients of the plan that was created upfront can help persuade them not to abandon the long-term plan in emotionally charged markets. It can also be a good remedy for the temptation of chasing the next ‘hot’ investment. This is where the faith and trust that clients have in a wealth manager is key. By establishing a strong relationship before euphoria or panic challenge the investor’s resolve, the wealth manager gives him or herself a better chance of being heard when it matters most.

Thankfully, potentially disruptive markets tend to occur only sporadically. But, when they do occur, a wealth manager may save their clients from significant wealth destruction and also add percentage points

– rather than basis points – of value. This kind of wealth manager activity can more than offset several years’ worth of fees.

1 See, for example, Philip Maymin and Gregg Fisher (2011)

2 See Westaway, Schlanger, Kinniry, Jaconetti and DiJoseph (2014)

3 http://www.fca.org.uk/static/fca/documents/rims-framing-experiment.pdf


Janine Menasakanian

Keeping control

How popular is passive investing in the UK?It’s really taken off over the past few years. Figures from the Investment Association (IA) show that 23% of mutual fund net cash flows in the UK retail sector went into passive funds in 2014, up from 11% three years previously and just 2% in 2009. So on the mutual fund side, passive is gaining significant share. We think there are a number of drivers behind this, but they can be summed up as a growing understanding of the impact of costs on investing success, and a desire on the part of wealth managers and direct clients to reduce uncertainty.

On the ETF side it’s much more difficult to pin the data down, but we do know that European ETF assets have grown substantially over the past few years. Our own experience is that we’ve gone from a standing start in 2012 to having more than £10bn in European ETF assets today, which suggests that there is strong demand for products that offer high-quality, low-cost access to markets.

What are the investment benefits to wealth managers of adding passive funds to portfolios?The benefits really fall into three camps: cost, risk control and speed of implementation. Asset allocation is one of the most important areas where wealth managers can add value and passive funds are a great way of achieving exposure to core asset classes at low cost. That allows the wealth manager to maximise the value they add through asset allocation.

Using index funds can also be a good way of controlling volatility, because their performance tends to be distributed much more tightly around the benchmark than is the case with active managers. This means that adding passive funds to a predominantly active portfolio can lead to

lower volatility and tracking error relative to the market index.

ETFs have one further potential benefit as a result of their intra-day trading: they can allow wealth managers to implement their views more quickly than might be possible with a daily-priced mutual fund. This could be particularly important in fast-moving markets when wealth managers need to move their portfolios nimbly. But ETFs can also be useful in ‘normal’ markets because they can help to minimise time out of the market when implementing ongoing asset allocation changes.

Are there any other factors that are driving passive adoption by wealth managers? Yes, I think there is also a commercial element. For wealth managers who are building white-label model portfolios, it’s important to be able to market those portfolios at a cost that leaves room for platform and adviser fees. A 2% all-in end client fee seems to be the magic level, and that puts a real focus on minimising cost when putting together model portfolios. ETFs and passive mutual funds can both help in this regard.

Are there any asset classes that lend themselves more or less to ETFs/passive funds?The traditional wisdom is that passive investing works best in ‘efficient’ markets, where it’s more difficult for active managers to gain the information advantage they need in order to outperform. But we’ve looked at the data as part of our annual The Case for Indexing research, and we don’t see much evidence to support this view.

In fact, in our most recent analysis we find that UK and European equities – both so-called ‘efficient’ markets – are two areas where active managers have done well recently. At the same time, active managers have done quite poorly in US and global equities, which are typically also seen as ‘efficient’ markets, as well as emerging market equities, which might be seen as a relatively ‘inefficient’ market. So the picture is far from clear-cut.

Our summary is that all markets are actually pretty efficient and that it’s difficult to deliver persistent outperformance anywhere. It’s not impossible, but it’s difficult. And, funnily enough, costs seem to be one of the best predictors of future performance. For active and passive funds, those with lower costs have outperformed over the long term in the vast majority of sectors.

Do you expect ETFs to grow their share of the passive investing market at the expense of mutual funds?Our US experience suggests that over the next few years, more people will come to ETFs as a quick and cost-effective way of gaining strategic exposure to core markets.

However, ETFs aren’t appropriate for all investors in all circumstances – for example, the stock broker fee that investors pay when they buy and sell ETFs means that they might not be the most cost-effective route for frequently-trading direct investors.

Where does “smart beta” fit on the active to passive spectrum and what does the future hold for these strategies?I think the term ‘smart beta’ is potentially misleading. At Vanguard we think of beta as being whole of market exposure: at its purest level, that would be a global market cap-weighted index. Any deviation from that exposure – whether that’s a deliberate home bias, a value tilt, an overweight in income stocks or whatever it might be – represents an active decision in a bid to create alpha, not beta.

So we think of these products as representing an active risk. They may have some benefits – for example, if you want to implement a conscious tilt in a portfolio, a smart beta product could potentially be a cost-effective way of doing that. But it’s important to note that they represent a deviation from the market cap-weighted index and, as such, they will have periods when they work and periods when they don’t.

Passive investing and ETFs are growing rapidly, reflecting a demand for low-cost products


From oil to interest rates, the key themes investors should be watching

On monetary policy and the markets:

Central banks in Europe and Asia have generally loosened their monetary policies, but the United States Federal Reserve has begun winding down its bond-buying stimulus program. It has also prepared the markets for a rise in interest rates, pushing short-term bond yields higher in the US and helping the US dollar gain strength against other currencies. But intermediate- and long-term yields have fallen as prospects for the global economy grow more clouded, geopolitical tensions continue to flare, and an upswing in inflation appears distant.

Sovereign debt interest rates declined sharply in 2014, making US interest rates more attractive for global investors. And with the European Central Bank, Bank of Japan, and People’s Bank of China all embarking on major stimulus programmes. US Treasury yield curve spreads have narrowed. Long-term interest rates are down significantly, and short-maturity rates have risen only modestly.

These developments have generally been a positive for global equity markets, but the rewards have depended heavily on currency dynamics. For example, the strong US dollar has dampened returns for US-based investors. In 2014, the MSCI AC World Index ex US returned a bit less than –3%. In local currencies, however, the same index registered a return of more than 6%, a nice reward for investors outside the United States.

On the outlook for interest rates in the US

In the months ahead, the Fed is likely to raise its target rate level by at least a quarter of a percentage point. The timing and scope of rate increases, however, will depend largely on the strength of the US economy. Our economists are focusing their expectations on inflation running at 1% to 3% in the US over the medium term, and a slow, modest rise in interest rates this year.

On oil prices and the energy sector

Energy was the broad market’s best-performing sector in the first half of 2014, and its worst performer in the second half, when energy stocks declined sharply in tandem with oil prices.

Several factors contributed to this, including forecasts of slower growth in global energy demand. The main driver was the roughly 50% drop in the price of a barrel of West Texas Intermediate crude oil, as quoted in US dollars. Natural gas also played a role: amid seemingly abundant supply – and in contrast to the more typical seasonal pattern – natural gas prices dropped significantly last autumn.

Falling oil prices produce both winners and losers. Beneficiaries include consumers, who enjoy lower prices at the gas pump, and energy-intensive businesses such as airlines. “Losers” include oil-exporting countries such as Brazil, Russia, and Venezuela. Oil exploration and production companies also suffer, and there are ripple effects for a wide range of related businesses.

Companies that concentrate on refining crude oil into other products were a bright spot: Lower prices for their primary raw material helped boost profits. Even in this group, however, there have been negative returns, especially among some non-US companies.

On precious metals

Performance in the precious metals and mining area has been disappointing. This is consistent with the ups and downs that can be expected from this sector, which tends to be much more volatile than the broad market. Fluctuating demand for gold and other commodities can produce periods of impressive growth alternating with sharp declines.

It’s important to consider that if you’re invested in the broad stock market, you already have exposure to this industry, whose stocks represent less than 5% of the global equity market’s total value.

On market volatility

Although volatility is inevitable, investors don’t have to ‘inherit’ it.

A few weeks ago, I answered questions from US clients in a live webcast. Not surprisingly, market volatility came up as a concern. My response? I stressed that how investors react – or don’t react – to dramatic market swings can determine how they fare over the long run. That’s why Vanguard always emphasises the need to maintain perspective and long-term discipline. (Read Vanguard’s Principles for Investing Success for more on this subject.)

We believe the best course for long-term investors is generally to ignore daily market moves. Investors ‘inherit’ what would otherwise be fleeting volatility when they sell in response to a market downturn. As one of my colleagues puts it, the only way to truly experience a loss is to sell when prices are down and realise that loss. Those are wise words to keep in mind when markets turn stormy again.

Bill McNabb

The investment outlook


Sales and contacts

Janine Menasakanian manages Vanguard’s relationships with global banks, asset managers, wealth managers, major distribution companies and wrap platforms. She joined Vanguard in 2011 and has over 20 years’ industry experience.

Mobile: 07775758217Email: [email protected]

Nick Davis is responsible for building and managing relationships with discretionary wealth managers across the UK. Nick joined Vanguard in June 2012 after working for a large global asset manager and a major UK platform since graduating in 2008.

Direct: +44 (0)203 753 6941Email: [email protected]

Andrew Surrey is strategic account manager responsible for all relationships with strategic accounts and platforms in the UK. Andrew joined Vanguard in 2014.

Mobile: 07712 324237Email: [email protected]

James Norton is responsible for building and managing relationships in the wealth management sector. James has fifteen years industry experience firstly as a private client stockbroker and then as a founding director of a leading London based financial planning firm

Direct: +44 (0)203 753 4341Email: [email protected]

Connect with Vanguard™

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Important notes

This information is directed at professional investors and should not be distributed to, or relied upon by retail investors.

This document is designed for use by, and is directed only at persons resident in the UK.

The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.

The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

The opinions expressed in this article are those of individual author and may not be representative of Vanguard Asset Management, Limited.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

© 2015 Vanguard Asset Management, Limited. All rights reserved. VAM-2015-04-20-2533

vanguard denmark - uk vs euro area · 2015-05-18 · 13 the investment outlook from oil to interest...

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