Focus on equities rather than bonds

1. Indexing:Is the case stronger for international than domestic investingEric Smith – Chief Investment OfficerVanguard Investments Australia Ltd AFSL 22726330th March 2005

2. Agenda • Focus on equities rather than bonds • Most bond manager performance is a beta bet – overweight lower grade credit • Two thirds of the money is invested in equities • Costs of participation are high – fees, implementation and tax consequences • The case for indexing? The question should be is there a case for active. • Australian equities • International equities.

3. Survey IssuesAustralian Equity Managers • Mercer survey at June 1997 • 69 managers/products listed • 67 with a return sometime in the last 12 months • 62 with a return at 30 June • Mercer survey for June 1997 at March 2005 • None of the (previously listed) managers without a return at 30 June still showing in the survey • 65 with a return at 30 June • The problem? • Only 39 return series are still the same • The 12 month average return of the universe has jumped from: 28.16% to 28.74% - an increase of over 0.5%

4. NeverthelessAssume the survey is okay and analyse it • 10 years to March 2005 • It’s a round number • Survey includes dead managers from June 1997 so only two years of strong survivorship bias • Include all monthly excess returns • 47 managers/products at April 1995 • 66 at June 1997 (none lost???) • 102 at March 2005 – gained 96, lost 41 • 9353 monthly excess returns • Analyse in quarterly bins

5. Median monthly return: 0.054% per month Standard deviation: 1.04%

6. NeverthelessAssume the survey is okay and analyse it • Is there a worthwhile effect • 0.054% per month is 0.65% per annum (log excess returns) • Typical active risk is 2.5% per annum • Hurdle rate is probably 0.5% per annum • There appears to be two sub-universes • Smart and random? • Seasoned and unseasoned? • Slice and dice by return type • For ease of analysis, simply categorise by ‘time in survey’ at the point of publishing a return. • Have only used a single distinction – those with less than 3 years and those with 3 or more

7. Unseasoned managers Seasoned managers

8. Unseasoned managers Median 0.059% per month Seasoned managers Median 0.030% per month

9. March 2000 to March 2001Were all the managers smart? • Everyone was a winner • Median active (non-index/enhanced) manger return was 17.9% • Index return was 13.6% • 51 of 55 ‘beat the index’ • However, the active manager universe does not hold the index • Chronic underweighting to mega-cap stocks • Chronic overweight to large-midcap stocks • This is a structurally-driven factor bet, not a positive decision Beta masquerading as Alpha

10. International Equities • A moving universe. In the Mercer survey: • There were 40 or 41 ‘core’ managers/products with 1 years returns in each of the last 5 years • There are 35 with a current 3 year return • There are 31 with a current 5 year return • Tracking errors against the FTSE World and MSCI All Country are lower on average than against the MSCI World • MSCI World is not the world market • Long history analysis shows ‘stopped-clock’ effects with managers holding fixed positions and looking more like each other than the market. • The outcome is window dependent relative performance

11. International Equities

12. Conclusion • Australian equities – active managers are not as hot as they look • Seasoned managers don’t outperform as a group. So how do you distinguish skill from luck? • Returns to structure mask the outcome. Can a simple model explain ‘median manager’ results? • International equities • Traditional ‘core’ managers have not outperformed the market in the last 5 years • Returns to structure can mask the outcome.