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Ahead of the curve: An active view on active passive

“Most active managers [….] fail to beat the indices after fees, and picking managers is not much easier than picking stocks themselves”. So read an editorial in the Financial Times on 11 March. It went on to say that “if fewer smart people are paid to engage in the zero-sum game of security selection, good.”

No one feels sorry for the fund managers at the end of this criticism, and it is not wholly unjustified. The asset management industry is too big and over rewarded. Most active managers do fail to beat their indices. However, the key word here is ‘most’. Not all. Moreover, it is not really that difficult to pick managers or stocks if you know what you are looking for and how to find it – in both cases separating signal from noise. 

Press polemics are not new, but they do not get less wearisome. The better part of the asset management industry does something worthwhile: we pool investors’ capital and allocate it in a cost-efficient manner to investment projects, generally through listed companies. This can create wealth. 

The problem is that too much of what passes for ‘investment’ simply is not. Perhaps a more constructive approach than indiscriminate condemnation might be to promote a better understanding of what investment is about. 

The UK Financial Conduct Authority recently looked into closet tracker funds, and as a result currently unnamed asset managers are paying £34m (€38.6m) in compensation to their clients. This is useful, and it would be nice to think it is a turning point in forcing transparency in a way that helps clients. 

The problem is that it does not address the bigger picture. The primary issue is not managers hugging an index while pretending not to, it is that most managers, and even regulators, regard the index as a gold standard against which to measure value. In the long run this is fair: the index is essentially the average return of all market participants within its universe, and skilled investors exceed the average. However, on any given day, the index is simply the clearing price for all the orders in the market. Only over very long periods – five years or more – can we start to see correlations between the operational performance of companies and their share prices. 

Investors measure fund manager performance over shorter time periods, so managers regard divergence from the index as a measure of risk. It is indeed a measure, but it is not the one that people think – it is a measure of business risk for fund managers. Hence the irrational concept of clients paying fund managers to own ‘underweight’ positions in stocks they dislike. This is a zero-sum game, and we do not need to play.

What is value for money in active management? There are a few answers to this, but certainly includes better returns, after all costs, than those of a passive fund. The paradox is that the more granular the analysis and the shorter the period over which investors assess active managers against their index, the less chance they have of their manager achieving it. The manager’s behaviour changes as a result of being measured, a sort of Heisenberg’s uncertainty principle for investors.

So what can investors do to leapfrog the artificially created misalignment that undermines active management? Fortunately some managers are still focused on the fundamental job of investing, and they are identifiable by characteristics which have been supported by independent academic research.

First, seek to invest with managers who are indifferent to whatever is in their fund’s benchmark index, and accept that short-term divergence is meaningless and requires no action. In industry jargon, seek out high active share.

Second, invest with managers who make decisions based on the prospects for the projects in which they are investing. Signs of this are low turnover and low transaction costs, and managers who can explain clients’ investment returns without reference to what other investors are doing, or homogenising whole categories of investments. 

Be unimpressed by statements such as ‘we underperformed because of our overweight position in China where concerns on economic growth weighed on returns’. What does that tell us about how capital is being deployed? Recent research shows that in terms of lifetime dollar wealth creation, the best-performing four percent of listed companies have contributed the net gain of the entire US stock exchange since 1926. In the same period, 57% of common shares have not outperfromed one month Treasuries1 . Market sentiment can be generalised and has little value; actual returns-generating investment opportunities cannot.  

Third, costs matter, but paying low to replicate an index is not necessarily the correct answer. They are a headwind that active managers have to overcome, not a statement of value for money. Costs include not just management fees but also administration fees, research costs paid through trading activity, audit and custody fees and in some egregious cases the direct costs of the fund managers. 

It is not difficult to assess all of this: thanks to recent regulatory moves, for pooled investors a fund’s ongoing charges figure should reflect it all. For institutional investors in segregated accounts, the same principles apply even if one needs to dig deeper to get the answer. 

The depressing reality is that all active managers are being tarred with the same high-cost/low-value brush which is detrimental both to long-term savers and to economic progress at large. My plea is for investors to look a little harder.

*Bessembinder, Hendrik, Do shares outperform Treasury bills? (21 November 2017) Journal of Financial Economics

Stuart Dunbar is a partner at Baillie Gifford

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