Crucial issue of benchmark choice
In the late 1990s the trend towards passive management became so prevalent that it was easy to believe the active management of large institutional investment portfolios would soon be little more than a niche product.
In one of the longest uninterrupted bull runs in the history of the stock markets, investors increasingly began to ask themselves the following question. Why pay high fees for active portfolio management which just brings you additional risks, when prevailing financial market theory shows that markets are efficient and cannot be systematically beaten anyway, and when, by choosing the cheaper option of simply replicating an equity index, you can earn a global average return of 14% per annum? However, since the US stock market started to move sideways in July last year, active management has been regaining popularity. Only those who manage to beat the market are now earning any money after fees.
A crucial factor in index tracking was and still is the choice of benchmarks. Since in practice no one can replicate the global equity market together with all the bonds traded, the success of an investment stands and falls with the choice of index to be tracked. The active investment decision is merely transferred to the level of the index, but cannot be totally avoided. For example, a Swiss pension fund opting for passive management based on the standard benchmark, the Pictet LPP-2, would have seen its investment performance beaten in eight out of the past 10 years by the average of active managers using the same benchmark index.
The index is so inefficient that some providers, such as Julius Baer Asset Management, have created their own benchmarks. Pictet itself launched a new family of indices in September. Inefficiencies in indices can arise where the stocks included do not provide sufficient risk diversification. The IT and telecom sectors, for instance, account for less than 3% of the Swiss Market Index, while financials and pharmaceuticals alone make up over 60%. Why should an investor accept such an unbalanced sector distribution as that imposed by passive management of the SMI?
One reason might be that the SMI accounts for only a fraction of an overall portfolio, so that sector diversification is achieved through the addition of other investments, and investors assume that the Swiss equity market is so efficient it cannot be systematically beaten.
Market efficiency requires, among other things, that all price-relevant publicly available information is factored into the price of securities without any intervening delay. That this is not the case is shown by a study carried out by Credit Suisse Private Banking, which analysed the behaviour of shares in the SMI in the month following a revision of earnings forecasts by analysts.
The value of a portfolio containing the 10 shares which saw the sharpest upward revision of earnings forecasts would have grown from Sfr100 in January 1993 to Sfr880 in June 2000; the portfolio with the 10 biggest downward revisions would have appreciated by just Sfr170 francs (see graph).
The analysis shows that the processing of information takes place with a delay and that individual investors may very well have an information advantage. If this applies to blue chips it is easy to imagine what the situation will be with small-capitalisation stocks. The following is just one striking example that contradicts the market efficiency assumption: the share price of Swiss Compagnie Internationale pour la Communication suddenly shot up from Sfr22 to Sfr120 last January and has since been gradually falling back to its original level. The clue: the abbreviated name of the company, which owns a forwarding operation and numerous properties, is CI Com.
Another much-cited reason for avoiding active management is the fear that any outperformance by the market is paid for by incurring higher risks. Where it refers to the tracking error against the benchmark this view is perfectly correct. The deviation in performance from the benchmark is primarily of relevance for the institutional investor whose assets are spread over various investment managers and has a set idea of what the risk of the consolidated portfolio should be. However, it is the absolute risk that matters for the overall portfolio. The fact that a high tracking error is not synonymous with high absolute risk is shown by the example of the Julius Baer Japan Stock Composite. Since 1993, the tracking error against the Topix has not been less than 10.8%, but the standard deviation of monthly returns has been only 21.6%, as against 22.8% for the Topix. Result: the Composite has outperformed the Topix by 7.2% a year.
These examples show that active management has its merits. Index tracking alone can never be a solution for the entire industry. Otherwise who would want to buy the shares that have just been removed from the index?
Rainer Marian is chief investment officer, Julius Baer Investment Management in Zurich