Enough of Star Managers? By Laetitia Peterson.

It is evident that the trend away from active managers is a global phenomenon.  After writing my recent blog on 9th June interpreting the 2018 SPIVA (S&P vs Active) data , I came across an article in The Times over the weekend during a trip to London which sang from the same song sheet.

Four stats jumped off the page:

98% of US actively managed funds failed to beat their benchmark over 10 years

£46.8bn moved out of actively managed UK-based funds in the year to the end of May

73.5% of UK actively managed funds failed to beat their benchmark over 10 years

£10.8bn flowed into UK-based passively managed funds in the year to the end of May

These stats are up to the end of May 2019, so it looks like the trend is getting stronger, not weaker.  This also confirms the analysis Dimensional Fund Advisers undertook recently to show that the move away from active to passive funds hasn’t made the market less efficient and opportunities for active managers to outperform are not improving contrary to popular belief.

The lead into The Times article was the suspension of the Woodford Equity Income Fund, an actively managed fund which is struggling from significant outflows and has had to suspend redemptions due to liquidity problems.  Investors have been warned to get prepared for the worst, i.e. the fund being wound up and a long wait for the proceeds.

The article goes on to quote Jason Hollands of Tilney Group, winner of the Wealth Manager of the Year Financial Times Award in 2018, “As the statistics show, a very small proportion of active managers add value in terms of outperformance.  The number in the UK who can deliver and sustain superior performance is in the single figures.”  It is vital, he said, to choose such funds carefully and be vigilant in monitoring them.  If you don’t have the time or appetite to do this, it may be appropriate to invest primarily in tracker funds.

The article also quotes senior portfolio manager, Peter Sleep of Seven Investment Management.  “If you buy a FTSE 100 index tracker, you will get the return of the FTSE 100, minus fees.  If you buy the S&P 500 you get the return of the S&P 500.”

Does this mean that all investors should switch to lower cost tracker funds?  The article gives a balanced view and highlights some of the drawbacks of index funds.  For example, it quotes Stuart Dunbar of Baillie Gifford, an active fund manager, who said: “The main reason that a passive investment approach has often fared well against its more ‘active’ rivals is that far too much of what passes for active management is simply short-term shuffling around of stocks, rather than genuine long-term investing”.  It also quotes Hollands again saying that traditional tracker funds weight their holdings based on company size, which can lead to a heavy concentration in the very largest companies.  For example, a FTSE all-share tracker will have more than twice as much exposure to a single oil company, Royal Dutch Shell, at 9.1 per cent of the index, as it does to the 281 smaller companies that make up only 3.7 per cent of it.  The FTSE all-share might appear to offer exposure to 632 companies, but in practice 37 per cent of your cash will be invested in only ten shares.

So, if active funds that consistently outperform their benchmarks are hard to pick like a needle in a haystack, and index funds although a lot cheaper have major drawbacks, should investors throw up their hands in despair caught between a rock and a hard place?

At The Private Office, we are acutely aware of the pitfalls of active management and the drawbacks of tracker funds.  To counter this, we use a much more sophisticated and unique approach which we believe is in the best interests of our clients.

As owners of a wealth management business, we need to take the lead in this debate as clients expect us to have a clear investment philosophy so they can stay disciplined and remain invested in good and bad times.  Based on my 30 years of experience in the markets, at The Private Office we have chosen to back an evidence-based approach, using what the academic world has learnt from analysing the data (security prices) obtained from the last 90 years of trading history.  This approach is also the one I feel personally most comfortable with for my family’s future financial security.

In a nutshell, what the academics have found strong evidence for is that investors should be paid for turning up (i.e. taking risk) and that there are different risk factors for which we can expect to be remunerated over time (these are referred to as premiums).  The risk factors depend on the nature of the investment. 

For growth assets, the risk factors are the:

1.     Market – if you invest in all tradeable shares in aggregate, you should get a ‘market’ return.  If you stock pick, you expose yourself to diversifiable risk for which you may not get paid.  This is called speculation.

2.     Size – smaller companies tend to outperform their larger counterparts across all markets.  They are more nimble and efficient, but also more risky.

3.     Value – companies which have a lower market value relative to their book value tend to outperform ‘growth’ companies (think of the FANG stocks: Facebook, Amazon, Netflix and Google (now Alphabet)).

4.     Profitability – profitability is the other side of the value premium which was discovered in 2012 and led to Gene Fama winning the Nobel Prize in 2013.  Profitable firms are less prone to distress, have stronger cash flows and have lower operating leverage.

For income assets, the risk factors are term and credit.  When investing in bonds, investors should overweight longer dated bonds if the yield curve is upward sloping (i.e. investors are being paid for taking term risk) and overweight bonds issued by companies with a lower credit rating (than Government bonds) if there is a positive credit spread.

When tilting portfolios towards these academically proven dimensions of expected return, we should be able to outperform both an active (stock picking) and passive (index tracking) approach.  And the good news is that this strategy can be implemented at significantly lower cost than an active approach as there are no ‘stars’ who stand between the investor and what they deserve to be paid for investing their capital.

This doesn’t mean that we take a static approach to investing.  In constantly changing market conditions where a share can change from being a value to a growth stock from one day to the next and a small company can grow to become a large company, we need to act swiftly.  We also need to consider ‘momentum’ when implementing portfolio changes and not allow ourselves to be caught up in a downward spiral or upward bull run.  This requires close monitoring of the fund managers in charge of implementing our evidence-based approach to ensure they effectively capture the dimensions of expected return.  With a portfolio containing about 9,000 securities, the management requires strong analytical skills and highly sophisticated trading tools. 


Source: Saturday June 15, 2019 – THE TIMES