I recently spoke at length to two leading fund managers at two different investment houses. Both were in charge of successful products with a particular investment objective: to deliver stable returns with a margin over libor. Each aims to produce a satisfactory outcome over a market cycle that will beat both libor and inflation. Both managers are qualified actuaries and great believers in a quantitative approach to provide proper risk management in order to deliver results for clients. Both individuals however, also stated categorically that their products, and investment management is ‘more art than science’.
And so it is. In order to identify the best opportunities which will deliver a level of return for a given volatility or expected risk, asset management businesses will need teams of individuals with the ability to recognize value, growth and income opportunities across and within global asset markets. Quantitative analysis can support that process but it rarely drives it. Just look at the erratic performance of Commodity Trading Accounts (CTAs) or momentum traders in recent years.
Both of the products referenced above aren’t managed to beat an index which leads me to ‘The Folly of Indices’.
‘Market capitalisation weighted indices are a useful reference point but not a portfolio construction tool’ – Hugh Young, Aberdeen Asset Management
George Ross Goobey, later acclaimed as a UK fund management ‘revolutionary,’ worked out in the late 1940s that equities were yielding more than gilts. This was in the post second world war period when gilt yields were artificially below inflation (sound familiar?). He persuaded the trustees of his employers, Imperial Tobacco, to eschew convention and invest in equities. Since then the cult of the equity has dominated and even survived events such as Black Monday (1987), the Dot Com crash and 9/11 until the financial crisis of 2007/8 caused a re-evaluation of equities’ investment role.
One of the lesser-mentioned aspects of Ross Goobey’s different approach was that he bought into mid and small-cap companies, thus avoiding the concentration of large stocks. Over time, good equity performance attracted large pension fund assets and the need to buy into large cap equities (because of capacity) became a necessity. From a point in the late eighties, UK fund managers became obsessed with their benchmarks: usually a FTSE index or, in the case of balanced funds, making minimal changes around where they thought the competition was positioned. Investment policy came to be centred on avoiding being wrong rather than serving the interests of their clients.
For those managing bond portfolios, this index fascination and being a slave to it was also prevalent yet it made even less sense. Consider those managing global government bond portfolios managed against the JP Morgan Global Bond Index. Japan represented over 20% of the index as it was the largest and most frequent borrower. Its weighting would rise because of that but many managers wishing to maintain their underweight position would be buying to do so and therefore not increase their ‘tracking error’ to the index. More folly.
Keep on tracking
Index fascination has continued with the rapid growth of tracker funds and exchange traded funds built to replicate indices and available at a ‘cheap’ cost. But how many investors, I wonder, peel back the label and check either the actual cost and/or variation of returns or tracking error versus the index. Consider too, counterparty risk – who exactly have you given your money to and, ultimately, will they pay you back? For the most part, tracker providers are well known and proficient, delivering products at a reasonable price. Tactically, they can be an efficient way to gain quick exposure to a market before investing money more specifically; but as a long term vehicle for investing in different asset classes? I have my doubts.
Consider that as a share price rises, with a tracker, you buy more of it and vice versa on the way down. Is that logical? Isn’t that chasing markets and returns? Isn’t the investor always behind the curve? More folly.
We are also told that the majority of active managers underperform their index benchmarks and therefore the low-cost tracker way of investing is better. The government’s auto-enrolment pension plan is based upon that philosophy. Although you can’t fault the desire to get more workers thinking about their pension needs, as an investor I don’t need to invest with the majority. I’m quite happy investing with the minority that outperform.
Of course the concept of market capitalisation weighted investing is something of a challenge. We can take any of the world’s indices, but let’s for example, look at one familiar in the UK – the FTSE 250. Logically and literally the name tells you that there are 250 stocks or companies in the index. They each have different weightings based upon their market capitalisation (share price x number of shares outstanding) which will determine their weight in the index. But as an investor, why should I care about weights? If the index has 250 stocks, doesn’t that mean that there are 250 separate opportunities? I’d rather own the ones I like and not own the ones that I don’t like. If the largest stock by capitalisation represents 8% of the index but I don’t like the company or the way it’s run, I won’t have it in my portfolio. To say that I’ll own 5% and be underweight as I don’t like the stock seems illogical. This is apparent in the US where Apple dominates the technology index with a 12% weighting.
Maybe that’s why many managers underperform but there could be other reasons.
Scale – Large managers have little choice but to beat indices, they are asset gatherers and see that as more important than absolute performance. Relative performance helps scale but effectively they become active ETFs or in some cases due to their size and proportion of holdings, activist investors.
Lack of Resource – A fund management business or team may lack the resources to provide adequate research into every company in the benchmark index it follows so is forced to make small under and overweight calls to try and beat the index.
Inability – They may simply lack the talent.
Cost –They may charge too much and the resultant cost when subtracted from fund performance, takes it below index returns.
It seems that Ross Goobey’s investment philosophy has been modified to become something of a convention that now looks distant from his initial ‘revolutionary’ thinking. As the need for products to be able to accommodate large scale investment amounts have become more important than the needs of the individual client, these vehicles may now offer the individual a less than optimal investment outcome.
Keep it simple
Let’s strip the rationale for investing back to simplicity. If you have a pot of money and you’ve landed on this planet for the first time, your overriding objectives are to protect your capital and grow it in real (above inflation) terms. The only variations to these considerations are your starting point (age), your expectations of lifestyle, retirement and longevity (death). As you get older you might need income in your retirement years but the investment concept is still simple. Protect capital; grow it in real terms.
‘Mature’ investors are being directed towards fixed interest as a more stable, reliable investment than equities (sometimes via an index!) suitable for their profile. Thanks to quantitative easing (QE) and before the recent 0.5% drop in inflation, gilt yields out to ten year maturities yielded less than inflation so there’s little to no growth in real terms there. In addition much of this asset allocation for the ‘mature’ investor is based on data from the recent 20 year bull market for bonds. Consider that without QE, gilts would trade on a real yield of 2% or more and the nominal yield would be around 4.5% or more and not 2.75%. The journey in capital loss terms from 2.75% in yield to 4.5% would be painful and make a dent in someone’s retirement pot. I’m not saying that either inflation or gilt yields are about to head north but you get my point.
My final point on this is that all this backward looking based asset allocation work tends to focus on investing to retirement at or around 65 years of age. As life expectancy is closer to 80, those investing for the future might want to take that into account or as it is termed in the US, the difference between ‘to or through’ retirement. Thankfully the compulsory purchase of annuities is a thing of the past. But investing for an ‘exit’ at 80 alters one’s asset allocation thinking significantly.
This is what you need!
For many years the asset management chorus has persuaded the investment industry to think in terms of three silos and then hit it with a proliferation of product. Until the past decade there was little thought given to providing what clients actually wanted – investment solutions; instead they were simply bombarded with product.
In the chart below the top section represents the three silos that asset management firms have felt comfortable in providing. Very rarely did the invisible but iron curtain between equities and fixed interest come down.
The middle two horizontal sections represent two different ways of investing with clients’ objectives in mind. The goal of preserving capital and growing it in real terms is at the core. The degree of real return will depend upon your risk tolerance and ability to incur a loss in any one year (the regulator’s current favourite measure). The component parts of those solutions are not just debt (a better description than fixed income as some of it is floating rate), equity and commodities but also a holistic view gaining exposure to the risk premia afforded by income (debt or equity) or growth investments with an implicit or explicit linkage to inflation. Consider an investor faced with a five year gilt yield well below UK inflation or an above inflation equity yield derived from a portfolio of companies who’ve raised their dividend in each year for the past twenty years. In the top section, that comparison isn’t made and the investment decision rests with the individual who is arguably less qualified than an investment professional to allocate assets. In the bottom section, the asset allocation is delivered as part of the solution.
The middle two horizontal sections reflect the two different ways of achieving multi-asset solutions. The top section is the directly invested method where one manager or team from an asset management firm allocates by directly buying securities from the ‘silos’ but without their constraints and ambivalent to market indices.
The lower of the middle sections is the whole of market solution which T Bailey offers and recognises that no single manager will have the best thinking, that finding the best unconstrained managers, rewarded by performance not by assets under management, is the route to the optimal asset allocation which in turn will deliver the outcome solution to fit the client’s objectives.
It reminds me of the ‘so what’ scenario when a fund manager marches in and his opening statement is ‘We manage £50 billion in assets under management’.
|FOR INVESTMENT PROFESSIONALS ONLY
This document has been produced for information only and represents the views of Peter Askew of T. Bailey Asset Management Limited (“TBAM”) at the time of writing. It should not be construed as investment advice. Every effort is taken to ensure the accuracy of the data used in this document but no warranties are given. All sources TBAM unless otherwise stated.
Past performance is not a reliable indicator of future results.
Issued by T. Bailey Asset Management Limited. T. Bailey Asset Management Limited is authorised and regulated by the Financial Conduct Authority No. 190291 and is a member of the Investment Management Association. Please note that T. Bailey Fund Managers Limited and T. Bailey Asset Management Limited do not provide financial advice to private individuals. Registered in England & Wales No. 3720372. Registered Address 64 St. James’s Street, Nottingham, NG1 6FJ.