Our industry is marshalled by the Financial Conduct Authority (FCA), the regulator and the Investment Association (IA), the trade body for asset management. These two are supposed to work together for the benefit of the end user – the investor. Since the FCA’s interim report on the asset management industry last November, criticising ‘active’ managers for running expensive, poorly performing funds, it has been open season for purveyors of passive investment products which have seen huge inflows (see chart 2) into exchange traded funds (ETFs) and exchange traded products (ETPs). Conversely, all those pursuing an ‘active’ management philosophy have been tarred with the same brush. The FCA’s criticism is that many ‘active’ funds have failed to beat their benchmarks after costs. Benchmarks in the FCA’s case means indices.
The key point is – who said an index was an appropriate starting point for portfolio construction and measurement?! It isn’t and as we have said many times before, an index is little more than a reference point. It is NOT a portfolio construction mechanism!
All this reminds me of the events of some twenty years ago when chartism was something of an investment fad. One of the equity fund managers in our investment team back then decided to make a name for himself and persuaded the CIO to take the chartist fad seriously. This person then built a team of four and at one stage was the largest customers in the world of one of the largest data providers! They all had parallel rulers.
Things go up as a rule – until they go down.
The team’s finest moment came when they found a stock that had a steep and consistently rising price history for the past six months. This was worth investing in they thought. They were unaware that the company had just accepted a cash bid and the future return was going to be cash! You couldn’t make it up.
The Emperor’s New Clothes
I read recently in the FT that a private bank director described the asset management industry’s story as being like that of the ‘Emperor’s New Clothes’, high fees and underperformance of the index. Actually, I believe the aforementioned fable’s moment is on the horizon – when investors realise the bubble of passive investing has burst. The concept of buying what’s gone up with no further rationale, fuels a rally of its own – until it doesn’t. This commodity like performance has a Ponzi-like element. The following chart gives you an idea of the size of flows. Of course, buying into a bond, debt or fixed index is even harder to rationalise – lending money to those that borrow the most?! Sure, central bank buying as part of quantitative easing (QE) has helped and distorted bond markets but that too will come to an end at some stage.
Chart 2 Speculative behaviour?
Given that QE was put in place to ward off economic collapse, its protracted use over seven years plus is in danger of creating a false environment for financial risk assets. If investors are primed to believe in momentum, low volatility with low risk, they will be drawn to the cheapest entry point. Momentum works both ways and sell-offs become more pronounced and damaging. As we start the eighth year of a bull market, a reversal of the above chart could be painful but that might not and need not happen to those that eschew indices as portfolio construction tools and invest with truly active managers that are index-agnostic.
The recent Standard Life/Aberdeen merger unkindly nicknamed ‘Staberdeen’ is an example of traditionally ‘active’ management houses scaling up to ward off the threat of passive behemoths like Vanguard. We hear that in order to continue asset gathering and maintain market share, the large ‘active’ asset managers are considering launching their own passive ranges while interestingly, the aforementioned Vanguard has chosen to launch a ‘low-cost active’ range. Where does this leave the investor? Plenty of choice but clearly less important than the shareholder in the pecking order.
Cheap isn’t necessarily best
What investors want are outcomes, what the bulk of the industry provides is product with asset-gathering and returns to shareholders above investors’ returns. That model has been challenged by a passive indoctrination aided by the industry regulator. There are privately-owned asset managers that place investors first and deliver relevant, meaningful outcomes AFTER fees. If it’s all about cost then why have the vertically-integrated firms done so well and continue to attract imitators?
This industry is all about trust and accountability. Large swathes of the industry have lost that trust. The regulator is in danger of creating a problem by attempting to solve another. The IA needs to make sure it represents all sizes and structures of investment providers and to be fair, they try to do that.
Two rulers – one goal, look after investors: all of them, not just the large institutional investors and their providers.