- Most active Australian fund managers have failed in recent years to outsmart the market.
- If passive investors dominate the market, the market becomes less efficient.
- The asset management industry faces a great rationalisation and only those who provide true value to investors will survive.
Late last year S&P Dow Jones Indices released a report that rattled the struggling asset management industry. Most active Australian fund managers had failed in the past three years, and five years, to outsmart the market and beat their benchmark.
For investors, including those investing for retirement, it raised serious questions. Why pay hefty fees to professional investors to make buy and sell decisions on their behalf? Aren’t they better off just putting their money into “passive” low-cost funds and exchange traded funds (ETFs) that simply track the market?
The harsh report comes as robots challenge the role of fund managers. Big investment firms, such as Blackrock, are replacing human advisers with robo (ie, automated) investors. Giant industry funds, including AustralianSuper, are also taking investment decisions in house and demanding lower fees from the shrinking pool of fund managers they still hand money to.
But if you’re so smart…
The S&P report, of course, is really nothing new. Research has long told the same story of active underperformance.
Almost 50 years ago academic economists, led by University of Chicago economist Eugene Fama, came up with the efficient markets hypothesis (EMH). It argued that markets were “efficient” and that all information is priced into the market. It was therefore impossible to beat the market.
The EMH theory argued that only by trading on illegal inside information could one gain an edge over other investors. Gun stock pickers, market sages, newsletter tip sheets, and pundits are all useless, according to the theory.
Most active Australian fund managers had failed in the past three years, and five years, to outsmart the market and beat their benchmark.
That’s difficult to accept, of course. The asset management industry attracts some of the smartest and most driven people on earth. Are they so dumb as to have picked an utterly useless career (not useless for themselves – most are highly paid)?
Since then, research such as the SPIVA report has largely supported the EMH theory.
What about Warren Buffett?
But there was a twist to the research that gave hope for active managers. Academics did find that there were some pockets of the market, or “factors”, where one could outperform. If one bought the likes of value stocks, small cap stocks or momentum stocks (stocks that have risen strongly) one earned a premium.
Many of Australia’s investment legends who have outperformed the markets over a significant period, such as David Paradice, are value investors, often focussing on the smaller end of the market. The S&P Dow Jones report found most of Australia’s small and mid-cap funds outperformed the market over five years.
Product providers are also now offering access to these premiums through low-cost “smart beta” ETFs, which means investors can get the higher returns without the fees and risks of active managers.
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Critics of the EMH say, “what about Warren Buffett?”. But as others have noted, Buffett is a businessman who runs an insurance company, not a pure stock market investor. And he’s hardly outperformed in recent years.
Buffett himself is a big fan of passive index funds for the average investor. And statistically, if there are enough asset managers, someone must outperform through sheer luck. But it’s impossible to tell ahead of time who that will be. You have no chance of picking the lucky gambler.
Increasingly, investors have bought into the passive investment argument. In the US, according to Morningstar, passive funds now account for more than 30% of managed assets. Australians have invested A$25b in ETFs. Late last year ratings agency Moody’s delivered the industry a vote of no confidence and slapped a negative outlook on the global asset managers.
It is difficult to argue against the passive case, particularly when one stretches out the timeframe. Most investments, particularly retirement savings, have horizons of decades. Even if you’re a 65 year old, you can now expect to live another 20 to 30 years. It’s impossible to pick an active asset manager that will outperform over those timeframes.
Passive investing is like the slow tortoise. The active management hares might spurt ahead for a few years but over the years, with its relentless, low-cost plodding, the tortoise catches up and then pulls ahead. Therefore, for anything over a five-year horizon, the bulk of one’s investments should be in passive investments exposed to broad indices.
Hope for an industry challenged
But does this all mean active investment is dead? There will be a role for active managers, particularly those that can offer rock-bottom fees.
One of the great strengths of active managers is flexibility – the ability to make big calls and avoid big market events. In fixed income (such as government bonds), active managers are better placed to deal with a rise in interest rates and yields (bond prices fall as yields rise, delivering capital losses). Unlike index funds, they can actively move to parts of the markets that are less exposed to rate rises. There is also a valid concern around the use of derivatives in many ETFs, which could ultimately cause problems in tough market periods.
Ultimately, things will swing too far towards passive. As Morphic Asset Management argues,we need active managers to set prices and make markets efficient. If passive investors dominate the market the market becomes less efficient, opening up areas where active managers can gain edges and provide value for investors.
But the industry, like others, faces a great rationalisation and only those who provide true value to investors will survive. They will be cheaper, more unique, more uncorrelated, more innovative, and much more active. That means taking positions in stocks and vigorously using their ownership to affect change and create value. And that’s a good thing.
This article is part of an ongoing Wealth Management column offering tips on personal wealth management and analysis of issues within the wealth management profession. Have something you’d like this column to cover? Email the Acuity team now.