Julian Ide: Action Speaks
Six months ago I wrote an article defending active management. The response, though undoubtedly positive, was interesting to the extent that many people seemed genuinely surprised that anyone would argue such a position. I am not sure precisely when assumptions on the supposed advantages of passive management became accepted wisdom, but it is, in my view, a dangerous and self-damaging prejudice.
We all know passive investment works. We use it ourselves day in, day out. In its rightful place, it is a simple, quick and cost-effective means of taking a position. But the rightful place of passive investment is both narrow and particular. It works in markets which have two characteristics. They need to be large, liquid and sufficiently invested to ensure price-sensitive information is disseminated rapidly and widely. And they need a high degree of consistency, even to the point of being relatively predictable in the short term.
On these measures, core government bond markets – Japan, Germany, the US and the UK – are an example of an asset type that is eminently indexible. Data likely to impact the price of gilts are well known and it is a market with near-perfect consistency – one 10-year gilt is generally as good as another and the probability of serious exogenous disruption is marginal. Many investors, including ourselves, use the cheapness and ease of index derivatives to access these markets for short-term exposure.
What we don’t do at Old Mutual is depend on other people’s decisions for our longer-term fortune. Neither do we run funds that are quasi-passive, funds which charge active fees while running close to a benchmark. Where we invest in a gilt index, it is as part of a broader active strategy. An income fund might use an index to manage interest rate risk. Our strategic bond funds will use indices as part of a wide mix of assets designed to benefit from – or protect against – economic or political change.
Although core government bond markets are eminently indexible, wider opportunities for passive investment in the fixed income world are extremely limited. Corporate bonds, an increasingly important asset class for income investors, fail the consistency rule – specific covenants, dependence on third-party rating agencies and the link to the financial performance of the issuer combine to make for a complex universe. Corporates often fail the liquidity test. High yield indices are especially volatile and are rarely tracked by passive investors. Where investment grade indices are tracked, they are often carefully reduced to avoid just such problems – and in the process reject what is arguably the best part of the opportunity set.
Equity markets are conventionally seen as more amenable to passive investment and much is made of the difficulty active investors have in beating the market. This is a legitimate point. It is the reason successful, high alpha-generating investors attract the respect and the rewards that they do. Where the conventional wisdom goes wrong is to assume that because it is hard to do it is rarely achieved and best avoided.
This year, a strong and sudden rotation has caught a good many active managers off guard, has reinforced this view. What actually happened was that when the market weakened, after several months of strong performance, out-of-favour, defensive sectors, such as telecoms and utilities, sprang to the fore. As these were generally under-owned by active managers, given their generally poor prospects in a time of economic recovery, tracker funds tended to outperform.
Though it may have felt longer, the actual time horizon for the rotation was about four weeks and its impact on long-term data has been below negligible. Over five years to the end of May 2014, not a single FTSE All Share passive fund beats the IMA All Companies sector average return of 103.3%. The best pure tracker returned 92.7%, the worst returned 71.5% and the average was 83.3%. The best active fund manager returned 257.9% and our own Old Mutual Mid Cap Equity Fund returned 144.2%.
The US equity market is different. Trackers, at least relative to the IMA North American Equity sector, tend to perform above the mean over the longer term. In our view this is biased by the nature of the peer group, which consists of fund managers in the UK. If we look at the IM US Large Cap Equity peer group, giving returns for institutional funds managed in the US, the S&P500 is third quartile and the smaller cap Russell 1000 is at or below the median over one, two, three, four or five years to the end of March 2014 (the sector only reports full quarter results).
Index fund managers often point to their lower fees, claiming to offer better value. In reality, their cost of production is not that much less than those for active funds, or not in respect to what is paid to the fund manager. Passive managers still need highly qualified individuals to run the funds. They still need buildings, data-feeds, marketing budgets, operations, client services, product development, fund accounting, legal and compliance teams – the basics of any fund management business. It is my view that in the new world of transparency and clean pricing it will be increasingly difficult for passive funds to sell themselves on cost.
We know this because we run active multi-manager funds. The commonest question is why we don’t construct our portfolios using ‘cheap’ passive funds, focusing our offering on asset allocation. There are three parts to the answer. One is that the institutional fees we pay to outside managers are competitive with those charged for passive funds. Two is that experience tells us that active management will work over time. The third is that we would restrict our asset mix to a small number of core markets as passive funds, as explained above, lack efficiency in such key areas as property, corporate bonds, high yield, mid and small cap equities and emerging markets.
There is nothing wrong with passive investment. Where it is done properly and for the right purpose, it supports strong, focused active management. Not all active managers will outperform the market, otherwise it wouldn’t be a market, and none will outperform the market all the time. But as the data clearly show, there is always a plentiful cohort of active managers meaningfully above the market over the medium to the longer term. We accept that in charging a premium for active management we need to deliver commensurate performance. It is for investors to pick those among us who have the skill and diligence to meet that objective.
Important information: For professional use only. Past performance is no guarantee of future results. The value of an investment and the income from it can fall as well as rise and investors may not get back the amount originally invested. Old Mutual Global Investors (OMGI) has no house market view and opinions expressed are the views of individual fund manager(s) as at the time of writing. These views may no longer be current and may have already been acted upon. Any underlying research or analysis has been procured by OMGI for its own purposes and may have been acted on by OMGI or an associate for its or their own purposes. OMGI is the appointed investment adviser for Old Mutual Fund Manager’s in-house OEIC funds. Old Mutual Global Investors is the trading name of Old Mutual Global Investors (UK) Limited. Old Mutual Fund Managers Limited, 2 Lambeth Hill, London EC4V 4AD. Authorised and regulated by the Financial Conduct Authority. A member of the IMA. Old Mutual Global Investors (UK) Limited, 2 Lambeth Hill, London EC4P 4WR. Authorised and regulated by the Financial Conduct Authority. Telephone calls may be recorded for security purposes and to improve customer service. OMGI 02/14/0075.