No one will feel too sorry for active investment managers now they’ve picked up the baton from the bankers as the next in line for regulatory scrutiny. The final report of the Financial Conduct Authority had many baying for blood, admonishing the City regulator for a report that didn’t go far and fast enough in enforcing change in the fund management sector.
Branding the industry as a bunch of fat cats making huge profits yet failing to deliver is a well-rehearsed piece of rhetoric. It feels like a victimless crime, but it is not. The loser in all this finger pointing is the saver who has lost faith, leaving their money in cash or putting it into passive funds, which have become the acceptable face of asset management.
We all know what the problem is with cash — the era of record-low interest rates has turned the asset class from a perceived “safe haven” into a sinking ship. But the perils of passive investing are far less well known or explained.
Now, before I go any further, a mea culpa of sorts. I work for an investment manager, one that is passionate about giving customers choice and therefore offers both active and passive investment products, but with a large and well-established active management capability. So, I won’t be surprised if the comments section gets filled up with lines about me having an agenda to push. That’s fine.
We could spend hours debating the merits of an “all-in” fee, independent directors on boards and the failure of many active funds to beat the benchmark. But there is a bigger picture issue here that warrants more column inches. The deluge of money flooding into passives and the lambasting of active management has the makings of a tragedy, not just for the notion of an efficient market, but if markets continue their trend of moving sideways, also for investors.
The idea that share prices are in some sense “efficient” relies on investors buying and selling and setting the fair value for a share at any point in time. Granted, smart investors carefully weigh up the expected future cash flows of companies but, in the end, share values are set by investor behaviour. Market participants set an equilibrium “consensus”. For the market to work efficiently, you need active investors setting the price. (There’s also the point that more money flowing into funds that passively seek the market return creates less price discovery and leads to more potential dislocations in markets.)
Some say it is lazy to argue that more money flowing into passive funds will ruin the market. Even when one is passively investing, they say, one does so within a defined world of securities — so in a sense making an “active” decision about investing in a particular market or index. As I said, I am loath to get into a complex debate about modern financial theory, so let’s put this very simply: without active, there would be no market for the passives to track.
Beyond the efficient market hypothesis, it is fair to say that passive funds’ rapid rise in popularity has not just been a function of fee levels (there are some very expensive tracker funds out there). Many passive fund advocates believe it is simply not possible to add value consistently through active management, so identifying the best managers is therefore a futile exercise.
To address why it might still make sense to find those managers that can deliver outperformance, you simply need to look at a particularly interesting stock market scenario from the past year or so, namely the so-called “sideways” market.
Thanks to the extraordinary levels of quantitative easing that central bankers have injected into the global economy, the past few years have been a good time to be a stock market investor. Share prices have been re-rated higher, while the shift in returns from labour to capital has boosted corporate profits. Both of those trends may now have played out and investors could face the prospect of a period of consolidating or sideways markets.
So while the great and good try to call when this grudging bull market will end in a bust, it’s worth reminding ourselves that not every market cycle is the same. It is entirely possible that this bull market does not follow the scripts from 2000 and 2007. Instead of ending in a loud pop, we could see the market drift for an extended period — look back over stock market history and you’ll see this is pretty commonplace and can persist for years.
If global stock markets are heading for one of these crab-like episodes, we can expect a significant divergence between winners and losers, and traditional stockpicking will really come into its own. A passive fund blindingly tracking the market won’t do the heavy lifting for you, by its very design. Sideways markets signal a good time to be picking stocks and a miserable time to be locked into a passive fund going nowhere.
Of course, fees matter and thinking about customers matters hugely. The asset managers who do this well will emerge as the long term winners at a time of intense industry consolidation and competition. But putting Joe Public off investing when cash is anything but king is dangerous. And when markets drift sideways, it is also risky to position passive funds as the pin-up for stock market investing.
Sideways markets are not the only thing passive funds are not very good at. Long-term investors are looking for more than just benchmark-beating returns. They want outcomes or “solutions”, whether this is sustainable income, managing risk, capital preservation, sustainable investing or the like. The best fund managers are focused on delivering such outcomes, not just beating benchmarks.
Paying a professional to roll up their sleeves and engage in the hard work of finding tomorrow’s winners makes sense. In spite of what the headlines may tell you, the UK boasts some of the most skilled stock pickers in the world: experienced fund managers who have delivered in both bull and bear markets, with the ability to look through the short term noise and find individual stocks that can perform strongly even while the overall market disappoints.
In my experience, they’re not out to overcharge investors. They’re there to deliver outperformance and good outcomes, and the measurability of their day job means there’s nowhere to hide.
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