If the NZ Super Fund, with all its resources and the brightest minds in NZ, only commit a small proportion of their portfolios to active global equity managers what chance does your average Authorised Financial Advisor with the benefit of a 12 month pseudo degree have? Four fifths of five eighths of not much I'm guessing.
Having said that in an email statement Fiona MacKenzie, Head of Investment at the Super Fund said "Our view on whether to invest passively or actively varies by market. Where we believe a market is fairly efficient (such as in the US) we invest passively. However, there are some specific markets where inefficiencies mean that, in our view, the expected returns from active management more than outweigh the higher costs involved. The NZ equity market is an example of this." As this column has always argued best practice is clearly a mix of active and passive managers.
Let's now move on to the flawed methodology for picking outperforming fund managers. The way that financial advisors and indeed many pension funds pick active managers is by spending weeks looking at the investment process used by the fund managers, conducting in-depth interviews of the fund management team and rigorous analysis of their risk management overlays etc etc. They then almost always pick the fund manager with the best historic performance.
Basically you check out who has performed and buy those funds. It makes intuitive sense but hello, it doesn't work so well. Indeed, as an investment model it is a very poor one as a recent research paper by one of the world's largest passive fund managers, Vanguard, points out. In a September 2015 research paper Vanguard quotes research by Morningstar which finds that return chasing behaviour cost investors in large cap, Australian equity funds an average of 4.0% pa over the ten years ended December 2014.
Performance chasing is not limited to individual investors — institutions do it as well. A paper by Goyal and Wahal in 2008 looked at the hiring and firing decisions of pension fund sponsors from 1996 to 2003 and found that the fund managers who were fired outperformed those who were hired for one, two and three years after the decision.
We have seen the theory, looked at what the experts do, now let's examine the facts. Each quarter Standard and Poors publish the SPIVA report which looks at the performance of active funds versus benchmarks. The December report shows that 82% of large cap US equity funds underperformed their relevant benchmark over a five year period and 88.4% of small cap managers underperformed.
Now let's follow the money. In a recent story the Financial Times advises that "the deteriorating ability of money managers to beat their indices has led to investors accelerating a shift towards a passive strategy such as Exchange Traded Funds. Last year ETF's attracted US$200 billion while actively managed equity funds lost US$124 billion. This year the assets of passive US equity vehicles crossed the 40% mark of total US equity fund assets, up from 18.8% 10 years, according to Morningstar". Morningstar apparently called this trend "flowmageddon" and said that passive funds have really gained the upper hand in the active/passive debate.
The AFA went on to say that "studies show that active management is better in times of market downturns". What studies? When? Where? By whom? If one is going to make claims like this it is reasonable to expect that they will be referenced. This column looked at a study by Vanguard back in November 2008, "Active or Passive, Plan Investments to Beat Markets" which showed that over the long term this claim was dead wrong.
Using a Morningstar database of every equity oriented managed fund in the US and Europe Vanguard compared the performance of each fund to its relevant benchmark in six bear markets since 1973 in the US and five bear markets since 1990 in Europe.
Vanguard analysts concluded "despite the bias towards survivors we observe that a majority of active managers outperformed the market half of the time in the US and less than half of the time in Europe. These results clearly indicate a lack of consistency." So even when the market is falling fund managers in the US only managed to beat the market half the time. Hardly something to get too excited about especially given the market rises more than it falls.
Coincidentally the Financial Times contained an article last week by John Authers, the FT's lead financial markets journalist, which quoted a report by Bank of America's quantitative team showing that the first quarter of 2016 was the worst since the bank's records began in 1998 in terms of judging managed US equity funds against the benchmark.
To quote Mr Authers, "in none of the many market breaks and crisis in those 18 years have managed funds so comprehensively failed to take advantage of opportunities offered to them." In the quarter only 6% of large cap funds beat the index and Mr Authers noted that this result fundamentally challenges the claim by active fund managers and AFA's writing in the Sunday papers that active outperforms passive in down markets.
The "get active over passive" story raises questions about AFA training in NZ however CPD is not likely to make too much of a difference. In a forthcoming two-day financial advisor conference more than half of the conference presentations were on non-investment related matters including "How to change from stressed to living the life you love", "Building a better you" and "Creating deep connections". Help me, Jesus.
Debate on this article is now closed.
Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.
