Written By: John Arthur
John Arthur of AllenbridgeEpic provides his personal view on how basing an investment approach on a passive philosophy can help when selecting long-term active managers
The recent government review of local authority pension schemes conducted by the DCLG and entitled “Opportunities for collaboration, cost savings and efficiencies” contained a Hymans Robertson report suggesting significant savings could be achieved by the local authority pension scheme funds if they collectively adopted passive investment management. Both the consultation and the Hymans report created a lot of discussion, some of which was useful and some of which reflected vested interests and entrenched positions; however, most seemed to come down on one side or the other in the passive vs. active debate. In this article I will attempt to give my own personal view on how to manage a portfolio and attempt to be as independent as I can. So I intend to concentrate on how passive investment management could be incorporated into a fund and what issues are raised by adopting this approach.
Passive investing is based on the Efficient Market Hypothesis (EMH); an investment theory that states it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing. There is a large body of academic research behind the EMH and an equally large amount which challenges it. However, it remains a fact that many institutional investment managers struggle to consistently beat an index over any reasonable time scale and that the signs of which investment managers are skilled at stock selection can be hard to spot amongst all the marketing noise.
So, why don’t active managers outperform more consistently? Even if you don’t believe in EMH a fund manager has a number of headwinds to overcome such as:
- They are affected by their own behavioural biases leading to sub-optimal decision-making i.e they are poor at their job
- The market does not reward their investment style or philosophy for a period of time, undermining their confidence and potentially their business model
- They work within an organisational structure which has other objectives alongside investment performance i.e. sales and increasing assets under management
- They are inadequately resourced to enact their chosen investment philosophy and process
- They become distracted by other issues, either managerial or personal
- Their investment process is not suited to the given mandate, or the mandate is too restrictive
The problem is the effects of many of these issues are not constant over time. In fact, there is limited correlation between the top quartile managers in one three-year period and the next. This perhaps explains why investment consultants may struggle to select outperforming managers. The only hard fact you have is a manager’s past performance, yet this is a poor indicator of the future. Interestingly, there is a slightly greater correlation between bottom quartile managers during one three-year period and the next. I do believe it should be possible to spot these consistently poor performing managers in advance. The only problem is that they don’t tend to last long before radical change is enacted to save the business model!
So, given the difficulty in spotting which investment manager will outperform and when, isn’t taking the low cost approach of passive investment management the best option?
Actually, I believe that through employing passive management as part of your approach it can enable you to challenge some of the issues which hamper you selecting good, long-term, active managers who are likely to add value.
To me the best investment managers have a strong investment philosophy, the key intellectual thinkers are actively involved in running the portfolio and are engaged in the ownership and direction of the company. They tend to run concentrated portfolios of high conviction positions with little regard for the benchmark. As an ex-fund manager, I always found it hard to really build a high level of conviction over more than 20 or so holdings at any one time. The rest of the portfolio was there to mimic the index and bring my risk, as measured by the expected volatility of the returns of my portfolio relative to the benchmark, down to an acceptable level for the client. If I had not added this long tail of holdings the resultant performance would have been very volatile over time with significant deviations between the return earned by the portfolio and the benchmark. This highly volatile string of relative returns would have been unacceptable to the client and probably cost me my job. Underperforming a UK equity benchmark by say 20% over a one year period would give most funds nightmares yet is a possibility with a concentrated, benchmark agnostic portfolio, even if the manager concerned produces good long-term returns.
My portfolio was sub-optimal, I had a string of marginal “bets” on stocks I did not know well enough to have much conviction over the future direction of returns and over the long term I suspect these stocks detracted from returns achieved by the portfolio. (Unusually for fund managers, I did run the same pot of money for the same client using much the same philosophy for over 20 years so it wasn’t all bad!)
The volatile returns produced by employing a high conviction manager running a concentrated, benchmark agnostic portfolio can be ‘dampened’ by two approaches which are not mutually exclusive. Firstly, you could employ a second or third high conviction manager whose philosophy and process are dissimilar to the first manager on the assumption that combining the two or more strings of uncorrelated future returns will reduce the volatility of the overall result. The second is to use a core and satellite approach. Employ say two, uncorrelated, managers running high conviction, concentrated portfolios and dampen the resulting volatility of returns to the desired level by adding an element of passive management against your targeted benchmark.
Build a thesis on why you selected each active manager and monitor their adherence to that thesis rather than short-term performance numbers. If they are underperforming, is it because the market, at the current time, is not rewarding their approach or is it because something fundamental has changed within the business or people? But most importantly, if nothing has changed, give the manager time. Assess performance over the long term.
Having set up a portfolio managed in this manner, with two concentrated, active portfolios each accounting for perhaps 20% of the portfolio value and one passive portfolio accounting for the remainder, is it then possible to add value from the passive portion? Again, I think the answer is yes over the long term. Because the passive portfolio will hold every stock in the index or a representative sample of them, the portfolio should be attractive to stock lenders who lend out your stocks to someone who wants to short (sell) the stock but does not currently own it: for this, you earn a fee. Also, because a good index will have a set of rules governing its construction it may be possible to “game” any weighting changes. There are a number of managers who run enhanced index funds and this would seem to be an area worth investigating.
More interestingly, in most recognised indices the constituents are weighted according to their market capitalisation. For an equity index like the FT All Share, the greater the value of a company’s equity capital, the greater its weight in the index. Research has shown that most other forms of index creation produce weighted index over the long term. Examples would be equally weighted indices and various indices biased to a particular style e.g, growth, value or momentum (smart beta indices). Even the proverbial monkey selecting stocks at random often outperforms the market-cap weighted index. This is partly because the alternative indices periodically require stocks to be rebalanced back to their starting position. It is this rebalancing which appears to add value, yet which is unnecessary in a market-cap weighted index. Rebalancing the constituents of an index back to a fixed starting point, be that set weights or exposure to set factors, means that you sell stocks whose index weight has increased and buy those whose index weighting has fallen. Selling high and buying low. That makes sense to me!
However, these alternative index construction methodologies are not guaranteed to outperform the market-cap weighted index over every period and, similarly to a high conviction active manager, there will be periods when the alternative index may radically underperform. Indices which focus on a single factor or group of factors may perform in phases, again reflecting the markets pattern of rewarding different investment approaches or styles at different times, often linked to particular phases of the economic cycle.
It should be possible to construct a passive portfolio which mimics a set of smart beta indices and then take the benefit of periodic rebalancing to add value over time.
So in conclusion, I would still look to select active managers but I would design the mandate to suit the type of manager I believe is most likely to add value. I would then look to bring the resultant portfolio risk level down to my desired range through exposure to a passive portfolio, but would think long and hard about whether I could bias that passive portfolio to specific styles or smart beta indices and periodically rebalance it back to neutral. Finally, I would do the real passive bit, sit back, resist the urge to tinker based on short-term performance numbers and concentrate my monitoring on the fund manager and process itself.