Spot the difference between skill and luck in active funds

Managers’ short-termism is blighting active funds. Those adding value should stand up and be counted as part of a campaign that could help sort the wheat from the chaff, says Andrew Pitts.

What must rank as one of the most hard-hitting, thought-provoking critiques of the investment management industry deserves to be widely read by investors and the firms that serve them. ‘Let’s Talk About Actual Investing’, by Stuart Dunbar, a partner at fund management group Baillie Gifford, explains why the investment industry has lost sight of its original goals; why most “active” investment managers are anything but that; and how short-term business priorities and performance measurements are damaging long-term wealth creation.

Baillie Gifford is also launching a campaign to encourage truly active investment managers – not only in the UK but globally – to clearly define their goals and how they aim to meet them. This comes at a time when there is a regulatory onslaught on actively managed funds, which also need to meet the challenge presented by the exponential rise in passive investment strategies.

The outrushing tide of investors into passive underlines the existential crisis that ‘active’ investment finds itself in. In the eight years to 2017, traditional active strategies have witnessed net outflows of $600 billion, according to the European Federation for Retirement Provision. In the same period, passive strategies have seen net inflows of nearly $1 trillion.

Dunbar identifies the active investment industry’s obsession with short-term gain or loss, regional and sector allocations, or value and momentum, as prime reasons why clients are voting with their feet.

“The main reason why a passive approach has often fared well against its more fundamental rivals is that far too much of what passes for active management is simply second-order trading of existing assets, with the main focus being to try to anticipate the behaviour of other investors,” he says.

“This has little to do with actual investing, and it creates huge amounts of over-trading and volatility. It also serves no useful purpose other than for those who make a very handsome living from transactional activity, or those who confuse their clients into thinking that [trading] short-term volatility is skill.”

Investors also find it difficult to identify where they are getting value for money. One reason is that the cost of investing has, until recently, been bundled through the entire investment supply chain. Relatively new regulations mean that asset managers are increasingly compelled to separate the costs of management, research, distribution and trading. This might, in time, help investors identify where they are getting value for money, but more needs to be done.

Increasing regulation

A further sign of increasing regulatory oversight is that open-ended investment companies will be compelled to publish an “annual assessment of value” by September 2019 – something that I suspect will leave a great many supposedly active asset managers scratching their heads.

It doesn’t help that the short-termism pervading the investment industry today – where success is measured by quarterly or annual goals against a benchmark – is seriously detrimental to long-term returns. Dunbar counters the widely preached mantra that because investors think short-term, the industry has reacted accordingly. On the contrary, he says, “our industry has foisted short-termism on clients in order to manage our own business risks”. For such firms, he levels the accusation that “being predictably average is more attractive than being unpredictably outstanding, even when average is worse than passive after costs”.

Nevertheless, the author agrees that passive investing has its place, particularly when it is increasingly difficult for investors to identify investment managers who can add real value. As he points out, cheap market access is better value than poor active management.

Some of Dunbar’s views are echoed elsewhere. Industry veteran Piers Currie, latterly director of marketing at Aberdeen Standard, says: “The industry needs to move on swiftly from a philosophical discussion of the virtues of active versus passive to addressing the nuts and bolts of how an annual value assessment might be presented in a way that is feasible for fund managers, fair to investors and acceptable to the regulator. With regulators impatient to demonstrate that they are operating in the best interests of consumers, it’s critical to define what we mean by the value of active management – and how it should be measured – sooner rather than later.”

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