close menu

The super fund manager vs little old 'Beta'

by Mike Abbott | Jan 10, 2015
  • Few roles are more mythologized than that of the financial investor. Some people, we are told, are blessed with a Midas touch and anything they invest in turns to gold. And for a newcomer to the industry, surely it’s obvious that some experienced investors are able to make better, more informed decisions than others? Not at all, many argue.
    Image of a super manager in front of a muscular drawing on chalkboard

    Critics believe that since many active fund managers charge significantly for their services, they would need to consistently outperform the market in order to make it worthwhile retaining them. It’s worth remembering that with the bulk of global investment being done by professional money managers, any market out performance is in fact a manager beating his peers at their (zero sum) game of choice. Interestingly, statistics from Denys Glushkov confirm that active managers are on track to record their worst year since records began, with 90 percent of large-cap managers under performing. The sad truth is the much lauded money ‘masters’ aren’t living up to the ideal.

    The “Efficient Market Hypothesis” illustrates the difficulties faced by the money manager trying to justify his fees. The ‘market’ is the average of all the decisions made by all the money managers and private investors. Being above the 50th percentile in the performance charts requires consistent outsmarting of your peers. But this is hard to do consistently over time. Mean reversion is a powerful force – powerful enough to suggest outperformance looks more like luck than skill. In a paper entitled “Scale and Skill in Active Management”, Robert F. Stambaugh, Luke Taylor and Lubos Pastor illustrate how the size of a manager’s fund hampers his attempts at outperformance. In effect, if he is successful, his success ultimately hampers his performance.

    Further research by the State Street Centre for Applied Research identifies the effect of the knowledge economy on the skills of the money manager. As a money manager’s absolute skill level rises his relative skills level is actually falling. This is simply because 90% of the world’s data has been produced in the last 2 years. The information ‘edge’ that the professional money manager had is eroding fast. He’s playing a zero sum game and his only advantage is better information. This is the ‘paradox of skill’ as explained by Stephen Jay Gould in his study of baseball.

    An awareness of this issue is what is driving so many people to adopt a “passive investment strategy”. Instead of seeking out winning stocks you “go with the flow” of the market, investing in a mathematically calculated range of stocks that reflect the market as a whole. Your portfolio will rise and fall with the index you are investing in. Passive investing has obvious advantages – the most obvious being the lower costs. This may be why there has been a recent surge of interest in passive investment: index-linked equity funds in the US had attracted $1.7 trillion by the end of 2013, adding $114 billion from the previous year.

    Nonetheless, on closer inspection passive investment itself faces a number of challenges. The fund must still define the index and decide on whether to opt for physical or synthetic replication of the index and whether sampling is to be used. Replication of a very large index in physical form is very hard to do and will result in large tracking errors. So as a result most tracker funds with physical replication tend to track large developed market indices where liquidity can be assured. These logical constraints make passive funds more available in some investment sectors and geographies than others. The job of getting full global exposure without neglecting small caps or emerging markets is hard to do.

    It’s therefore clear that both “active” and “passive” investments have constraints. But can one combine the flexibility of the active investment model and the cost effectiveness of the passive strategy? Surprisingly, the academic sector has been developing such approaches for many years but it’s only in the most recent decades that these strategies have been tested in the market place for real. Theory is getting tested in practice and the results are very encouraging. This approach (called smart beta by some) focuses on investing globally and passively and tilting the portfolio toward known elements of higher expected return (as demonstrated by research). Hence you have a passive investment strategy with an active evidence based overlay.

    The inspiration for this approach comes from finance academics, Eugene Fama and Kenneth French. In their research they have identified two dimensions of known out performance, namely the ‘small cap premium’ and the ‘value premium’. In 2012 Robert Novy-Marx added a third dimension known as the ‘gross profitability premium’. The ideal fund, then, would seek to track such elements. This is where things get tricky. The real value add is in the design of funds that manage to get global passive exposure while incorporating these out performance ‘premia’. This has to be done at a cost that does not negate the benefits of these said ‘premia’. Fama’s theory is much admired, and it landed him the Nobel Prize in 2013.

    All of these different options can be confusing. Which way should investors go? The temptation to try to be Warren Buffett and make your fortune by outperforming the market is undeniably a powerful one. Behavioural economists such as Daniel Kahneman would tell us we are hard wired to try. But before you embark on this strategy, make sure you’re not being taken in by the myth of the brilliant investor. The evidence suggests he might not exist. Any fund manager’s attempts to be one risks exposing your money to the wrong side of the mean. Whatever your decision, this is certainly a debate that should be raised. If you don’t, you’re selling yourself short.


    For more information on the topics covered in this post, or for any other wealth-related queries, you can contact us on +44 (0) 20 7759 7519 or email our wealth team.

    We are a professional services company that specialises in cross-border financial and immigration advice and solutions.

    Our teams in the UK, South Africa and Australia can ensure that when you decide to move overseas, invest offshore or expand your business internationally, you’ll do so with the backing of experienced local experts.

    • carrot-incentive-running-track
      UK pensions: Between a QROP and a hard place? Or is it a damp SIPP?
      Jun 21, 2018  |  by Niel Pretorius
    • piggy-bank-dollar
      What to do with your living annuity when you retire abroad
      Jun 11, 2018  |  by Niel Pretorius
    • house-london
      In the UK, mortgage inaction is pickpocketing thousands of homeowners
      Jun 07, 2018  |  by Bill Monty
    • Hand-currency-blue
      Saying goodbye to South Africa? Financial emigration can give you access to your RA before you turn 55
      Apr 13, 2018  |  by Niel Pretorius
    • Dubai_skyline
      Lessons learned on a trip to Dubai: South Africans take note
      Nov 10, 2017  |  by Mike Abbott
    • Piggy-banks-thinking
      Financial emigration: Transfer your retirement annuities out of South Africa
      Oct 20, 2017  |  by Niel Pretorius
    • row-of-houses-UK
      Bank of England overhauls mortgage affordability rates: Here’s what you need to know
      Oct 09, 2017  |  by Ian Henning
    • saving-money-investing-piggy-bank
      Limited company owners: What to do with your lazy cash
      Oct 02, 2017  |  by Ian Henning
    • house-home-loan-key-door
      Remortgage, anyone?
      Sep 27, 2017  |  by Marlon Borez
    • businessman-tightrope-risk-balance
      Group life cover: Why you should be worried about your lifetime allowance
      Sep 25, 2017  |  by Bill Monty
     
     

    South Africa

    Cape Town

    Regent Square
    Doncaster Road
    Kenilworth 7708 +27 (0) 21 657 2120

    Durban

    201 The Annex
    Ridgeside Office Park
    Umhlanga +27 (0) 31 536 8843

    United Kingdom

    London

    Castlewood House
    77/91 New Oxford Street
    WC1A 1DG +44 (0) 20 7759 7514

    Croydon

    5-7 Selsdon Road
    South Croydon
    CR2 6PU +44 (0) 20 7759 7581

    Australia

    Melbourne

    9 Yarra Street
    South Yarra
    VIC 3141 +613 (0) 8651 4500

    Sable International is a trading name of 1st Contact Money Limited (company number 7070528) registered in England and Wales. Sable International is authorised and regulated by the Financial Conduct Authority in the UK (FCA no. 517570), the Financial Services Conduct Authority in South Africa (FSP no. 41900) and holds an Australian Financial Services License issued by ASIC to deal in foreign exchange (AFS License number 335 126).

    This site uses cookies, read more or close this notice.