The reality of the impact of investment skill
In June 2016, the Brexit referendum began a prolonged period of political instability. Traditional polling methods have become less reliable, making for more shocks in election outcomes across the globe. This has been reflected in markets.
While the FTSE 100 has climbed steadily since Britain voted to leave the EU, it has been a bumpy road to get to current levels. Similarly, the NASDAQ 100 index has been on a twisting climb throughout surprise elections, snap elections and increased uncertainty.
During these moves, there have been plenty of opportunities for an active fund manager to trade in and out, take profits, average down and up, and actively and skillfully navigate the waters. Indeed, recently, the active management versus passive management debate has focused heavily on the application of professional skill in order to beat the market return.
However, the market return is nothing more than the sum of the returns of its constituents. A market return can be outperformed in just two ways: by selecting between market constituents (stock picking) or by adjusting exposure to all or part of the market (market timing).
Media coverage of the debate between active and passive has mainly focused on stock picking as an application of the skill of a fund manager and a reason to justify management fees. It has become clear that the vast majority of asset managers are failing to add value through stock picking, especially true once their fees are added into the equation.
Many investment managers have reacted to this change in investor perception by establishing portfolios using passive ETFs (exchange traded funds) as building blocks. This approach allows charity investors to benefit from the reduced cost associated with rule based ETFs, and is often presented to charities as a passive solution.
But, while this strategy means that managers aren’t focusing so much on stock picking, and are looking to gain increased cost efficiency, it continues to rely on the manager’s skill in timing markets. The manager adjusts the strategic asset allocation over time (or applies a tactical asset allocation, which has the same effect) in an attempt to maximise portfolio returns while protecting the investor in turbulent markets.
While this offering uses traditionally "passive" products in ETFs, charity investors should realise it is not a true passive proposition. Even though the manager is no longer stock picking, he or she is still trying to time the market, a skill based activity. It eliminates one element of skill associated with active management but firmly retains the other with the aim of delivering a better than market return.
This style of portfolio management is perhaps best described as a hybrid active strategy. It pays lip service to the academic conclusion that active managers do not add value, but also is comforting to investors who may feel more relaxed in the belief that they need to be actively advised across market cycles. It also very neatly allows professional managers and investment consultants to preserve and justify their fees while, at the same time, extracting cost from the underlying fund layer.
Analysing the evidence
This begs two questions for charity investors: whether trying to time the market works and whether managers can justify their associated fees.
The answer to both questions is likely to be "no". Numerous studies have concluded that there is little or no evidence that managers add value through market timing. Neither Chang and Llewellen nor Henrikssen found evidence of consistent market timing skills within the mutual fund universe. In later studies, Jiang and Becker et al confirm these findings.
If one looks closely at this issue one can find data that is even more pessimistic. Recently, a study reviewed the performance of several third party managed portfolios with a view to comparing their performance relative to that implied by their strategic asset allocation.
It measured the portfolios over a period of eight to ten years and found that performance is just not up to par, even before fees and charges have been taken out. More surprisingly, the single largest component of shortfalls has been intentional deviations from the agreed risk profile through tactical asset allocation processes and through risk reduction measures in turbulent markets; in other words, through trying to time the markets.
Even famous and "big name" managers are falling prey to a behavioural bias. They tend to be over-defensive and sell during market falls. Unfortunately, this means that they tend to miss out on rewards during market recoveries. The opportunity cost of consistently running at a lower risk than is specified in the mandate can mount up over time. The market volatility of the last year means that there have been plenty of opportunities to test this.
As markets have risen and fallen across 2016 and 2017, being able to time the markets should have provided a number of great opportunities for a hybrid-active manager to show the value of its skill-based approach.
Recent market experience
But this hasn’t happened. Across this period a low risk, passive portfolio, expressed in US dollars, produced 10% returns. In pounds sterling, that’s even higher at 25.2%. However, if we look at the performance of a hybrid active fund such as the 7IM AAP (Asset Allocated Passives) Balanced Fund. We can see a return of only 12.5% in sterling terms. Even worse, it underperformed its own benchmark by 1.2% in the process.
This suggests a simple conclusion: in the majority of cases, investors should benefit by targeting the generic market return as opposed to paying for active or hybrid management.
Passive investing skill
The supposed benefit of employing the traditional manager skills of stock picking and market timing have been shown time and again to be extremely elusive. Charity investors should be careful of working with a manager that is offering a hybrid strategy which still relies on a manager to be able to predict the future and react before events have even happened.
Of course, this doesn’t mean that there’s no skill in investing. Even passive investment needs skill and understanding, especially at the design stage. Properly constructing a passive portfolio must begin with a high level risk allocation focused on the investor as an individual. A granular set of indices representing the relevant investable universe will then form the benchmark for measurement of performance.
Following on from that, the ETFs and index funds that track the benchmark must undergo a screening process that looks at methodology, tracking error, liquidity, costs, tax efficiency, structure and counterparty risk.
When charity investors consider a passive approach, that assessment and screening process is where the adviser earns his money. Selecting the wrong products can mean disaster as the full investable universe is not addressed, or the correct benchmark is not achieved. If this first process is managed correctly, then the skills that don’t work - stock picking and market timing - are less necessary, generally resulting in better performance and a safer journey through the markets.
Passive investing for charities
What does this mean for charity trustees? The charity sector needs to become better at measuring the net benefit it achieves over the investment cycle through paying for subjective management skills. Manager performance should be regularly reviewed against the performance of the relevant market benchmark, and not against the main bunch of a collectively underperforming peer group. Consistent underperformance should be eradicated.
Most charity investors have at some point defined a strategic benchmark, but relatively few rigidly track the performance of their portfolio and its constituent parts against that marker. Benchmarks tend to be treated as theoretical concepts. In fact, they represent the highly achievable objective market return, and should be front and centre for anyone with fiduciary responsibilities.
As a start point, one would advocate that trustees should set up a relatively small passive portfolio designed to replicate the charity’s stated market benchmark. This will provide ongoing tangible evidence of the intrinsic market return, net of all fees, against which the charity's active portfolios and its investment consultants can be measured and held to account.