If you can only take the same risk as the market, you will only get the same return
It’s something of a cliche that most of the large fund management companies are asset gatherers rather than asset managers, and that the very largest are the passive managers. A major part of their growth has been fueled by the argument that, on average, active managers can’t outperform the market and, leaving aside the obvious point that, unlike in Garrison Keilor’s lake Wobegon, “where all the children are above average”, it is definitionally impossible for the average to outperform the average, nobody really questions this assertion anymore. More importantly, nobody really asks why, if true, this might be the case.
- First, and most obviously, there is the issue of cost and fees - as an active investor (bias revealed) - the effect is similar to comparing the price of a chicken from your local farmer’s market with one from the ‘value’ section at Tesco’s. For the biggest tracker funds, fees are between 10 and 20bp, which only work at scale, even if you match the index, you will ‘underperform’ the passive for this reason alone. To continue the analogy, to justify the higher price, the farmer’s market chicken has to offer something else to the consumer. The problem is, that most of them are not really allowed to
- The real issue in our view is that most active fund managers are institutionally prevented from beating the market on account of their own risk management structures - and strictures.
The uncomfortable - and largely unspoken - truth of most fund management is that the risk return decision is made not by the fund manager on behalf of their clients, but by the managers of the fund management company on behalf of themselves.
In the institutional markets, risk is measured by tracking error and volatility, a classic case of managing what you can measure, with the seemingly primary aim of reducing both. This is not only demanded by large institutional clients, but also by internal controls at the asset gatherer manager. This became even more pronounced post the Financial Crisis in 2008, when at the major institutional investor I worked at, the risk management teams swarmed over all portfolios demanding that they manage (i.e. reduce) their VaR, which stands for Value at Risk. They were not alone in doing this, to my understanding, all the major firms did exactly the same. Never mind that this is a measure designed for short term, usually leveraged, trading books rather than long term investment products and meant to be used to assess the overall exposure of the manager rather than that of the underlying client. Nor that volatility is a risk that should actually be taken by long term investors, top down controls were - and still are- imposed on the active managers such that they take no more risk than the market.
A lot of the ‘historic’ returns of ESG was the old trick of hidden benchmark risk
- The result of this, of course, is that it is different to generate a different return - unless that is you change either the definition of the benchmark or you take some other, hidden, risk. In the first of these, historically, this has often been done by country or sector funds, where the returns have come from the asset allocation more than the stock selection, but where the manager is rewarded for, largely unacknowledged, benchmark risk as, for example, the technology fund, or energy fund, or emerging market fund is compared (for marketing purposes) with the wider benchmark. This of course works so long as the ‘smart beta’ is positive and can become self re-inforcing as liquidity flows into the ‘top performing’ funds and thus into the stocks they already own, squeezing them higher.
However, this is taking another sort of risk, which is concentration risk. As and when the caravan moves on to a different country, sector or thematic, the liquidity moves with it and what worked well on the upside, kills you on the downside.
A recent example of this has been the rush to ESG. The willingness by large institutional asset managers to embrace ESG was driven not only by client demand, but also by the fact that it allowed managers to take significant ‘hidden’ benchmark risk and this be paid more. Comparing an ESG fund, particularly its back tested track record, to a standard benchmark showed that it outperformed handsomely, without acknowledging that to do so it was taking a huge implicit benchmark bet of being short energy and long tech, something that no ‘ordinary’ active manager would be allowed to do. Energy at one point was 12% of the benchmark - having zero would simply be deemed ‘too risky’ and thus you would have gone down in line with the market as it shrank to 2%. Being ESG however, delivered ‘active performance’. As with the illiquidity and leverage bets, this worked well, until it didn’t and the sharp rally in the former and sell off in the latter last year were not unrelated.
If you aren’t allowed to take ‘measured’ risk, like volatility and benchmark, the obvious thing is to take ‘hidden’ risk, like leverage and liquidity
- Another way to take ‘hidden risk’ has been through leverage and or illiquidity. Thus, we have seen a huge growth in ‘alternative’ strategies that were sold as low risk on account of having low volatility. The fact that most if not all of these were generating their ‘excess returns’ over the benchmark by taking ‘hidden’ risk in terms of leverage or, particularly, liquidity, was only tacitly acknowledged. But since these weren’t being measured, everyone was ‘happy’. Of course, as with the ESG this worked well until it didn’t. During the last decade when leverage was cheap and liquidity was plentiful, it was the only game in town. Obviously, less so now.
- Which brings us to the issue of behavioural finance, cutting our winners and running our losers. Now, by introducing emotion into investing, we always run the risk that the manager does this, but the bigger issue is that their underlying clients do. Clients selling a passive index do not cause an index fund to under-perform, it simply sells everything in line. But clients selling an active strategy can and will lead to ‘forced selling’ and the market quickly catches onto this. It can be a country or sector strategy that has gone out of fashion, or indeed a thematic. In many cases it has been a factor approach, a famous value investor like Julain Robertson, or Tony Dye in the UK being forced out ‘at the bottom’, or more recently a go-go growth investor like Kathy Wood. The market smells blood. At the very least, this will raise the risk premium on the basket of stocks they hold, but more often than not, it leads to ‘informed speculation’ against the positions. The idea that a Prime Broker might actively look to squeeze the short positions of a failing client while going short their long book never happens at all of course. Never.
.Behavioral finance also comes into this - many active managers are forced to sell at the bottom, because their clients do
As the saying goes, if you think you aren’t taking any risk for your return, the truth is you just don’t know what risk you actually are taking
So to conclude, most active managers don’t under-perform because they are bad managers, it’s that they operate in a bad system. Not a bad system for the fund management companies of course, just a bad one for the underlying investors.
