UBS on active management: myth busters?
By Rolf on 1 November 2017
It has again been a very long time since my last post. Sorry again. But I have now decided that it might be fun to get involved in the ongoing discussion over the merits of active management, particularly since so much of it is self-serving nonsense — incidentally on both sides.
UBS has now weighed in with its defense of active investment. In a recent paper, the bank calls the superiority of passive investment a myth and claims that, on average, active funds have outperformed both their benchmarks and passive funds. This result contradicts decades of academic research but, if true, would obviously be very good news for the beleaguered active management industry. But is it true?
Given that investment in any market is largely a zero sum game before fees for all investors taken together, somebody else would have to underperform if active funds are to outperform,. UBS claims to have found the main victims: direct investors, i.e., those not investing via UCITS or mutual funds. But direct investors are a very heterogeneous group. UBS has chosen to focus on retail investors to whom they assign most of the blame for the underperformance. But institutional investors such as hedge funds and insurance companies are also part of this group and it is not obvious why their performance should be worse than that of active funds, particularly since their portfolios are often managed by the same investment teams that also manage funds. Finally, direct investors also include stakeholders, those long-term strategic investors whose holdings are often excluded from the free float-based indices. In many markets, stakeholders are the single largest group of investors in equities (the US are an outlier in this respect). Since they usually hardly trade at all, they behave more like passive investors, except with a much more concentrated portfolio. Again, it is not obvious why they should do systematically worse than other investors, as a group. Paradoxically, UBS recently published a study on family-dominated firms that suggested that family firms tend to outperform. Family firms are, of course, the most obvious stakeholder dominated firms (I am being somewhat opportunistic here since I do not fully believe the results of that other UBS study either). Thus, there is really no evidence that institutions and stakeholders underperform relative to funds and there are not enough retail investors left to drag down performance in a meaningful way. Consequently, there is no obvious counter-party that can provide the required underperformance to allow active funds to outperform. This still leaves us with the task of finding an explanation for the results of the study.
Posted in Active/passive management, Essays | Tagged Alpha, Market efficiency, Small caps | 4 Responses
Inequities in equities?
By Rolf on 12 February 2015
I have written about certain idiosyncrasies of Swiss capital market regulations before. Most Swiss corporations started as family firms and, for a long time, outside shareholders were considered a mere nuisance and treated accordingly. Some remnants of that attitude remain. While there is now a reasonably modern set of rules governing listed firms, there are many exceptions. It is possible to have share classes with different voting rights. As an example, there may be one share class that has only one fifth of the par value of the second share class but with both classes having one vote per share. Thus, in this example, the privileged shareholders – typically the founding family – control the corporation with less than twenty per cent of the capital. There is also the usual rule that when a purchase of shares leads to a holding that is greater than a certain threshold, an offer to all remaining shareholders must be made at the highest price that was paid before. But Swiss companies may decide to “opt out” of this rule, i.e., simply ignore it. The combination of privileged voting rights and opting out allows the controlling shareholders to sell their block to a buyer who will not need to make any offer to the outside shareholders. Naturally, the controlling families routinely insist that they have no intention of ever selling. This is true until the day on which they change their mind, which is what happened recently to Sika, a chemical firm, with Saint Gobain the buyer. The outside shareholders were not amused since the price of their share class dropped by almost thirty per cent – the privileged share class is not listed – and they are now trying various legal tricks to prevent the sale from happening. They are led by the board of directors who had not been informed. It is turning into a bit of a farce with the board trying desperately to present itself as the champion of the outside shareholders – whom they had previously completely ignored. The only obvious winners will be the legal advisors to the various parties.
Posted in Comments/ramblings | Tagged Beliefs, Switzerland
By Rolf on 15 January 2015
I admit that I did not finish Piketty’s Capital in the 21st Century. If you did and liked it, you may want to stop here. I did get a bit further than the typical reader who, according to reports based on annotations on the Kindle version, made it to about page 26. I found it interesting but heavy going. French academics are often more concerned with impressing the reader with their erudition than with clarity. Even in translation, this annoying habit shines through. Fortunately, a colleague has pointed me in the direction of some superior alternatives. One is a lengthy review, the second a review of that review. They are critical but give a fair assessment of Piketty’s arguments.
If you are looking for an excuse for not reading the book at all, there is hope. A very recent article suggests that Piketty took some serious liberties with massaging his data. Given the importance that he places on data analysis, this is a most damaging accusation.
Posted in Comments/ramblings | Tagged Empirical research, Philosophy, Statistics
James Montier – the World’s Dumbest Idea
By Rolf on 11 December 2014
I am a fan of James Montier. I find his insights into behavioural finance very interesting and mostly rather entertaining. Some of his essays, such as the one on Abu Ghraib and the Milgram experiment, are memorable if depressing. He has his obvious prejudices and his bêtes noires (Milton Friedman, the CAPM, efficient markets – actually, pretty much anything that seems to be remotely associated with the University of Chicago – and quite a few more). If one wanted to find fault, it would be that he occasionally draws very pointed conclusions on somewhat slender evidence. But in his latest piece, The World’s Dumbest Idea, he appears to have decided that, this time, logic and reason should not get in the way of a good rant, particularly since the targets are all among his favourites.
The dumbest idea referred to in the title of Montier’s piece is shareholder value maximisation (SVM), i.e., the idea that a firm’s objective should be to maximise the value of the existing shares. According to Montier, SVM is responsible for an impressive list of ills: lower equity returns over the past two decades, excessive executive compensation, increased income inequality and the plight of the middle class. Serious accusations indeed. Unfortunately, there is no evidence to support the accusations. The chain of causality that Montier constructs is flimsy and does not hold up to any scrutiny.
Posted in Comments/ramblings | Tagged Asset pricing, Beliefs
The best of the best?
By Rolf on 8 October 2014
A few years ago, the Alaska Permanent Fund (APF) – Alaska’s sovereign wealth fund with assets of USD 50+ bn (website) – introduced an interesting element into their portfolio. After an exhaustive search, they appointed five asset management firms as external CIOs. They gave each about USD 500 million in a largely unconstrained mandate (the only constraints being no real estate and no lockups longer than two years). The winners were AQR, Bridgewater, GMO, Goldman Sachs AM and PIMCO – no surprises there. The winners were expected to provide access to their senior investment professionals and report regularly in person – this is the CIO element. Their return target is five per cent above the US CPI.
At the time, I found the exercise very interesting and innovative. I also hoped that it would succeed. Failure would be very discouraging for anybody who believes that active management makes sense for some well-informed investors. If a very large fund, assisted by a well-known consultant, cannot reliably identify the best of the best among asset managers, then who can? And if the best of the best cannot beat a benchmark that they had accepted at the outset with an unconstrained mandate, then who can we expect to consistently beat their benchmark?
Posted in Comments/ramblings | Tagged Manager selection, Pension funds, Performance | 1 Response
The Economist and CalPERS
By Rolf on 23 September 2014
After a series of posts that were rather critical of the media, it seems only fair to praise an article that makes its points succinctly. This week’s Buttonwood column in the Economist discusses hedge funds and pension deficits in the context of the decision of CalPERS to abandon hedge fund investment. It makes for rather depressing, but also very interesting reading.
The most provocative part of the article is the assertion that pension funds allocate assets to hedge funds as part of a “Hail Mary” bet, i.e., a desperate attempt to improve performance to justify their often unreasonable return assumptions. As an example, CalPERS return target is 7.5 per cent, which seems rather ambitious in the current environment. It is indeed rather unlikely that a traditional 50/50 or 60/40 portfolio of equities and bonds will offer more than, say, four to five per cent per annum in USD terms over the coming years. Additional return sources would need to be identified to meet their higher target. But active long only strategies are unlikely to make up the difference.
This is where the attraction of opaque private market investments and hedge funds comes in. Hedge funds, private equity, infrastructure and even insurance linked strategies are rather less well understood than traditional investments; it is often not very clear how their returns are generated. The ignorance about their true characteristics encourages some investors to overestimate their performance potential, which leads to unreasonably high return forecasts. But there are no miracles either in private market assets or in hedge funds; only a minority of them will provide positive added value. Winners always need losers. But maintaining the illusion of vastly superior return potential allows politicians to delay the day of reckoning for public pension funds at least past the next election.
Some people will praise CalPERS for their “courage” to abandon hedge fund investments. But they continue their “Hail Mary” bets with substantial positions in private markets. If one applies reasonable return assumptions, CalPERS’ actuarial position is desperate. Pity the poor tax payers in California. They are not alone but that is never a great consolation (I know, I live in Geneva).
Posted in Comments/ramblings | Tagged Hedge funds, Pension funds
Bill Sharpe’s dim views on smart beta
By Rolf on 25 May 2014
Advisor Perspectives has run a story under the title Bill Sharpe: "Smart beta makes me sick". Since smart beta looks like it is going to be around for a while, Bill is likely to keep suffering for some time – if the story quotes his views correctly. But what seems to be causing Bill Sharpe such discomfort?
It seems that he is unhappy about two things; first, the label "smart", which implies that those who do not embrace smart beta strategies are dumb and second, the fact that not everybody could pursue those strategies.
Posted in Comments/ramblings | Tagged CAPM, Smart beta
Did The Economist miss the point?
By Rolf on 13 May 2014
Ten days ago, a teaser on the cover of The Economist proclaimed the “Death of the fund manager”. Inside, there was a leader – which is what The Economist calls its editorials – and a lengthy article. Given the tone of the teaser, the content is hardly surprising. It berates financial intermediaries for their greed as demonstrated by the fact that, forty years after the first index fund, most investors are still sold active products even though they are more expensive and lead, on average, to worse performance than passive products. The Economist is right, of course, that many active products underperform their benchmarks and that many (some would say most) active managers are clueless. But is that enough to proclaim the death of an industry? In this case, I think that The Economist is missing the point. Active management is but a venal sin, even for the clueless. The main culprit for the poor performance of many investors must be found elsewhere.
The article quotes a study by PwC in which they use an example of a young Chinese woman in 2020 who “uses her smartphone app to buy, in a single click, a range of funds that most meet her needs and risk appetite”. What the quaint image does not elaborate on is how the young woman will determine what her needs and risk appetite are. But this is the fundamental problem of investment. It is one that the missionaries for a world without active management tend to ignore. But there is no such thing as a passive solution to asset allocation. Any asset allocation is the result of an active decision. And we are pretty awful at this decision. Behavioural factors tend to get in the way. We buy what has recently done well. We increase risk when things go well. We bail out at the worst moment, at great cost. I am convinced that poor allocation decisions cost investors rather more, on average, than the selection of actively managed products. As an example, did the endowments of certain US universities have a disastrous 2008 because of poor manager selection or because of a poor asset allocation decision? The evidence seems quite clear: the problem was not that they had bad private equity managers, they simply had much too much private equity.
The role of an intermediary, or to use a less tendentious term, of an advisor, is not limited to product or manager selection. It also includes advice on asset allocation and perhaps most importantly, the protection of the investor, institutional or private, against his or her own greed and fear. The Economist presents the intermediary as the enemy. They suggest that if only investors could liberate themselves from the shackles of that oppressor, they might finally achieve better returns. I beg to differ. The US experience with 401k plans shows that many investors, left to their own devices, are either overly conservative – investing mostly in cash – or unreasonably concentrated – investing mostly in their employer’s shares. Let us not forget that it is just as easy to generate poor returns with an overly timid allocation as it is with one that is too aggressive.
In my mind, the discussion on the merits of active vs. passive management is a pointless distraction. The most important unsolved problem for most investors is to find a strategic allocation that has sufficient performance potential to give them a reasonable chance to reach their return objective while being subject to a level of risk that is “survivable” even in periods of crisis. In this area, there is a continued role for advisors. So yes, The Economist really missed the point this time with its love song for ETFs.
Posted in Active/passive management, Investment strategy | Tagged Asset allocation, Manager selection | 1 Response
The performance of asset managers
By Rolf on 25 April 2014
I have made only one specific investment recommendation on this weblog so far and it has turned out to be rather poor advice, at least in the short term. I questioned the wisdom of investing in the Carlyle IPO almost two years ago. But Carlyle has comfortably outperformed both the market and its sector since then. Naturally, if you read my disclaimer, you know that I am quite adamant that you should not listen to anything I say about future market movements. But despite Carlyle’s good performance, I remain skeptical about listed asset managers. The fundamental issues that I mentioned in that post remain in place.
But now there seems to be empirical evidence to prove me wrong. Guinness Asset Management, a UK fund manager, have a fund that invests exclusively in asset managers. In their marketing literature, they show that asset managers outperformed the MSCI World index by over ten per cent per annum over the past twenty-four years.
Posted in Comments/ramblings | Tagged Empirical research, Manager selection, Performance, Statistics | 2 Responses
How to ensure poor performance
By Rolf on 10 November 2015
Consider a typical active global equity team, supported by sector analysts, managing a portfolio with standard investment guidelines for an institution. Its objective is to beat the MSCI World index over a three year horizon.
The analysts provide the portfolio constructors with lists of their best ideas within their assigned sectors. There will often be many more names on the lists than are “needed” for the portfolio. Thus, the portfolio managers have to choose from among the analyst recommendations. Given that the portfolio managers know rather less about the names on the list than the analysts do, one may wonder whether this selection process is likely to add value. The optimal use of the information contained in the analysts’ recommendation would be to invest in all of them but that would lead to large portfolios and many investors believe that only concentrated portfolios are truly “active”.
Posted in Active/passive management, Comments/ramblings | Tagged Alpha, Performance