It is surprising that some 10 years after the FTSE 100 Index peaked at 6930.5 on 30/12/99, over 20% above the current level, index trackers and other passive investment strategies are still being marketed as an effective and low risk way of investing. However, there is evidence investors are unconvinced - not only because of the lack of progress by equities but also by erratic markets. US retail investors for example are net sellers, withdrawing $70 billion from equity funds since May.
The contrarian view is that this lack of enthusiasm for equities and disinterest in researching the prospects for individual companies has created exactly the right environment for active investment managers. Just how unfashionable something is, is hard to gauge but to quote a well-known investment manager who was profiled in a national newspaper quite recently:
“Extensive research has proved that 90% of returns are derived from asset allocation.” Really? These assertions merit further investigation.
The influential Brinson, Hood and Beebower research paper published in 1986 was based on a study of the returns achieved by 91 US pension funds between 1974 and 1983. They concluded that 90% of the variability of the returns could be explained by the allocation to cash, bonds and equities. In other words, stock selection skills hardly mattered.
Ever since, this conclusion has been used as the starting point for any discussion about the merits of passive investment strategies.
The time is right to challenge accepted practices and to discard illusions based on the recent past. This is the right environment to be an active investment manager.
The passage of time has surrounded the original research with an aura of invincibility to the extent its conclusions are often presented as fact and seldom challenged.
So how relevant are the events described by Brinson when planning a successful investment strategy for today? This month marks the 30th anniversary of the start of my City career, arriving at Sheppards and Chase as a freshly minted science graduate. I was confident problems could be solved by a combination of effort and intellect, having been lectured by a few Nobel prize winners and knowing that someone in a wheelchair at the Cavendish Laboratory who had only a few years to live was going to provide answers to questions that defeated Einstein.
Immersion in the financial world was a complete contrast. It was still a City of aquatint where men (predominantly) walked in narrow streets and spoke as they had in the days before the motor car. At that time the City thrived on diversity. Firms, and the individuals who worked for them, approached investment in very different ways. Successful strategies were created by a combination of experience, experiment and insight. Not many of the practitioners had studied finance and there were hardly any CFAs outside the US. Those who survived traumas of the 1970s made use of this freedom but had an intense respect for detailed knowledge and risk. They would have wondered at how our acceptance of ‘extensive research and proof’ had brought us to the current rather unstable financial system.
Brinson was analysing investment returns when the market was dominated by active managers, a time when index-tracker funds were a new development. At that time I attended a course at the London Business School for fund managers. We were told we should expect to have short careers as active investors. Perhaps the lecturer had a point as moving forward to 2010 the market is increasingly dominated by passive investors and closet trackers who are so close to the index it is hard to see the difference.
Before listing my 10 reasons to be active, one further piece of research should be considered. In 1997 William Jahnke published a study called ‘The Asset Allocation Hoax’. He argued that Brinson’s interpretation of the data was open to question and a far stronger case could be made for the importance of stock selection - to the extent that Brinson’s conclusions could be completely reversed.
In these tough times when all potential sources of profit should be investigated
our view at Cheviot is that both asset allocation and stock selection matter.
We have resourced our business accordingly.
Ten Reasons to be an active investor:
1\. Future annual economic activity is likely to be more volatile than in the recent past and economic cycles are likely to be shorter.
2\. Annual inflation is also likely to be more volatile.
3\. There is an increased probability of policy error by governments as the high growth countries in Asia and Latin America interact with the larger economies of North America and Europe.
4\. Diversification reduces risk on a tactical rather than strategic basis.
5\. During periods of change investment markets reward investors that actively seek return, from a wide range of asset classes and strategies.
6\. Trend following strategies tend to be unrewarding in volatile markets.
7\. Identifying the correct entry price for asset classes will have an important effect on future returns. Volatility puts a premium on timing.
8\. Active investment can be lower risk than passive. The latter is susceptible to concentration risk, as was the case 10 years ago at the height of the dot-com boom.
9\. Globalisation presents opportunities to identify attractive sectors and industries in any country relative to their position in the economic cycle. Active managers can then select the strongest companies.
10\. Company finances are in good shape. This year there have already been a number of takeovers. Expect more to come.
The combined weighting in the FTSE All Share Index of these companies, pre bid, was only 1.2%. In contrast BP’s weighting has declined from 7.0% to 4.8% year to date. Tracker funds will have suffered the full effect of BP’s problems whilst registering only minor gains from the appreciation of these mid-cap stocks. As Prudential discovered, mega-cap takeovers are hard to finance and so less likely to occur.
The time is right to challenge accepted practices and to discard illusions based on the recent past. This is the right environment to be an active investment manager.
