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The Unpopular Case for Active Management
Stuart Dunbar, Partner. Second Quarter 2017 -
Recently, the volume and frequency of commentary highlighting the shortcomings of the active investment management industry has been significant.
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The UK Government has flirted with compelling funded public sector pension schemes to use a passive approach for listed securities; a CASS Business School report purported to demonstrate that “almost all active fund managers fail to outperform the market once fees are extracted from returns”; several local and regional regulators in Europe have carried out investigations into the existence of closet-index funds charging active fees; and the use of passive management for the equity component of defined contribution schemes is becoming ubiquitous as the certainty of low costs outweighs the possibility of outperformance. Impartial observers might be forgiven for thinking active managers will soon be an endangered species – and deservedly so.
Despite being entirely dependent on clients’ active management fees for our income, we at Baillie Gifford have sympathy for this basic criticism of the active management industry. Though we think some of the studies are conceptually flawed and rely on adjustments that are only observable after the fact, in their own over-complicated way the academics have alighted on a basic truth: the active investment industry as a whole seems to be rather better at enriching itself than adding value for clients.
However, there are honourable exceptions. At Baillie Gifford, we have outperformed the market across almost all of our investment strategies over long periods of time. For example our two flagship global equity strategies, Long Term Global Growth and Global Alpha, have outperformed their benchmarks cumulatively by 138% and 66% respectively after fees since inception (both around 12 years ago)1. This could of course just be statistics – if you start with enough managers then some of them will outperform – but we think there is much more to it, and crucially that good active managers can be identified before the fact and not just in hindsight.
Annual Past Performance to 30 June Each Year
2014
2015
2016
2017
2018
Global Alpha Composite Net (%)
24.7
3.4
-5.3
28.0
17.8
LTGG Composite Net (%)
37.8
11.3
-3.8
35.1
38.0
MSCI AC World Index (%)
23.6
1.2
-3.2
19.4
11.3
Source: Baillie Gifford & Co. and underlying index provider(s) US Dollars.
Past performance is not a guide to future results. Changes in the investment strategies, contributions or withdrawals may materially alter the performance and results of the portfolio. All investment strategies have the potential for profit and loss.
The Baillie Gifford strategies are more concentrated than the MSCI AC World index.
1. Baillie Gifford Long Term Global Growth composite inception date was 27/02/2004 and performance measured against MSCI AC World Index. Baillie Gifford Global Alpha composite inception was 31/05/2005 and performance measured against MSCI AC World Index (MSCI World Index prior to 31/03/08). Figures to 31/03/2017, in sterling.
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Defending the indefensible?
It may seem that way at first glance, but there are at least two incorrect foundations on which much of the criticism of the industry is founded. Firstly, academic studies of the active investment industry have mostly started in the wrong place: they look at the whole universe of managers who purport to be active without reference to whether they really are, and without differentiating between the wide variety of investment approaches, corporate structures, client types and motivations that exist within the industry. As we shall see below, these factors are easily significant enough to suggest that a more nuanced view is worth pursuing.
Secondly, the ‘zero-sum game’ is blithely and frequently cited – that aggregate investor returns are by definition the (given) market return less costs, and that costs are therefore all that matter. This statement is correct up to a point, but in the context of the active industry it again starts from the wrong place: the professional active fund management industry is not the whole market. Many observers then compound this error by looking only at publicly available pooled funds, which are themselves only a part of the active market. We think it is intellectually lazy to dismiss an industry on the basis of such an incomplete approach.
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A DIP INTO ACADEMIA
As previously mentioned, we broadly agree with the plethora of research that suggests active investment managers as a whole don’t add after-fees value relative to passive managers: we just don’t think such research is a very worthwhile activity. The more insightful and potentially useful research is that which seeks to examine the differences between investment organisations and investment approaches, and focus on the common characteristics of those that appear to work.
Such research is scarcer than attempts at whole-industry analyses, perhaps because of the difficulty of getting data other than historical returns, and probably because subtle – if important – arguments don’t lend themselves to news-grabbing headlines and political grandstanding. Thankfully, there is a fast developing body of work that is taking a more thoughtful approach. We highly recommend to readers that a few hours spent becoming familiar with these studies is one of the most valuable things you can do to materially improve the likelihood of successfully selecting active investment managers to generate excess investment returns.
Our first port of call is a widely cited academic thesis of 2009 by Cremers and Petajisto of Yale School of Management, which was one of the first attempts to stratify active managers according to how they actually invest. Cremers and Petajisto found that investment managers who have high ‘active share’2 are substantially more likely than those with low active share to add value over and above that of a passive investor, even after the higher fees of active management are taken into account. In 2013 Petajisto refined this work to suggest that managers who have high active share but low tracking error (that is, those that take uncorrelated stock positions rather than top-down bets) tend to do better. In 2014, Cremers teamed up with Pareek of Rutgers Business School to narrow down the most-likely-to-outperform managers to those who also trade infrequently.
More recently Harford, Kecskes and Mansi showed that the existence of long-term shareholders improves corporate decision making (and by implication shareholder returns) in the companies that they own: such companies are less likely to experience options back-dating, misconduct and financial fraud; and are more likely to return capital to shareholders than indulge in management empire-building at the expense of shareholders. Cohen, Polk and Silli found that the largest active positions in professionally managed portfolios outperform significantly – suggesting that a long tail of stocks for diversification purposes may be detrimental to added value in a portfolio. Fees and total expenses matter: a Morningstar report found that “expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.” An article from Spring 2015 in the Journal of Portfolio Management by Hsu, Ware and Heisinger suggested a correlation between strong investment performance and firm culture – specifically the existence of a ‘no-blame’ culture around random short-term investment outcomes (thereby avoiding pressure on individuals to make sub-optimal short-term decisions).
There is also a growing body of evidence that suggests the average investor – both amateur and professional – significantly underperforms the average investment fund or mandate (both passive and active), through poorly timed fund transactions and hiring and firing of managers, and extreme short-termism by investors in passive funds/ETFs. Evidence of this can be found in various papers: Ben-David, Franzoni and Moussawi3 find that the average holding period for the Standard & Poor’s Depository Receipts (SPDR) family of ETFs ranges from 9 to 43 days (the largest ETF in the family, the SPDR S&P 500 has assets of $225bn and turns over on average every 9 days). Hsu, Myers and Whitby4 speculate that the possibly substantial losses incurred by mutual fund investors through poor market timing is likely gained by institutional investors because “mutual fund investors have sufficiently higher [short term] risk aversion than institutional investors”. Here then is the elusive academic explanation of why institutional investors are not operating in the fabled ‘zero-sum game’.
In early 2017, Hendrik Bessembinder5 published some startling research with enormous implications for how investors should go about their task. He found that “the entire gain in the US stock market since 1926 is attributable to the best-performing four percent of listed stocks”. This astounding figure comes about through the long-term impact of positive skewness in the distribution of stock returns and compounding of returns. This study merits a review all of its own – suffice to say here that it suggests there exists the possibility of truly outsize excess returns over the very long term, and that cutting winning stocks purely on valuation grounds has a hugely negative impact on compounding returns over the long term. To put this another way – an index fund will ensure you have roughly 25x dilution in your participation in wealth creation as reflected in the stock markets. It may not be easy to pick the winners of course, but the rewards are startling for those that can tilt the odds in their favour.
Average cumulative abnormal holdings based returns for $1 investment in portfolios of institutional holdings
Source: Cremers and Pareek, 2014, Patient Capital Outperformance.
2. Active share is a measure of the extent to which a portfolio differs from its index. In itself it proves nothing, but a high figure does indicate that a manager is probably not seeking to remain unnoticed behind index-like returns.
3. “Exchange Traded Funds (ETFs)” – Annual Review of Financial Economics, Vol. 9, 2017
4. “Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies”, The Journal of Portfolio Management, Winter 2016. This study found that dollar-weighted returns in US mutual funds underperformed time-weighted returns by 3.2% p.a. for growth funds and 1.3% for value funds from January 1991 to June 2013.
5. “Do Stocks Outperform Treasury Bills?” Arizona State University Feb 2017.
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To whom do the gains accrue?
According to a study from Davis Advisors, the average stockholding mutual fund returned 9.9% annualised from 1991 to 2010, but the average fund owner earned only 3.8% per year. In 2016, Hsu, Myers and Whitby found something similar – the average fund investor underperforms the average fund by 1.9% p.a. They also found that the average passive investor underperforms the average passive fund by 2.7% p.a. Goyal and Wahal found that institutional investors hire managers with average historic outperformance of 10.4% over three years, but who then do not add any value statistically different to zero in the subsequent three years. They also found that managers who are fired – though not always for performance reasons – go on to outperform on average by 3.3% over the subsequent three years. If the whole market is indeed a zero-sum game then there must be a body of investors who gain what these investors lose.
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Separating the wheat from the chaff
Measuring and critiquing the results of the entire active fund management industry is therefore not a particularly useful exercise, and presents an overly-simplified active-versus-passive choice for investors. Serious investors should aspire to something better, and not just for obvious selfish reasons: it is also in the interests of society that investors act as responsible and effective long-term allocators of capital, in order to foster the productivity gains and creative destruction that are the roots of rising living standards. This allocation of capital cannot arise from a purely passive investment approach (though we should acknowledge that good passive managers can play a positive role in capital allocation within the companies that they must own).
At Baillie Gifford, we take heart from these studies, which we believe provide academic evidence of positive investment characteristics that we have long intuitively believed, and which have been tested through a decades-long process of trial and error. Investors who back their conviction, running relatively concentrated portfolios while ignoring market benchmarks; take a long-term perspective on the companies in which they invest, engage with company management and rarely trade; and who charge reasonable fees, are more likely to deliver outperformance for clients. To us these traits are not just academic observations, they are the building blocks on which we invest.
If it’s so easy...
If the ingredients for successful active management are both intuitive and – more recently – academically demonstrable, why do investors so rarely manage to combine them? This, surely, is where the discussion on active management should really focus. At Baillie Gifford, we think the answer is obvious: our industry suffers significantly from agency issues and misalignments of interest, existing both within the investment managers themselves and at the investing institutions which form much of our client base. As an industry we have failed to work together with our clients to help raise levels of investment understanding and to bring about better outcomes. Taken together, these failings make it very hard indeed for investors and investment managers to implement the investment approaches that we know are more likely to work.
how to avoid being fired
The obvious way for an investment company to retain its clients may seem to be to outperform the competition, but in fact the manager’s implicit goal is more cynical than that – it is to avoid standing out from the crowd. Active managers are often fired when short-term performance (by which we mean up to three years) is noticeably poor, whereas the middle of the pack is a fairly safe place to be. This is an incentive for manager herding and overall mediocrity. Throw in the completely unpredictable short-term ability of brokers and other investment commentators to create price-distorting market chatter (remember these organisations depend respectively on transactions and an impatient get-rich-quick readership to survive) and the strong tendency for managers is to survive this unpredictability by hiding somewhere close to the safe haven of the index. Safe, that is, for the manager – not necessarily for the investor in a world of creative destruction. Unfortunately, the overall result of multiple managers all seeking to avoid drawing attention to themselves is that collectively they stop making conviction-based investments, and sure enough overall performance across those managers does indeed become index performance less costs. No wonder the active-versus-passive debate has taken on such a one-sided hue.
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“Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press”Warren Buffett
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Defending the indefensible?
Why do clients hire and fire investment managers on the basis of historic, often short-term, performance? We think it’s not always because they don’t know any better. Misalignments of interest exist in different forms all along the investment chain. Investment directors at pension funds, investment consultants, wealth managers and investment advisers usually find themselves frequently accountable to someone who may be quite distanced from investment matters – pension scheme trustees and sponsors, high net worth clients, individual savers.
Typically, that ‘someone’ is not an investment expert, or they would not be employing professional help, and the frequency of accountability is often quarterly. This is much too often to form any sensible view on the skills or otherwise of the professional investor but the problem is that the assessors don’t always know that, and those being judged don’t care to contradict it. It gets worse: rather than addressing this issue head-on by offering discussion and education for clients, professional investors instead seek to avoid short-term unpredictability by encouraging the management at companies in which they invest to provide a steady stream of quarterly earnings – even at the expense of profitable long-term investment projects. Boards of listed companies generally want to keep shareholders happy, so they in turn incentivise corporate management on short-term (and easily manipulated) earnings per share, with predictable behavioural consequences.
This is the worst sort of vicious circle: clients hire and fire investment managers based on short-term performance (by which we mean less than three years – though five is more realistic); investment managers avoid making meaningful and differentiated investment decisions because short-term share price moves are completely unpredictable; and corporate management manipulate earnings and forego profitable projects so as not to surprise those self-same investment managers.
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Cost is not the same thing as value for money
Clearly, paying less rather than more for the same item is a good idea. The problem is that in the context of active management, there is no standard ‘item’. If active managers don’t outperform passive managers then the answer is to buy the predictable and cheap relative performance of passive. The fact is though that there is no single thing called ‘active management’ and therefore no single measure of value for money. The key point is that investment managers with certain characteristics do, on average and in the long term, demonstrably outperform by much more than the fees that they charge. Because the focus of the research and debate has been so much on active managers as a homogenous lump, this much more useful observation has gone largely unnoticed, and cheapness has often come to equate to value in buying investment management services. The agency problem exists here too – why would scheme trustees or a governance committee employ active managers if they are repeatedly informed by ‘homogenous lump’ studies that they have only a 50/50 (or worse) chance of beating passive? They will get no thanks in 20 years time from scheme members who have benefited from outperformance, but they may well be heavily criticised or even sued for underperformance. Faced with that, why would anyone choose active? The choice, of course, is a false one: good active management will create better end-investor returns than passive. Poor active management won’t. This false dichotomy is no idle observation: it is a major contributor to the rapid abandonment of active equities as a component of defined contribution schemes, potentially to the detriment of future pensioners.
As noted overleaf, there is clear evidence that less expensive funds on average outperform more expensive funds after fees. This should hardly come as a surprise but we think the argument is not just about direct management fees – levels of fund performance are also significantly impacted by embedded transactions costs, mainly broker commissions and market impact. Broker commissions vary from an execution-only rate of around 5bp6 to an average full-service rate of around 15bp. Market impact measures efficiency of trading and can be reduced through treating trading as a source of added value, delegating order execution to skilful dealers working across a variety of venues. These costs really matter: turning over a portfolio at 20% per annum on execution-only commission rates, and assuming zero market impact, incurs trading costs of 0.01%. Turning over 100% per annum at full-service commission rates and 10bp market impact incurs trading costs of 0.25% per annum. The difference of 0.24% is a contributor to investment returns rather than a direct cost, but it is no less real. And here’s the thing: that increased cost may then in part be returned by the broker to the investment manager through the provision of investment research. So, the client pays for investment management services directly and also pays through transaction fees for investment bank research, an arrangement which at best lacks transparency (though recent regulatory guidance is pushing managers to at least separately account for this). On top of that, since most investment bank research is widely available and rarely focuses on the long term, it’s hard to see how investment managers can form differentiated views on the basis of it. So, if clients are paying in more than one way for research then managers should be offering a clear explanation of why this is money well spent or, even better, managers should improve performance by footing the bill for external research out of the management fees they receive.7
6. Baillie Gifford’s average commission rate across the whole firm was actually less than 5bp in the year to 31 December 2016.
7. Baillie Gifford’s investment team subscribes to and directly pays for well over 100 independent sources of research to help us form our in-house views.
Breaking out of the downward spiral?
How can the active investment industry break out of this destructive collective-action problem? The answer lies in investor education and having the fortitude to be different. Investment managers must engage with their clients on the nature of investing: clients need to understand that performance over short periods is just noise. Clients who are themselves investment professionals need to have the courage to say the same thing to their own clients, colleagues, appraisers and scheme members. The entire industry needs to engage constructively with the regulatory and accounting bodies that so often get in the way of adopting a long-term perspective. Fund managers should decline to invent stories to explain this month, quarter, or year’s performance when in fact there is no real explanation – so giving a false sense of comfort in managing short-term risks that doesn’t really exist (or matter). These are daunting problems and it will take time to make a difference, but if the better parts of the active investment industry want to avoid going down with the ship it’s time we spoke up for true investors.
It should be possible for good investment managers to ask clients to focus on the operational progress of the companies in which they invest, and to treat gyrating share prices in the short term as nothing more than a game in which we choose not to participate. However, such is the evident practical difficulty of this that the more realistic way of resolving our time-horizon conundrum is probably for good investment managers to unilaterally address it, and then hope to bridge the client gap by thoughtful and effective communication.
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Making things better
As a start, we think the debate around active versus passive management needs to be better structured and of higher quality. We firmly believe that there is value both for end investors and for society in employing good active fund managers who act as responsible stewards of capital, and that the discussion should focus on what ‘good’ means in this context. So, with apologies for what is unavoidably a view which correlates closely to how we do things at Baillie Gifford, we humbly offer some thoughts on what we think investors should be looking for: -
1. Patience
Stop trading so much. Remember, the unending noise in the market only exists to create the order flow upon which swathes of the industry rely. Investment decisions should be based on fundamental business analysis. Such an approach naturally reduces turnover and therefore costs, forces a focus on long-term business fundamentals, and encourages investment managers to engage with the companies in which they invest to maximise long-term value creation. Good investment managers should actively encourage the management of companies in which they invest to ignore ‘the Street’, eschew quarterly earnings targets, and create long-term incentives for management which are aligned with this.
2. Education
Everyone involved in the investment chain needs to be bold enough to explain to clients that quarterly and yearly investment performance have zero value in terms of assessing fund manager skill. We need to refuse to invent stories to satiate the need for explanations of short-term share price movements. We need to try to work with clients who understand this, help those that don’t to do so, and resist the constant pressure to conform to misguided industry norms.
3. Alignment of interests
The incentives of the industry need to be aligned with the long-term outcomes we achieve for clients. That means rewarding fund managers (if we must motivate them based on investment performance at all) over periods long enough to be meaningful, likely at least five years. Over that period there’s at least a reasonable chance that share prices will have progressed based on the underlying earnings of a company, and that if the manager has skill it will be observable via portfolio performance.8 In the meantime, measuring the quality of our research is a far more useful activity, not in terms of share prices but in terms of the operational progress of companies relative to our own expectations. If we get our analysis right most of the time, share prices will eventually follow – but it’s worth noting that this link between operating performance and share price is not at all robust over short periods. Short-term share price outcomes are simply not within the control of fund managers, so offering rewards or criticism based on them will only have the effect of making managers highly risk averse, to the detriment of clients.
Ownership and culture are crucial factors which must be properly handled to facilitate long-term investment success. Investment firms with short-term outside shareholders (ironically some such shareholders being other investment firms) can find themselves under pressure to achieve a steady progression of profitability which is wholly unsuitable to investment companies whose revenues are largely dependent in the short run on volatile market levels. This outside pressure compounds the incentive to hide in the middle of the investment pack, and can also drive investment companies to cut resources when markets fall – just when clients need managers to be most focused on the investment opportunities that will undoubtedly arise. Investing is a five-year plus activity, as is managing an investment management firm. In the long run, achieving good investment results matters much more than hitting an annual profit target. Firms should be prepared to close to new clients when they have investment capacity or client-handling issues which could distract from the key activity of investing, in the knowledge that in the long run this will be beneficial not only to clients, but to the firm as well.
4. Governance and Engagement
It is in the interest of all investors that the overall level of returns available in investment markets is as high as it can be. Outperforming the market is one thing – helping the market as a whole to achieve better returns is another. This is not a completely unrealistic aspiration if large institutional investors engage constructively with the management of the companies in which they invest. It is to everyone’s cost that as an industry we collectively push and incentivise corporate management to ‘make the number’ rather than to dispassionately assess investment projects for long-term returns potential. Good investors should engage with companies regularly about what opportunities they see, and actively encourage sensible long-term investments and risk taking – not just shout loudly or vote negatively when a particular resolution or remuneration arrangement is deemed to be unacceptable. In fact as technology brings about an increasingly ‘capital-lite’ model for corporate growth, positive engagement with the management of existing listed companies is increasingly a source of overall investment returns.
5. Costs matter
Cheap does not equal good, but the more that is charged to the fund the less it must return. Investors should seek value for money, and even good investment firms should not seek to charge an unfairly large share of their added value over the long term (25%?). Respecting clients with honesty, treating their assets with the care you would your own, and embedding a sense of fiduciary responsibility right through the firm is not only good for the client but is a positive way to secure the future of an investment company.
6. Understanding the Structure of Returns
We get exasperated when we are asked to measure the success of our investors based on how many ‘correct’ buying and selling decisions they make. This strikes us as absurd as it suggests a deliberate decision to not own every stock that is not in the portfolio, and hence the investment scourge of ‘coverage’ rather than positive idea generation. Investing (in equities at least) is an asymmetrical activity where the majority of returns in the market come from a small number of highly successful companies who achieve really significant growth9. Investors need to understand this: it is far better to spend time on original research activities uncovering such opportunities than it is to cover all of the available universe, only to rule out the vast majority. Pick the right companies and it doesn’t matter if you get more wrong than right.
7. Conviction
If you strongly believe something, back that belief with serious investment conviction. Fretting over differences between portfolio and index holdings is pointless. Dispersion around index returns (tracking error) is not an ‘error’ at all but simply measures the difference between two things that have quite different purposes. The focus on benchmark-relative risks that now prevails in the industry is very counterproductive, founded as it is on the comprehensively misguided notion that market prices are generally efficient. We need to defy the academics and have the courage to explain this to clients.
8. Of course there are many ‘investment’ firms who are not really investing at all, but set out to outsmart other market participants based on market dynamics. This skill may well exist in a completely different environment to the one we describe here, but it is surely rare and you won’t find it at Baillie Gifford. It’s not investing as we know it.
9. See Hendrick Bessembinder, February 2017, ‘Do Stocks Outperform Treasury Bills?’: the entire gain in the US stock market since 1926 is attributable to the best-performing four percent of listed stocks.
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To be quite clear, there are many good active managers other than Baillie Gifford and we respect and admire many of them. Our plea to the others who drag down the efforts of the industry is this: stop trading so much, stop charging so much, put existing client interests ahead of your own, back your investment conviction and engage meaningfully with your clients. In such a way we might go about repairing the damaged reputation of our industry. In the meantime, we can only urge the buyers of investment management services to focus on finding the managers who already do these things.
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Important information and risks
The views expressed in this article are those of Stuart Dunbar and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in the second quarter of 2017 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
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S&P
The S&P 500 (“Index”) is a product of S&P Dow Jones Indices LLC, a division of S&P Global, or its affiliates (“SPDJI”). Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC, a division of S&P Global (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.
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Stuart Dunbar PartnerStuart has worked in the investment management industry for 20 years. After previous positions at Aberdeen Asset Management and what was then Dresdner RCM, he joined Baillie Gifford in 2003. He is a Director in our Clients Department and chairs Baillie Gifford’s Global Marketing Group. Stuart became a Partner in the firm in 2014. -
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