Thinking of forking out for active investment management?

09 June 2015

Beating relatively efficient markets is difficult. However, there are times when it is hard to agree that all markets are efficient and rational:

A good example of this would be on 19th of May when the ECB’s Governing Council member, Benoit Coeure, stated that the ECB planned to moderately frontload its purchases of Euro Area assets to avoid excessive trading in the summer months when liquidity can be less plentiful. This purely technical adjustment led some investors to behave like they had received an early Christmas present; triggering  a strong sell off in the Euro vs Dollar. Simultaneously, the Euro area government bonds recorded one of their strongest mornings in May.

Some people might dismiss the above example as a short-term knee-jerk type reaction, but from time-to-time, we can also observe longer-term market distortions. Over the past year, the Shenzhen Composite Index has nearly tripled in value despite a slowdown in the Chinese economy (although monetary conditions have been softening at the same time).  While the average price/earnings (p/e) ratio is not much higher than that of the US S&P 500, the median share now trades on a p/e of 75 (some highly weighted sectors such as Banks have been left behind). Some notable examples of froth can be seen in a former manufacturer of floorboards that joined the frenzy by rebranding itself as an online gaming company. There is also a manufacturer of conventional fans trading at 732 times earnings!

In markets where we observe seemingly irrational movements like the ones above, employing someone to spot the opportunities (and avoid the pitfalls) might well pay off.

However, there are other cases where paying an active manager for scanning the market for opportunities is less likely to provide a fruitful outcome.

Looking at a random sample of 20 FTSE-250 companies, the average company’s equity was covered by over 20 professional research analysts and no company was covered by less than 11 analysts – all pouring over exactly the same data. It is worth pointing out too that only analysts listed on Bloomberg were counted in this survey.

For example; as at 1 June 2015 Lloyds Banking Group, forming part of the FTSE 100 index is currently followed by at least 28 Bloomberg-listed analysts.

Of these 28 analysts, 13 currently recommend buying the stock, 7 recommend selling and 8 suggest  holding the Bank’s equity – in any given time-frame, a large proportion of these analysts are going to be wrong. Clearly, any investor with a limited governance budget could spend their time on something more productive than trying to make sure they are backing the right analyst.

On the other hand, while Lloyd’s equity seems to be quite the crowded market, the Banking Group currently has more than 1000 different bonds in issuance. These bonds  have differing structures, different (or no) credit ratings and trade at different prices – thus purchasing corporate bonds appears less clear cut compared to playing a developed stock market - finding a robust investment manager to undertake classic credit analysis could well pay off.

Of course you can hit the jackpot and back a great developed market equity manager, a new Warren Buffet or a Neil Woodford if you like. Here, I would have liked to write; “chances are equally large that you end up backing a Nick Leeson or Bernie Madoff instead” – but statistics suggests you are most likely to spend your governance budget (and fees) backing an average manager who just about fails to deliver, benchmark-positive, net-of-fees return.

Ultimately, when deciding between active or passive management there are a number of market specific factors to consider: depth, liquidity, analyst coverage and complexity to name a few.

The most important factor is whether you believe there are systematic market inefficiencies and whether the chosen active manager has the capabilities and skill to exploit these opportunities.

In the real world, no market is completely efficient and the degree of efficiency can, and will, change over time. For active fund managers, asking them whether passive management is the way forward is akin to asking turkeys to vote for Christmas.

Many people are invested with active managers due to legacy arrangements and old habits often die hard. Ultimately, if you are unable to make a clear case that active management in a certain market can create real, substantial value, over the long run – I would suggest you save your money and governance budget and go passive instead. After all, Christmas is coming…

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