Published : 10 years ago, on 10/01/2015

By Mike Abbott, Head of Wealth of the Sable Group

Few roles are more mythologized than that of the financial investor. Some people, we are told, are blessed with a Midas touch and anything they invest in turns to gold. And for a newcomer to the industry, surely it’s obvious that some experienced investors are able to make better, more informed decisions than others? Not at all, many argue. Critics believe that since many active fund managers charge significantly for their services,they would need to consistently outperform the market in order to make it worthwhile retaining them.It’s worth remembering that with the bulk of global investment being done by professional money managers, any market out performance is in fact a manager beating his peers at their (zero sum) game of choice. Interestingly, statistics from Denys Glushkov confirm that active managers are on track to record their worst year since records began, with 90 percent of large-cap managers under performing. The sad truth is the much lauded money ‘masters’ aren’t living up to the ideal.

The “Efficient Market Hypothesis” illustrates the difficulties faced by the money manager trying to justify his fees.The ‘market’ is the average of all the decisions made by all the money managers and private investors. Being above the 50th percentile in the performance charts requires consistent outsmarting of your peers. But this is hard to do consistently over time. Mean reversion is a powerful force – powerful enough to suggest outperformance looks more like luck than skill.In a paper entitled “Scale and Skill in Active Management”, Robert F. Stambaugh, Luke Taylor and Lubos Pastor illustrate how the size of a manager’s fund hampers his attempts at outperformance. In effect, if he is successful, his success ultimately hampers his performance.

Further research by the State Street Centre for Applied Research identifies the effect of the knowledge economy on the skills of the money manager. As a money manager’s absolute skill level rises his relative skills level is actually falling. This is simply because 90% of the world’s data has been produced in the last 2 years. The information ‘edge’ that the professional money manager had is eroding fast. He’s playing a zero sum game and his only advantage is better information. This is the ‘paradox of skill’ as explained by Stephen Jay Gould in his study of baseball.

An awareness of this issue is what is driving so many people to adopt a “passive investment strategy”. Instead of seeking out winning stocks you “go with the flow” of the market, investing in a mathematically calculated range of stocks that reflect the market as a whole. Your portfolio will rise and fall with the index you are investing in.Passive investing has obvious advantages –the most obvious being the lower costs. This may be why there has been a recent surge of interest in passive investment: index-linked equity funds in the US had attracted $1.7 trillion by the end of 2013, adding $114 billion from the previous year.

Nonetheless, on closer inspection passive investment itself faces a number of challenges. The fund must still define the index and decide on whether to opt for physical or synthetic replication of the index and whether sampling is to be used. Replication of a very large index in physical form is very hard to do and will result in large tracking errors. So as a result most tracker funds with physical replication tend to track large developed market indices where liquidity can be assured. These logical constraints make passive funds more available in some investment sectors and geographies than others. The job of getting full global exposure without neglecting small caps or emerging markets is hard to do.

It’s therefore clear that both “active” and “passive” investments have constraints. But can one combine the flexibility of the active investment model and the cost effectiveness of the passive strategy?Surprisingly, the academic sector has been developing such approaches for many years but it’s only in the most recent decades that these strategies have been tested in the market place for real. Theory is getting tested in practice and the results are very encouraging.This approach (called smart beta by some) focuses on investing globally and passively and tilting the portfolio toward known elements of higher expected return (as demonstrated by research). Hence you have a passive investment strategy with an active evidence based overlay.

The inspiration for this approach comes from finance academics, Eugene Fama and Kenneth French.In their research they have identified two dimensions of known out performance, namely the ‘small cap premium’ and the ‘value premium’. In 2012 Robert Novy-Marx added a third dimension known as the ‘gross profitability premium’.The ideal fund, then, would seek to track such elements.This is where things get tricky. The real value add is in the design of funds that manage to get global passive exposure while incorporating these out performance ‘premia’. This has to be done at a cost that does not negate the benefits of these said ‘premia’.  Fama’s theory is much admired, and it landed him the Nobel Prize in 2013.

All of these different options can be confusing. Which way should investors go? The temptation to try to be Warren Buffett and make your fortune by outperforming the market is undeniably a powerful one. Behavioural economists such as Daniel Kahneman would tell us we are hard wired to try. But before you embark on this strategy, make sure you’re not being taken in by the myth of the brilliant investor. The evidence suggests he might not exist. Any fund manager’s attempts to be one risks exposing your money to the wrong side of the mean. Whatever your decision, this is certainly a debate that should be raised. If you don’t, you’re selling yourself short.