We held the first in our new ‘elephants in the room’ webinar series on 30th March to debate those large awkward subjects which we would all rather not acknowledge. Aoifinn Devitt hosted and the panellists were:
Robin Powell, Freelance Journalist
Piers Lowson, Director, Baillie Gifford & Co
Karl Massey, Investment Advisory
Mark Lyon, Head of Internal Management, Border to Coast Pension Partnership
The first pachyderm in the spotlight was why so many institutional managers are reluctant to invest passively. The academic evidence on returns is overwhelming that on average active funds underperform index funds. There was some debate over exactly how many outperform and whether active management might be due its day in the sunshine, but there was no doubt about the overall proposition. Active managers tend to hug benchmarks to mitigate business risk and to buy and sell too frequently, and on average their results are inferior to passive.
There was a debate about the ability to select managers, both whether it is possible and why it is not done better. One panellist cited Petajisto and Cremers (see reading list) to suggest that active share and low turnover were good predictors of outperformance, and to say that it was possible; another thought that responsibility for poor selection lay with trustees not challenging consultants sufficiently. He pointed out that in the US they are facing legal challenges for not doing so.
We asked whether there are behavioural issues behind the decision to invest actively. There is some romantic attachment to the belief that active managers outperform and outsourcing means trustees can blame somebody else for poor results. In contrast passive investment avoids the risks of bad actors such as Woodford or more recently Archegos.
We looked at the concentration in passive indices, with 27% of the S&P in just nine stocks (four tech, three consumer, two financial). Passive strategies can also lead to distortions: when Vodafone acquired Mannesmann in 2000, investors scrabbled to buy Vodafone’s stock. The same may have been true of Tesla this year when it entered the index.
Defenders said that there have always been index concentrations, usually led by technological change, and doubted whether concentration risk mattered. The riposte was that indexing was a lazy way to allocate, just ‘tipping money into the length and breadth of the stockmarket irrespective of each company’s valuation or sustainability.’ Bessembinder’s academic paper showed that all the value added in the S&P over time came from 4% of stocks, so why own the rest?
Back came the reply that passive investment guaranteed a weighting in those companies, whereas active management was up to the skill of the manager. Bessembinder was therefore an argument for investing passively.
We then debated whether passive strategies could be sustainable. Here views differed: our active proponent suggested that they could not engage with their large universes in a meaningful way and cannot divest. While passive funds may have processes to vote their shares, how meaningful was that when a lot of stock was lent out? The counterpoint was that passive funds are by definition long holders, whereas active managers hold on average for 19 months, not long enough to engage meaningfully.
At the end of examining our first elephant, there was more common ground than might be imagined. The benefits of passive were seen as lower cost and governance risk; however, there is a conscious decision made to invest passively, which trustees need to think through, and the inconsistencies between investing passively and sustainably were generally acknowledged.
We then turned to why pension investors still hold low returning liquid assets such as government bonds when they do not need the liquidity.
The obvious reasons are as a safety net for times of stress, so that pensions can be paid and to provide some income for funds turning cash negative. One suggestion was that, in an environment where all assets are low-returning, cash and bonds did not stand out, but the counter to that was that in real terms a 10-year bond yielding 0.8% to redemption was almost certainly losing money.
One panellist set out the case for cash as a deployment option. He believed that there was a higher chance today of the investing equilibrium being destabilised than there had been for many years. The risk of not holding liquidity was that investors would find themselves locked into an illiquid old world portfolio. Holding significant cash provided the option to make changes and the value of this at a time of change was higher than it had been.
The return from the other side of the net was that even where investors did hold strategic cash, they were almost never set up in governance terms to use it. At times of opportunity, appetite for risk inevitably fell (eg. March 2020 when few were advocating buying into the market*), and trustees and particularly their advisers were unable to take advantage.
At this point a number of other elephants began to make the room aware of them. Are markets too complacent about inflation and will that lead to existential change in the market? Is the real culprit the investment consultants exaggerating their capabilities, the actuaries and the way in which actuarial discount rates are set, or trustees not taking responsibility but relying on advisers?
We ended with a debate on whether a static strategic allocation was a better long-term approach. On one side was the view that a passive allocation regularly rebalanced was the best way forward. There was no need to beat the market and strategic allocations should be set to obtain the long term return target and then not changed. On the other side was the view that at a time of higher uncertainty, this involves a significant risk of being left with an illiquid and unsuitable portfolio.
*I have to wave Linchpin Advisory’s flag here. Please see my articles on this website ‘Two weeks is a long time in markets’ on 27th March 2020, where I cautioned against too much negativity, and ‘V for Victory?’ on 14th May 2020, where I was fully positive about both markets and the economy.
Reading list
Study of active vs passive management
Two industry scorecards showing that very few active funds outperform with any consistency…
.. and active bond managers fare little or no better than active equity managers:
Why positive skew is another reason for indexing:
Academic evidence that investment consultants cannot predict winning managers in advance and extract value by trying to do so:
The record of passive managers on corporate governance is actually slightly better than those of their active counterparts:
How active is your fund manager? A new measure that predicts performance – Cremers KJM and Petajisto A - referred to in the summary
Do stocks outperform Treasury Bills? - Bassembinder H - referred to in the summary
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