Tuesday, 6 December 2011

A defence of Active Investing?

Are active investors akin to Pilot Fish or are they more like Ticks?

The paradox of active vs passive investing is that the active investors drive efficiency in the market but on average lose as much as win (lose more after fees) and passive investors get to benefit from active (apparently rational) capital allocation decisions but will be the nature of the product *never* outperform a given index.

Therefore for the individual investor with no market experience it makes sense to buy the index but if we all did this the markets would be horribly inefficient simply moving stocks up and down by free floats / liquidity from flows in the index - in addition pure index investing could create a vicious cycle of weights driving liquidity and liquidity driving weights. I often wonder now and in the future about the myriad of investment opportunities for individuals that could open up with an increasingly indexed stock market. For instance if you look at real dividend income yields and the whole index is getting dumped by passive funds potentially you can pick up solid income generating stocks at bargain prices/ This is different from the past where active fund managers might have sold down their cyclicals in preference of their defensive cash flow plays in a downturn. With some much automaton money out there it must create opportunities where the return of a stock is defined by more than just its buy and sell flows i.e where it returns cash to investors.

Part of the problem to my mind is the use of indexes. An index is a synthetic thing which is difficult to beat often by virtue of its own construction - for instance just like hedge fund returns indexes have a huge amount of survivorship bias - a fund can get stuck with a stock it cant sell that gets dumped out the index and lose a lot of performance, further a fund can find a stock dumped out the index resulting in forced selling and equally a loss of performance. Other issues include; when a stock moves in and out of the index it doesn’t suffer frictional costs, funds always hold some cash for liquidity purposes and that funds may be forced out of positions by their own flows. Now of course one could still argue that the fund manager still has a great chance to outperform the index through simple stock selection and this is true. But my experience is that clients want to micromanage their fund managers and micromanage their risk so its dangerous from fund managers to do much but hug the index tightly and try and squeeze out a little alpha against the aforementioned frictional headwinds.

I think the issue of benchmark investing is anathema to individual investors. These investors just want to make money on a total return basis against cash or some target return with relatively low risk. The issue on the institutional side is that between asset managers and investors there is a layer of consultants whose job it is to be a go-between for assets and asset managers and provide as lot of allocation type advice. Therefore they advise 10% in UK equities, 15% in Gilts etc so they then start looking for a fund which beats the UK equities market or Gilts market consistently.

Now clearly part of the criticism of active management is the fees and the amount of money the industry pays itself. This is fair to my mind as 1% a year off a mutual fund over a 30 year timeline is a serious take in terms of value for investors – equally 2 & 20 is something of a crime – although my favourite is the private equity model where the manager charges the investors to borrow their money in the form of called down capital – that is an astonishing financial Jedi mind trick. But discussions on fees ignore the scalability of the industry. One can manage a $1m or a $1bn with a very similar sized team of individuals. Arguably funds have better performance when they are smaller as they can trade the market rather than move it. This means in some ways the funds are self limiting; when they become too big they lose performance, lose clients and therefore lose fees. However a much fairer model to my mind would be something along the lines of a performance fee against a nominal total return benchmark and then an imputed management fee based on a cost plus model for the fund manager. I read somewhere that Michael Burry ran his hedge fund somewhat along these lines.

Finally there is the issue of value destruction via fees and trading which would appear to rob the world of its wealth. My criticism is this simplistic view takes no account whatsoever of the impossible to quantify benefits of efficient capital allocation. When investors invest in IPOs they regularly lose money or sometimes make money (usually the former in my experience) but they also distribute capital. When investors favour one stock over another the preference helps drive relative returns in the market and lower the cost of capital for the presumably successful company again helping future economic growth by rewarding efficient and productive businesses with additional capital. You can’t quantify what the value of this is but the relationship between investors and wealth may well be at least as much symbiotic as parasitic if only investors weren't charging so much for the privilege.

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