January 11, 2013 11:00 pm
You can’t buck the market. Margaret Thatcher said it, and investment managers know it is true.
2012, as year-end reviews showed, was an easy year in which to make money. Most important stock markets were up by more than 10 per cent. Passive mutual funds and exchange traded funds (ETFs), which charge low fees and replicate the performance of benchmark indices, therefore did well.
But “active” funds, paid to beat the index, failed to capitalise. In the US, only 32.4 per cent of large-cap funds beat their benchmark, according to BofA Merrill Lynch. In the previous two years, barely 20 per cent of managers had done so.
As for hedge funds, which can invest the money only of wealthy clients, and have many useful extra freedoms, such as leveraging up their returns through borrowing, and betting on stocks to fall by selling them short, the results were even worse. By Goldman Sachs estimates, some 88 per cent of equity hedge funds lagged behind the S&P 500, the main index of US stocks. According to Hedge Fund Research of Chicago, equity hedge funds in total gained 7.4 per cent; the S&P was up 16 per cent.
This is a problem for active managers, as their clients are pulling their money out and moving to ETFs. But it is hard to see any solutions that do not create even greater problems for everyone else.
What happened? There are strong arguments that underperformance like this is inevitable. Some use the EMH (efficient markets hypothesis). Discredited in its hardest form by recent financial disasters, this holds that security prices always reflect all the news that is known about them. Thus they follow a “random walk” in response to news. Beating the market is impossible.
Alternatively, Jack Bogle, founder of Vanguard Funds, suggests the CMH (cost matters hypothesis). Funds are so big that their average performance is almost by definition equal to the market. But mutual funds charge fees upfront. The expense incurred in attempting to beat the market guarantees that as a group they will lose to it.
Even with these points in mind, managers ought to be able to make some money out of the market’s inefficiencies. But there were some further devilish problems in 2012:
Beating the market requires a consistent strategy. The best known investment styles are “value” – buying stocks that look cheap compared to their fundamentals, such as their earnings – and “growth” – buying stocks with strong and growing earnings. Normally, these styles move in long cycles; value beat growth from the end of the tech bubble in 2000 until the credit crisis in 2007. Growth had won ever since; until a muddled 2012, when Russell indices show a hard turn in the middle of the year, and value stocks ended up slightly outperforming.
That shift was difficult to spot, and wrongfooted many managers.
Equity fund managers are uncomfortable judging sharp top-down turns in the market, caused by big economic or political events. These drove many funds off track last year.
The European Central Bank’s longer-term refinancing operations (LTROs) triggered an unlikely rally in the early months, which mutual funds generally spotted, and hedge funds missed. There was a sudden turn in the spring, as Europe’s situation grew uglier. Then another acronym, the ECB’s OMTs (outright monetary transactions), sparked a longer rally, which mutual funds missed. Hedge funds were more likely to spot it.
How difficult was it to spot macro turns last year? According to HFR, macro hedge funds, which specialise in exploiting macro events, actually lost a little money.
Some investors are more skilled than others. But nobody can tell which. The science of measuring investment skill remains in its infancy.
Michael Ervolini of Cabot Research in Boston, a pioneer in the field, says that all the emphasis is on outcomes: do managers beat their benchmarks? By comparison, a golfer is judged by his final score, but is well aware which of golf’s various skills, from driving to putting, are working well, and which are working badly. This is not true of fund managers.
The job is to break down each decision to buy or to sell, to see where skill lies. Mr Ervolini cites Freud’s dictum that most human decisions are made to seek pleasure or avoid pain. In the years of the credit bubble, investors sought pleasure; more recently, they have hurt themselves with excessive attempts to avoid pain. They stayed underinvested and missed opportunities for pleasure.
It will help everyone if active investors can work out what they are doing wrong. We rely on them to keep the market efficiently priced; a market in which all assets were managed passively could not work.
But for now, investors are best advised to pull money out, and switch to ETFs or index funds. That will put pressure on active funds to sort their act out. Until they do, it is hard to see any case for a retail investor to stay with them.
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