The decline and fall of Mt Gox, the Tokyo-based Bitcoin exchange, is a cautionary tale for our time. It speaks to the fear and greed narrative that seems to guide much investment thought and action and leads people to suspend disbelief in the hopes of getting rich quick.
No doubt the behavioural economists can tell us why we fall so easily for the story of easy money, but our tendency to do so is an essential support for all financial services providers.
It lies at the root of the strong preference for an active approach to investment management over a passive one displayed by most investors. Despite all the academic studies and data crunching over the years showing that active management cannot be relied on to deliver the outperformance it promises, it still accounts for the lion’s share of assets under management.
Interest in passive management has grown significantly in recent years, fuelled by a growing awareness of the cost advantage. But the share of passive management (including exchange traded funds) in global assets under management still only reached 13 per cent in 2012, up from 5 per cent in 2003, according to a report by the Boston Consulting Group last year.
The share is much the same for institutional investors as for supposedly less sophisticated retail ones. If anything, institutional investors have drunk even more of the Kool-Aid, having increasingly turned to the uber active brigade of hedge fund managers and private equity groups, whose fees ensure the managers make good money even if the investors do not.
Given the premium investors pay for active management, they must believe they are getting value for money. Perhaps they do not analyse outcomes in that light, or have insufficient data to get a complete picture. In any case, the belief that skilled managers can do better, after fees, than a market index, after (much lower) fees, dies hard.
Of course, there are managers who outperform, although they remain hard to identify in advance, and may go through periods of underperformance. It is arguably rational to entrust some money to active managers in the hopes of squeezing extra returns from assets. But why do investors have such a strong bias to active management?
Research by Ron Bird, Jack Gray and Massimo Scotti, of the Paul Woolley Centre for the Study of Capital Market Dysfunctionality, published in the Rotman International Journal of Pension Management last year tries to answer this question. It confirms the existence of a bias to active management among institutional investors, and finds it is “reinforced by a competitive environment and supported by a complex mix of behavioural, agency, organisational and cultural factors”.
Based on a survey of chief investment officers (mainly of Australian pension funds) and asset consultants, the study found the two main reasons for favouring active management (of eight tested) was the expectation of higher net returns and a belief in market inefficiency.
There was also a fairly strong belief in an ability to choose better managers, with around 70 per cent of both groups claiming they can consistently pick top quartile performers.
The researchers attribute the strong showing of these reasons mainly to behavioural factors, particularly overconfidence. They also found agency effects to be significant, with a positive correlation between use of active management and having a regular investment consultant. The reasons for this are clear from some of the comments made by those surveyed. One consultant said: “The case for passive is strong. I would like to use it more but am not empowered to by our business model.”
The authors conclude that, governance structures notwithstanding, investment decisions at pension funds are made “in ways that support the psychological and financial interests of the agents, including trustees, internal investment staff, asset consultants and managers”. Funds need “more technically adept and independent trustees” to ensure decisions are made, instead, in the best interests of the pension scheme members.
Anyone feeling confident in the ability of active managers to outperform should study the scorecards for indices versus active funds produced regularly by S&P. The latest report, to mid-2013, shows just over half (54 per cent) of US equity funds were beaten by their benchmark over one year. The proportion increases to 79 per cent over three years and 72 per cent over five years.
The story is much the same for international equity funds, with the exception of small-cap funds (only 18 per cent were beaten by the benchmark over five years). And fixed income funds fare little better.
A useful analysis on bogleheads.com, a discussion forum, looking at scorecard results from 2001-12 shows the 2013 data are not unusual. Indeed, active funds managed to outperform index returns in a majority of the nine style boxes included in the analysis in just three years – 2003, 2007 and 2009.
Still, why let data get in the way of a belief that easy money is there for the taking?
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