Updated: May 19, 2022
Schroders’ head of investment Peter Harrison is correct in thinking that “it is going to be tough over the next five years for the asset management industry” (Schroders launches a tech tour de force, July 6). It is going to be particularly tough for active fund managers who now face competition from “smart beta” as well as conventional passive funds.
"A fund manager’s job is to assess opinions not to have them"
To date there has been room for both active and passive. The three decades that followed Vanguard’s launch of the first passive fund in 1975 were ones that saw the pie growing rapidly, courtesy of falling inflation and a global credit boom. The two strategies were also different: active was all about making predictions, passive about not making any. Smart beta, which captures both the systematic nature of passive investing as well as clever – or ‘active’ – exploitation of proven inefficiencies, has been quietly changing this.
At the forefront of systematically converting well-known academic findings, such as the outperformance of low price-book or high yielding stocks into moneymaking reality, has been Dimensional Fund Advisors, which now boasts assets under management of $356bn. Others have followed and the term smart beta is becoming understood and accepted. Traditional active managers – individuals as well as the companies they work for – need to wake up.
It is possible that what Dimensional and smart beta’s success represents is similar to IBM’s chess-playing computer Deep Blue beating Grandmaster Garry Kasparov in 1997. Many had believed or, at least, hoped this would never happen. There was something fundamental – troubling even – about a computer beating a human at a game as complex as chess. Could it be that the computers behind Dimensional and other smart beta funds have found a way to beat humans at a game as intricate as investing?
Unlike conventional passive funds, smart beta funds de facto make predictions about future price movements, namely that the historical patterns they are seeking to exploit will persist. The opponents of smart beta funds argue that the price anomalies will disappear once they are arbitraged away by the funds themselves, while supporters believe the enduring strength of smart beta funds lies in their being continually rebalanced. But smart beta’s advantage lies in investment “decisions” not being clouded by emotion or inconsistency. Indeed, the anomalies they seek to exploit are themselves the result of irrational herding by active investors, both amateurs and professionals.
Traditional active fund managers need not panic yet. Their industry has thrived despite consistently appalling win-loss statistics. But smart beta has raised the bar – threatening in a way conventional passive never did – and active managers need to get smarter.
One way to do this is to improve smart beta decision-making processes. I have always been struck by the lack of clear decision-making processes in the active management industry. Perhaps fund buyers just assume that good recent performance reflects a strong process whereas the reality more often than not is it is just randomness. Heart surgery or bridge building or piloting an aeroplane would likely be disastrous without a procedure or checklist. Why should fund management be any different?
The answer, of course, is that in fund management, successful investing is about being different, about being better than your competition. In recent years I have become increasingly disinclined to join social conversations about, say, the euro or, more broadly, the economic outlook even though, given my profession, I am expected to. I recall a friend once turning to me and saying, “Elston, you haven’t expressed a single opinion all evening.” I was offended, but realised later that I should not have been. A fund manager’s job after all is to assess opinions not to have them.
Nevertheless, my antidote to such situations is to talk about my investment process with respect to the topic under discussion, using as much technical language as possible. So far I have a 100 per cent run rate in rapidly moving conversations on to something more interesting, just one more reason on top of many others for having a clear investment process.
Published in the Financial Times
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.