From Seneca Investment Managers' public marketing material. Seneca is now part of Momentum Global Investment Management.
My attention was drawn last month to a recent McKinsey report entitled, Diminishing Returns: Why Investors May Need to Lower Their Sights.
"It should be possible for active managers to work out how to profit from such knowledge"
The thrust of the report was that investors’ current expectations for future returns have been shaped by actual returns enjoyed over the last three decades. Since these were unusually high, expectations for the future are now too high. The report notes that high returns over the past three decades were due to sharp declines in inflation and interest rates; high GDP growth that was the result of positive demographics, productivity gains and rapid growth in China’s economy; and even stronger corporate profit growth due to such factors as declining corporate tax rates. Some of these trends, the report argues, have now either stalled or gone into reverse, meaning that future returns will be lower, perhaps considerably so, than they were in the past.
I have sympathy with the conclusion, and in fact would add the cost of climate change to the list of factors that will increasingly impact growth – and indeed aggregate corporate profits - in the decades ahead.
As an investor, one has two choices: one can either accept the lower returns or one can do something about it. Or, to put it another way, you can either ‘be’ the market by investing in passive funds that will simply provide you with these lower returns, or you can seek to ‘beat’ the market by investing actively, thus enhancing your returns if done successfully.
It is therefore ironic that flows into passive funds appear to be accelerating (see FT article, Passive funds grow 230% to $6tn2) at a time when market returns are in decline. Furthermore, if you need to make your savings pot last longer because you are going to live longer, you are effectively doubling your problem by going passive.
This is not to say that I think beating the market is straightforward. It clearly isn’t, as the plentiful evidence that most actively managed funds fail to beat their benchmark indicates.
I am thus dismayed that, as the FT article cited above notes, active managers have been “attacked by academics and consumer groups for not offering value for money.” Of course active managers do not as a group offer value for money! The reality is that active investing is not like Blackjack in which it is possible for all players to win, but Poker, in which some win necessarily at the expense of others. The above attack is the equivalent of criticising lotteries on the basis that the vast majority of participants win less (i.e. nothing) than they spend to play.
This analogy is not a perfect one, because winning lotteries is about luck. If financial markets were efficient, and it was thus impossible to beat the market, I can assure you my savings pot would be stuffed full of passives.
But they’re not.
The prices of financial assets do not move randomly but exhibit pattern, meaning that price movements are a function of previous movements and are thus predictable (unlike random movements which are by definition independent and thus unpredictable). This assertion is not opinion but fact - there are plenty of statistical tests that have found pattern in financial markets.
For example, when real interest rates are high, real returns from bonds will tend to be high (the converse is also true). Another one: when the dividend yield of a higher quality company’s stock is higher than the market average, the stock’s total return tends to be higher than the market average. (Another name for the pattern at work here is mean reversion.)
However, taking advantage of these patterns is harder than it might appear.
First, it requires a contrarian mindset. The reason why dividend yields or interest rates become too high in the first place is generally that the companies or economies in question get into difficulty (think about falling oil prices over the last couple of years that drove up yields of oil majors or the high inflation of the 1970s that drove up interest rates). It takes a strong mind to see such difficulties as opportunities rather than as things to fear. Such strength is rare in any walk of life – most humans prefer to be part of a group rather than to stand apart from it. And of course we humans are emotional beings – being fearful is a natural trait that we evolved to protect ourselves from genuine threats such as sabre toothed tigers and disease. Human nature will per se always be hard for humans to counter.
Second, spotting patterns in markets requires a fair grasp of mathematical concepts that is also fairly uncommon. Computers are now bypassing humans in this endeavour, enabling the emergence of so-called smart beta funds that seek to take advantage of patterns such as value, quality, and momentum. But there will always be some scepticism about putting your savings in the hands of computers, and thus mathematical nous will remain a valuable skill for so endowed active managers. Furthermore, smart beta funds themselves will likely by virtue of their buying and selling create other patterns that the skilled active manager can take advantage of. After all, any fund that invests according to a strict, and public, set of rules, whether traditional passive or smart beta, is essentially flagging to the world what it is about to do. It should be possible for active managers to work out how to profit from such knowledge.
Third, funds may become too big to be able to take advantage of market inefficiencies. Peter S. Kraus, chairperson and chief executive of AllianceBernstein, recently wrote that, “Active equity managers as a group made two mistakes: one, as we grew quickly, we got complacent about our ability to effectively manage larger pools of assets. Then, with bigger portfolios to invest, many managers over-diversified their holdings as a way to reduce risk and preserve those assets.”
I am reminded of Warren Buffett’s comment in a 1999 interview for BusinessWeek: “If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
Now, I have an awful lot more to prove than Buffett, and I’d be thrilled if I had a fraction of his ability, but I do know three things:
Our Seneca funds are sufficiently small to be able to take advantage of investment opportunities that are out of reach for our bigger competitors;
I suspect they can grow several-fold before this advantage begins to wear off, and;
If and when we reach that point, I will be very conscious as to any trade-off between further growth on the one hand and capacity to produce good performance on the other to prevent us growing further.
After all, my duty of care is to our investors as well as our shareholders.
Published in Investment Letter, June 2016
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.