An Attack on Poor Active Management

Updated: May 18

From Seneca Investment Managers' public marketing material. Seneca is now part of Momentum Global Investment Management.

I abhor poor active management.

I abhor it because there are so many individuals whose retirement savings have been invested in poor products; because it has given the active management industry in general a bad name; and because the big firms who are the worst offenders continue to peddle the notion that bigger is better – witness a certain recent merger – when in fact my - and Warren Buffett’s! - opinion is that the opposite is the case.

"Active managers should be aiming to beat their benchmark by a wide margin to compensate investors for the risk that they will fail to reach it"

With, for example, football clubs and DRAM companies, bigger generally means better quality. This absolutely should not be the case with active management, where the more interesting investments tend to be smaller and thus out of the reach of large firms.

While I abhor poor active management, I adore Gina Miller (on a strictly professional basis I should add). I too get an itch when I think “people are being bullies, or being dishonest or hypocritical”. Most big fund management companies for me tick all three of those boxes.

I do not think I am alone in thinking this way. Indeed, although I am very critical of my industry, there are many outside it whose criticism of active management is far more vitriolic. Some will have had a bad experience investing in an active fund, others will have been appalled at the asymmetrical rewards on offer in the industry, others still may see us as a bunch of coin tossers masquerading as skilful practitioners.

Whatever the reason, there is plenty of evidence that most actively managed funds fail to beat their benchmark net of costs – this is indeed the way the newspaper headlines always seem to be framed. However, the implication of this – and the headlines – is that funds that beat their benchmark have done a good job, and that funds whose performance is in line with the benchmark have achieved what they set out to achieve.

This has to be wrong.

Active managers should be aiming to beat their benchmark by a wide margin to compensate investors for the risk that they will fail to reach it. Why on earth would I as an investor accept index performance with risk when I could get, from a passive fund, index performance with no risk?

Most single asset class funds have an investment aim or objective that is vague, and a benchmark which is an index (this was certainly the case with ten UK equity funds that I selected at random). Where there is a benchmark stated, it is not generally clear what it is there for, but let’s assume it is for investment performance measurement purposes – after all the proper definition of a benchmark is ‘a measuring device’ rather than ‘something to be copied’, not that you’d know it by looking at many funds’ holdings.

So, I have a simple solution. Active funds should state the margin by which they aim to beat their benchmark, net of costs. For example, FTSE All Gilts + 2% per annum, or S&P500 + 3% per annum. At Seneca, we do this with our multi-asset funds, either explicitly or less formally, taking account of the value we seek to add from active management decisions.

Furthermore, why would performance in line with benchmark be acceptable when what this means is that managers give all the outperformance to themselves in fees once other costs have been paid, leaving nothing for the customer!

So, I have a different approach.

My starting point is to consider the costs for a particular fund, then to aim to produce a multiple of these costs in gross outperformance (alpha). I make sure that we have sufficient tracking error to give our funds the potential to produce this alpha (too little tracking error is in my view worse than too much) then trust our value-oriented investment style and process to achieve it.

What is the multiple? It depends on the total costs, but for all three of our funds, it’s considerably above two.

We recently changed the benchmark for our investment trust, the Seneca Global Income & Growth Trust, to:

“Over a typical investment cycle, the Company will seek to achieve a total return of at least CPI plus 6 per cent per annum after costs with low volatility, and with the aim of growing aggregate annual dividends at least in line with inflation, through the application of a Multi-Asset Investment Policy.”

Benchmark changes are generally met with great scepticism, and rightly so, but in our case we have raised the bar rather than lowered it. Furthermore, the change will not mean we have to start jumping higher (we will not change the way we manage the fund). The bar has been raised to a level commensurate with our process rather than at an inappropriately low height.

It had become increasingly clear to us and to the Trust’s Board in recent years that the previous benchmark of LIBOR + 3% did not reflect how the trust was being managed. Nevertheless, there were some who expressed concern that the new benchmark was too ambitious.

Given my earlier remarks, I would argue instead that the objectives of most actively managed funds are not ambitious enough. Perhaps this is why the active management industry is so despised. Many, including me, think it is still providing a safe harbour for the cowardly.

Published in Investment Letter, August 2017

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.

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