T A seminar the other day given by Sparrows Capital, Tim Jenkinson, a professor of finance at Oxford, was talking about investment consultants and, specifically, how good or not they were at picking winners.
Mercer, Aon, Willis Towers Watson and others advise pension trustees on choosing fund managers. The first three have about half of the market.
Jenkinson has been written about before - in 2015 - when he published the first version of his research.
In it, he showed that investment consultants had no manager selection capabilities whatsoever. In fact they were worse than average.
Naturally it produced a storm. “Billions wasted on investment advice,” said the FT. “Nobody knows anything,” said The Economist.
The consultants hit back. They said that while some firms might not pick winners, their firms most certainly did. They easily beat the market. The leading three said that, for equities alone, they beat the benchmark by 2.21% per annum.
So Jenkinson looked at their marketing claims. He covered the 10 years to 2015, and asked two questions:
1) Do investment consultants really have manager selection abilities?
2) How do the claims that investment consultants make compare with our assessment?
And what happened?
Well once again the consultants did poorly. There was again no evidence that they performed better. However hard he tried, Jenkinson could not make the consultants’ returns match the reality.
The Sparrows seminar then rammed home the point about the problems of active management.
a) US research, in 2005, suggested that only 2% of active managers deliver alpha (beating the market).
b) UK research, in 2008, suggested only between 5% and 10% of active managers deliver alpha.
c) The Financial Conduct Authority in June 2017, said actively managed investments do not outperform their benchmarks after costs.
d) ESMA, the European Securities and Markets Authority, in 2019, said actively managed funds clearly produce higher costs to investors than their passive peers, while equalling them in terms of gross annual performance, or even under-performing.
But there is a different view. Hendrik Bessembinder is a professor at Arizona State University who wrote two years ago that 96% of shares do no better than US Treasury bonds.
He calculated every single stock in the index for 90 years from 1926 to 2016. Only 1% of shares, of the 26,000 he looked at, made phenomenal money, while 3% made a bit.
The rest did not make anything at all less than if investors had gone into Treasury bonds. Some people think Bessembinder’s research means they might as well be in a tracker because almost no one will hit on winners — there being so few of them. But in fact this is why active management is a good thing.
Imagine a share comes into the index at 100p then over the next five years it rises to 200p. Then over the next five years it drops back again to 100p, at which point it departs from the index.
Bessembinder would count that share as showing a 0% gain, given its time in the index. But an active manager, one with skill, could have bought the share at 100p when it came in, held it for five years, and then sold it for 200p.
His profit is 100%; Bessembinder with the same share made 0%.
Unfortunately most active investing is no longer about taking long-term risks in definable investment projects.
It is more about free riding on the market return at minimum cost; participating in an expensive zero-sum arms race of better, faster, smarter analysis; shuffling risks around through financial engineering disguised as value creation, and confusing people on costs.
But there is an alternative: where they have unconstrained mandates; where regulators cut some slack; where they look to the long-term; where they have concentrated portfolios; where they do not hug benchmarks; where the fee structure is performance-driven rather than based on the value of funds managed; and where they don’t have to kowtow to investment consultants.
These are the genuine active managers. But the real question is: will the asset managers give them the mandates?