“Disagreeable data are streaming out of the computers of Becker Securities and Merrill Lynch and all the other performance measurement firms. Over and over and over again, these facts and figures inform us that investment managers are failing to perform”. So began Charlie Ellis‘ landmark article in the Financial Analysts Journal back in 1975, describing why he believed that money management had become a “loser’s game”. The investment management business, he wrote, “is built upon a simple and basic belief. Professional money managers can beat the market. That premise appears to be false”.
Recent experience has done nothing to invalidate this conclusion, at least at the aggregate level. Despite having the smartest and best incentivised talent pool, for example, most hedge funds lost money in 2011 – a lot of money, in some cases. It was their worst year since the calamity of 2008 exposed the fundamental flaws in the hedge fund proposition. Meanwhile the latest survey of UK private client managers’ performance by Asset Risk Consultants notes that in all four of their risk categories – from cautious to equity-rich portfolios – clients lost money on average in the year just gone. In the process, the average private client firm underperformed the relevant APCIMS benchmark each quarter and did so by a record amount over the year as a whole.
A check on the latest figures on active versus passive fund performance from Standard & Poor’s also shows no change in a now familiar picture. Only 12% of the large cap US funds which were in the top quartile of the performance tables in the five years to 2006 were still in the top quartile over the five years to 2011. That’s barely half the 25% figure you would expect if the outcome was simply random. Something similar holds for the number of funds that have maintained top half performance in each of the last five years: large cap funds mildly ahead of a random outcome (6.25% of funds), mid and small cap funds somewhat behind.
And yet, bizarrely, as Marc Faber has noted, the notable feature of 2011 was that it wasn’t that bad a year, taking most mainstream asset classes into account. Although emerging markets were weak, US and UK equity markets barely moved over the 12 months; according to Dimson, Marsh and Staunton, the last time US and UK equity markets moved so little in a calendar year was back in the 1970s. The dollar, pound and euro all finished the year almost exactly where they started. Government bonds did exceptionally well, and corporate bonds okay. Gold had its 11th consecutive year of increases, although some other commodities (base metals, sugar, cotton) did do poorly.
With hindsight, in fact, there is no reason why investors using conventional asset allocation should not have eked out a modest positive return. The main reason why most private client managers lost rather than made money in 2011, says Graham Harrison, managing director of Asset Risk Consultants, is that so few of them were willing to put a benchmark weighting of government bonds into their clients’ portfolios. Most followed the consensus path and overweighted emerging market equities and underweighted government bonds, which turned out to be a serious error in timing (though the logic was, on the face of it, impeccable).
So, in global historical terms, we have a paradox. For all the dramatic headlines, 2011 was in reality a nothing sort of year – not much upside, but not much on the downside either. Yet the majority of professionals could still not make ground. It is easy to understand why. The news was dominated by sovereign debt concerns and the interminable Eurozone crisis. Buying gilts on a negative real yield is patently a high risk strategy. The daily volatility of equity markets spiked to exceptional levels for part of the year. Fear of a rerun of 2008 was widespread and far from irrational. We had the Arab Spring and the Japanese nuclear accident. The more informed you were, the more worried you were likely to be.
The best strategy, in fact, was probably to switch off the Bloomberg and go abroad for a year, leaving others to fret about the exceptional volatility of daily price movements. That of course was precisely the point that Mr Ellis was making all those years ago. The smarter the competition, the harder (and more ambitious) it becomes to achieve, let alone sustain, outperformance. (Note that this is not quite the same as saying that the markets are efficient; last year demonstrated that investors are all too prone to make the same mistakes simultaneously).
The “new normal”, on last year’s evidence, is a world in which actively managing money has become no easier. With interest rates so low, and likely to remain there for some time thanks to the distorting activities of central banks, nominal returns from most asset classes continue to fall, leaving little or no room for investors to make money in absolute terms, let alone after the deduction of fees and trading costs. Whatever long term effects the fallout from the financial crisis will prove to have, the evidence to date supports the view that most professional money managers have yet to work out how to deal with them effectively, although those who can escape from the straitjacket of consensus thinking and plot a path through these hazardous waters can (and will deserve to) prosper.
Jonathan Davis 