Fund charges, as we discovered in Part 2, compound hugely over time and can make a huge dent in your long-term investment returns. But as well as being very expensive, actively managed funds have a dismal performance record. Research shows only 1% of fund managers are able to beat the market consistently, and even those managers keep for themselves the value of any outperformance in fees.
In How to Win the Loser’s Game, Part 3, Michael Johnson from the Centre for Policy Studies explains how fund managers are competing against each other in a negative-sum-game and that choosing which fund to invest in is an expensive lottery. That’s a view shared by the Nobel Prize-winning economist Eugene Fama who argues that markets are now so efficient that it’s become almost impossible to distinguish fund manager skill from pure chance.
Michael Johnson is a public policy adviser with a specialist interest in pensions. He says the Local Government Pension Scheme report is a wake-up call for the whole investment industry.
Michael Johnson says: “I think it’s a seminal moment in the history of investment management or fund management because it really lifts the lid on what is essentially an industry that adds no value to anybody. Essentially, very few people enter that industry with the express purpose of enriching others, and they’re good at what they do, which is enriching themselves.”
Alan Miller was a successful fund manager. But over the years he became disillusioned with the industry, and particularly with the poor performance that managers were delivering year after year.
Alan Miller says: “It used to be that the institutions had a big advantage. They would see the company first, they would see the management, if they were asked sensible questions they would get information before other people. This does not happen anymore. There is something called the internet. There is something called information given to everyone and, therefore, to have an edge it’s much harder. It’s a bit like companies drilling for oil in the middle of nowhere, where no one’s drilled before. It doesn’t mean they’re not going to discover oil, but the vast majority are probably just going to discover fizzy water. The marketing budgets within the big retail companies are millions and millions of pounds, and they’ve created this image whereby the customer thinks that these big brands are nice and safe, nice and solid, and they think they’re getting something better. They’re actually getting something worse. This is the irony. If you were to sum it up, less is more. The bigger the institution, the bigger the brand, normally the more you pay and normally the worse the performance.”
Michael Johnson says: “In a nutshell you have an industry of fund managers who are trying to out-compete one another in a giant negative-sum-game. Not a zero-sum-game, but a negative-sum-game, because whilst they’re doing this, they are extracting charges and fees on an annual basis which erode the capital of savers. In this competition of trying to out-compete one another, there are bound to be winners and losers every year, and there are some that claim that they add value, i.e they win more often than they lose, but if one actually examines the data, as I and others have done, it is nigh impossible to work out who is going to outperform the rest on a consistent basis. For virtually all investors, making a decision as to which active fund to invest in is a pure lottery.
And that’s more or less what the Nobel-award winning economist Eugene Fama has been saying for more than 50 years.
Eugene Fama: “There are lots of studies of persistence and performance. I had one of my students do a very famous thesis on this. He ranked the funds based on five years of past returns and did this every year, and examined whether that predicted future performance. No, it doesn’t. There is very little persistence in performance. But if I take all of the funds and look at them over their entire histories, then you’re going to see that some of them did extraordinarily well, and books get written about those managers, but in fact that distribution is pretty consistent with chance.”
We asked several of the largest fund management companies to talk to us about performance, but had no success. But the trade body, the Investment Management Association, did agree to give us it’s point of view.
SITV says: “What evidence do you have that active fund management actually works?”
Daniel Godfrey says: “OK, well over long periods of time, active managers pick stocks that they believe will go up more than the market. But, of course, as a group, as a whole, we are the market. So, that’s why you will quite often see reports in the press saying that active fund management doesn’t outperform the market. Well, the fact is that active kind of is the market – and passive obviously is the market too – so, as a group, they can’t outperform the market. What people are trying to do is find mangers that do outperform the market over a long period of time and, in fact, most people are quite successful at doing that because what you’ll find is that the managers that demonstrate an ability to outperform the market reasonably consistently, have the bigger funds and ones that don’t contract quite rapidly. So the lion’s share of new money and switching money goes into the funds of people who do outperform.”
But Michael Johnson is unimpressed.
Michael Johnson says: “That is mathematical nonsense. How can you suggest that the majority of money is successful? How can the majority be outperforming the minority? Doesn’t make sense. This is an industry that is a genius at obfuscation and bamboozlement, with terminology that is utterly meaningless. And it needs to be challenged.”
So, what are the implications of all this for the investor? Well, the system needs active managers to set prices – to ensure we all receive value for value for money. But that doesn’t mean every investor has to pay for their services.
Indeed, the high cost of active management combined with its dismal track record – and the near impossibility of identifying the next star performer – should make the average investor extremely wary.
But, before investigating alternative approaches, we’re going to find out what the academic evidence says about investing – and how best to go about it.