The Problem in Fund Management
Active fund management, with some notable exceptions, has largely failed to outperform passive management net of fees, which is particularly the case, since the 2008 Crash. The impact of this has been substantial flows from ‘active’ managers into passive alternatives. Less well realised is that the passive alternatives pose significant risk issues that have yet to be tested in a severe market downturn. Their growth arguably represents a major mis-allocation of resources. AMps provides an intuitively attractive solution to the problems of both current active and passive management within the IAM Advisory investment process.
It can be demonstrated that the opportunity for adding to returns through proper ‘active’ investment is substantial. A few managers, who are consistently performing well and are clearly thinking ‘outside the box’ have successfully captured this active opportunity. There is academic works that suggests that the difference between possible active investment outcomes and the actual results remains has increased, particularly when compared, net of fees, to passive management where charges have been reduced to extremely low levels.
We contend that the cause of this mismatch, between potential active returns and actual outcomes, is the fund management industry’s almost universal obsession with market indices at every level of the investment process. Typically a static composite index benchmark allocation is used for initial portfolio construction and in setting a risk profile. The portfolio is then managed around this benchmark for both strategic and tactical decisions and, finally, the portfolio performance is measured against the same standard. Managers consider one risk as being the distance from the market benchmark. In such an environment it is unsurprising that the potential for active management is not being fully accessed. It is illogical and counter-intuitive that we should attempt to drive an ‘active and dynamic’ investment strategy by referral to, and comparison with, a passive static standard and then complain about the result.
What is less appreciated is that passive strategies also represent substantial and unappreciated risks and costs.
- The average passive investor has a poor record on timing, entry into and exit from the market
- Many funds are covering their market exposure, all or in part, through derivatives, particularly at times of market stress. This potential counter-party risk is not and cannot be reflected in the statistics - until there is a market failure
- More complex or specialist passive strategies are still charging fees that can be significant
- As passive funds become more focused the clients are in effect taking ‘active’ decisions in determining the character and size of underlying specialist allocations and rarely getting these difficult decisions correct
- Serious anomalies are emerging in the passive universe. To name but one, the total holding in Apple, in the three largest passive fund groups, is 15% of its capitalisation. This is held as a function of the market value of the company relative to the total market, not because of the underlying value of Apple or its prospects. In the event of sustained selling of these indexed funds, the managers will be struggling to place the orders in a reasonable time frame and provide contracted liquidity without in turn affecting the pricing. A potentially dangerous feedback loop.
- The decision of when to enter into, out of or how much to hold in an index is arguably a much more complex decision than whether to hold a single stock in a portfolio.
- Investors in passives often forego the asset allocation portfolio structuring advice available from investment advisers which is effectively an ‘active’ decision
AMps provides a direct solution to the problems in the way current active strategies are managed and to the explicit and implicit risks of passive strategies. This significantly increases the potential for extra returns and provides a more dynamic way to control risk.