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Money: Stock pickers are “under duress”

03 May 2018

The head of one of the world’s biggest investment organisations has spelt out the urgent need for change in the funds management industry[1].

Michelle Seitz is the CEO of Russell Investments, a world-wide funds manager with over US$270 billion of funds under management. She is one of the few women running funds management businesses in the world today. Russell have a New Zealand arm.

Russell are mostly an active manager, which means they believe they can pick companies that they think will out-perform. Likewise, an active manager will try and pick which investment sectors are going to out-perform in advance and over-weight those sectors. In effect, what a lot of people think all investment managers to do. We call this ‘stock picking’ and ‘market timing’.

There are two problems with the stock picking and market timing approach:

  • It costs a lot more to try and time markets and pick stocks as the research is expensive. Investors pay these extra costs in higher fees, whether the market timing and stock picking works, or not.
  • For all the active managers in the world it is a ‘zero-sum game’. What does that mean? It means that before costs, half the managers will under-perform the market while half will out-perform the market, on average, as together they make the market.

When you combine these two points together, the higher costs and the overall average return, this sort of active management under-performs the market return, on average. It is hilarious when you get in a room of these types and they all claim to be out-performing the market. Because of costs, by definition, less than half will out-perform the market.

Michelle Seitz was in Wellington recently speaking at a conference and she told delegates that there was an “enormous sense of urgency about the changes happening in the funds management industry.” She said that the active funds management industry had been coasting along charging too much and it was unsustainable. “Data masks a lot of sins in this industry,” she said. “It has been possible to run a bad business in this industry and still do well. We, the active funds management industry, needs to change.”

Michelle talked about the need for a period of ‘creative destruction’ to take the excessive funds management fees out of the equation. “There are too many active managers. Active management is under duress. It is, after all, a zero-sum game on the active side.” It is great to see some straight talking from the heart of the industry.

It is the zero-sum game nature of investment markets that led me personally to believe it was a waste of time spending our investor’s hard-earned money on active management research that couldn’t, on average, generate anything in return. It was a huge relief to me to discover that a style of funds management existed that did not waste money on trying to out-guess the market. Statisticians tell us that trying to out-guess investment markets doesn’t work … except in hindsight!

The head of Morningstar research in New Zealand, Chris Douglas, was quoted in the last edition of NZ Asset as saying, “Funds management fees are the one constant factor that will take a cut out of an investor’s returns and luckily, it is the one thing they can control.” Douglas says that there are active fund managers out there in New Zealand charging up to 4% per annum for their funds, and that is excessive.

“Too often, active managers were charging for performance that was not of their making but simply driven by the movements of the market they were invested in,” said Chris.

As a contrast, the overall average funds management cost of investment portfolios built using passively managed funds is around 0.2% to 0.4% per annum and this type of cost allows the investor to keep most of the market return for themselves.

World-wide there is a massive trend towards passively managed funds, for all the reasons discussed above. In 2017, global passive funds investing in shares attracted nearly $500 billion of investor’s money, while active funds lost over $150 billion through redemptions, according to the Financial Times, December 23, 2017.

I will challenge anyone as to why they would invest in actively managed funds. I have studied the case for and against actively managed funds for over 30 years and I haven’t yet seen anything to prove the extra cost is worth it.

Keep asking great questions …

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[1] Quotes for this article are taken from various sections of the March edition of New Zealand Asset magazine published by Tarawera Publishing Ltd