As the financial services sector of the share market heads back towards its 1980s share of about 10 per cent of total market capitalisation, compared with the peak of 40 per cent in 2006, one could be forgiven for wondering about the fundamental value proposition presented by banks, funds managers and insurers. It is well documented that funds managers as a whole do not add value; that’s why there are index funds. But a sufficient number do and their names change often enough for that industry to expand.
As has been famously said of banks: banking is essential, banks are not. And insurance companies clearly provide a service to smooth out risks but perhaps the price, especially in insurance of investment management products, is generally too high. The two main beneficiaries of the credit bubble, arguably exacerbated by Alan Greenspan, the former Federal Reserve governor, with his reaction to the bursting of the tech bubble in 2001, have been financial services and property companies. The two are closely linked.
The unreal spreads in the credit market, the unreal lending policies of some institutions, led inexorably to an unreal appetite for risk and unreal property prices. Investors, and indeed all Australians, can take some heart from the unusually statesmanlike speech by Glenn Stevens, the Reserve Bank governor, last month just prior to the extraordinary rescue package proposed by the Bush administration. Stevens said that the crisis would lead to a return to greater prudence, increased savings and reduced consumer expenditure – “living within our means” – and that would be good for the long term wellbeing of the economy.
While that may sound overly wholesome and simplistic for sophisticated market participants, a bubble is a bubble and a binge is a binge – they cannot continue indefinitely. A major irony is that funds managers contribute to bubbles. Active managers with an element of momentum in their style, which is possibly the majority of managers, will continue to buy as long as there is good ‘news’. Cap weighted index managers take their investors on the same ride. The irony is, though, that active managers can show their true worth in this sort of environment.
Research by Russell Investment Group shows up the cyclical nature of outperformance, or lack of it, by active managers. After a difficult 18 months, active Australian equities managers have again outperformed since September last year. This month marks the 21st anniversary of the 1987 share market crash and to a certain extent, markets have come of age since then. Peter Gunning, the global chief investment officer of Russell, told the firm’s annual conference in Melbourne last month that while active management relative performance was cyclical and managers tended to struggle in highly speculative environments, they also often rebounded strongly.
For instance, after underperforming by 1.95 per cent in the 12 months to May 2007, active Aussie equities managers outperformed by 0.88 per cent in the 12 months to May 2008 – a trend which could be expected to continue for the next two years according to an analysis of previous similar periods (see table). Gunning says that managers need two things to outperform their market: skill and an opportunity set to demonstrate that skill. In most markets managers have a rough time outperforming when cross sectional volatility is low, because this reduces the opportunity set. “But now volatility is back with a vengeance … active managers like markets that are not narrow,” Gunning said. Russell also looked at whether ‘older’ managers tended to lose their ability to outperform – “do managers lose their mojo with age?”
There is some evidence of this, given the well-known ability of boutiques and especially early-stage boutiques to outperform. The Russell research indicates that there appears to be mean reversion in active management. Gunning says: “If you can time the alpha cycle that would be a great tool. But we’re not yet confident enough in that to put it into practice.” A big wild card over the short-to medium term is the intervention of the authorities in the markets. The use of derivatives, securitisation, the acceptance of short-selling and relaxation of currency and other restrictions over the past 21 years have improved the efficiency of the financial system.
In times of crisis these are scrutinized by governments and central banks, which are prone to short-term ‘remedies’, such as the bans on short selling. In a similar fashion, in years gone by, governments have introduced prices and wages freezes to attempt to stop inflation. Such moves, economists will normally argue, do more harm than good. The current crisis and the reaction by the US government, and even our own ASIC, will provide valuable case studies for the next generation of investors. Was intervention worth the cost? Would the markets have sorted the problems out more quickly or more efficiently? Will a stifling new round of regulation follow on from government intervention? At least investors can take some heart from the likelihood that their active managers have re-entered a cycle of outperformance if history is a guide.