The London-based Paul Woolley Centre for Capital Market
Dysfunctionality held a workshop in Sydney
last month, at the affiliated University
of Technology Sydney (UTS), which discussed a range of new research
initiatives, including a proposed study about why investors continue to employ
active managers. GREG BRIGHT reports.
Given the massive fall in the value of
most stocks on listed markets in the past 18 months, the age-old debate about
whether institutional investors should use active or passive management has
come to the fore once again. Australian Super, a fund which others like to
emulate, made headlines last month with its decision to significantly reduce
its active manager line-up and index half its Australian equities allocation. If
you believe that the recovery is just around the corner, then most of the gains
from investments in the next year or so will be broad market gains – so you may
as well index.
There’s not much point in paying high fees to chase a few percentage
points of alpha if the broad market rebounds with double-digit returns. However,
at the same time, active managers are saying that we are currently in a
stock-picker’s paradise. Credit spreads are still close to the widest they have
ever been and a lot of companies are teetering on the edge of bankruptcy. For
the astute manager, this is a buyer’s market. Against that backdrop, the Paul Woolley
Centre for Capital Market Dysfunctionality has commenced a research project in Australia
to see why people prefer active management to the extent that they do.
The
project is being undertaken by professor Ron Bird, of UTS, and adjunct
professor Jack Gray, of Brookvine, both of whom are affiliated with the Centre.
The Centre is based in the London School of Economics and supports two affiliated
schools, at the University
of Toulouse and UTS. Bird,
Gray and the Centre’s founder and benefactor, Paul Woolley, are all former executives
of funds manager GMO. Gray said at a workshop held at UTS last month that the
Centre had already sent one questionnaire to a “general population” of
non-professionals with mixed results.
This survey showed that 8 per cent of
respondents believed active management failed, 29 per cent believed passive
“failed” and 45 per cent believed passive meant “average”. Those respondents
who were either poor, had some knowledge of shares or had read something
“financial’ in the press recently were more likely to believe in active
management. The Centre planned to conduct surveys of investment professionals at
pension funds across Australia
and New Zealand – with some
in the US
– later last month, followed by a survey of asset consultants in June.
Gray
said at the workshop that there were nine main reasons that investors tended to
prefer active management, notwithstanding all the evidence that, on average,
this was unlikely to lead to outperformance after fees. Those reasons were: .
The tendency for people to extrapolate from the short-term past into the future
– in all other areas of life, past performance is a good guide to the future.
“You don’t go out and hire a contrarian builder,” Gray said. . Ignorance, poor
reasoning and cognitive biases.
The belief in the inefficiency of markets. .
Risk control – active managers should have lower volatility. . Knowledge
transfer. . Vested interests, such as financial planners recommending the
commission- paying investment products. . Competition with other investors, which
was “really destructive”. . Non-standard utility, including the status element
to having an active manager. . Some active management was needed in the market
to ensure efficiency. Gray said this reason was never stated, however the
market could not function if all investors were indexed.
Gray and Bird are
working on a research paper that will argue that super funds would be better
served if they cooperated more with each other on their investments and if the
funds management world had massive consolidation. Bird said that index funds
did not represent the answer for the majority of funds because they would not
lead to allocative efficiency. There needed to be some form of competition in
the investment marketplace. He believed that a solution to the problem which
would lead to optimum returns for members was to have only six or so super
funds and six to eight fund managers, which could be owned by the funds.
The
proposed paper is called “An (Im)Modest and (Un)Popular Proposal”. Bird said
that competition did not seem to work in the financial services industry. The
superannuation industry existed to service the needs of the members and to
engineer the best possible investment outcome, subject to the individual needs
of the members. However, it did not succeed in achieving its aims, he said. “There
are manifest problems with agency relationships, asymmetric information and so on
which make the members easy pickings.
The competition which we have at the
moment leads to inefficient pricing, a misallocation of capital, diminished
growth and lower investment returns.” Bird and Gray estimate that the total
cost to members of the current system is about 3 per cent a year. This consists
of a “conservative” estimate of 1 per cent cost due to inefficient pricing, 1
per cent cost due to their being too many super funds, and 1 per cent
additional cost due to agency issues, such as managers managing their own
business risk ahead of their investors’ risk.
They said to achieve its goals
for members, the industry needed to encourage “productive” competition, remove
or minimise agency costs, significantly reduce costs overall and maintain
incentives for innovation. They predicted significant consolidation among super
funds as well as managers but this was not likely to happen anytime soon
because of vested interests. Paul Woolley presented at the workshop an update
of a paper he wrote last year on the impact of momentum investing, which most
managers incorporated into their styles and processes for business reasons.
He
said that GMO survived the tech bubble, as a value investor, because about 30
per cent of its style was due to momentum. Without the contribution from
momentum it would have lost all its business because most investors would not
have had the patience to wait out the tech bubble. Woolley said that the
momentum style tended to be more active than value, so most of the trades for
GMO at the time were due to momentum and bore no relation to fair value.
Woolley’s
paper explores two of the most prominent financial market anomalies: momentum
and reversal. Momentum is the tendency for assets with good or bad recent
performance to continue to outperform or underperform in the near future.
Reversal concerns predictability based on longer performance history, whereby
assets that have performed well over a long period tend to subsequently
underperform.
Both momentum and reversal are difficult to explain within the
standard asset-pricing paradigm of rational agents and frictionless markets.
Most explanations are behavioural, assuming that agents react incorrectly to
information signals. The Woolley paper argues that momentum and reversal can
arise in markets where all agents are rational. The delegation of the
management of portfolios to financial institutions, such as mutual funds and
hedge funds exacerbates the problem.
