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mso-bidi-language:#0400;}Dear Editor,

Jack Gray and myself were disappointed
in the general tenor of the cover story last month on passive versus active management
and annoyed by some of the views expressed. Therefore, we would like to take
this opportunity to “correct” some of these views. We have restricted ourselves
to those that we think are most important which we will address in the order
that they appear in your article:

1. The proposition on page 17 that the
markets this time “overshot the downside”. It is not clear who should be attributed with this
observation but it is a huge call typical of those made by individuals charged
with selling active equity management. It would indeed be “different this time”
to what we experienced in the two periods for which we have data which are most
equivalent to the current situation – the 1930s and the 1970s when we both
experienced several nonsustained bounces undoubtedly driven by encouraging (but
probably biased) views such as that expressed in the article.

2. The
questioning of the proposition on page 17 that active managers tend to
outperform (underperform) in falling (rising) markets. Bird and Gallagher
(2002) establish this to be the case across (almost) all of the developed
equity and bond markets, largely reflecting that managers hold cash and so run
portfolios with a beta of less than one. There may be exceptions to this but it
is a useful proposition to which to adhere.

3. The proposition first mentioned
on page 17 but consistently made throughout the article that this is a “great time
to be active”. The basis for this proposition being that conditions are likely
to result in us experiencing greater dispersion of active returns in the immediate
future. This ignores the point made a zillion times by Bogle that active
investing is by construction a zero sum game so only the “winners” will produce
a sizable alpha which will be offset by the large negative alphas experienced by
the “losers”. In other words we are in a period when active investment is more
risky from the viewpoint of the client.

4. It is suggested that we have some
type of panacea in the form of fundamental indexing (“Beta prime”). Rob Arnott
and others have shown that using other weighting systems to market
capitalisation when forming “passive” portfolios produce superior returns. The
reason being that markets are inefficient and hence so are cap-weighted
indexes. The existence of these inefficiencies provides a necessary but not a
sufficient condition for active management. Asness and others have questioned whether
these inefficiencies are best exploited using a dumb and expensive technique
such as fundamental indexing.

We would support this view and suggest that
fundamental indexing is just another fad that is being oversold. I will now
turn to the important issue that we are addressing in our research “Why
Passive?” As is correctly pointed out in the article, we need active
(information-base) investors to obtain efficient pricing. However, as Grossman and
Stiglitz (1980) rightly point out, we have an anomaly in that active investing
is costly and there is no incentive to pursue this form of investing if markets
are perceived as being efficient. As such, those employing active managers might
be seen as doing a public service by meeting the costs of active management with
no recompense but in the process contributing to market efficiency.

The problem
being that the competition between active managers is not working with the
current institutional structure contributing to large and persistent, relative
and absolute mispricings (Bird et al, 2008) which contribute to capital
misallocations resulting in lower economic growth to the detriment of all of
us. You acknowledge in your article the need for asset managers but currently
they are not delivering. The one conclusion that we have slowly reached over
the last 40 years is that just about all of us (professionals and otherwise)
have no idea about what an equity security and equity market is worth.

Unlike
other assets, this valuation is at the mercy of thousands of events that will
evolve in the future about which we have traditionally shown little forecasting
ability and, even worse, the processes that we follow have gradually taken on
almost ensure that on average we will be wrong most of the time. Of course,
this does give rise to opportunities but only a handful of individuals and
quantitative processes have been able to demonstrate that they can effectively
exploit them. As many have acknowledged in the past, our industry is one of the
greatest “trust me” industries that exist but it has done little to justify
this trust.

This brings us back to the focus of our research as to why investors
have a preference to pursue active management. It is unlikely to be explained
by the philanthropic (but misguided) motives alluded to above. It is unlikely
to be explained by the pursuit of a very focused objective of maximising the
wealth of the individual to whom the funds belong. We look forward to reporting
our findings on what motivates people to pursue active investing and wish to
acknowledge the assistance of many of your readers by responding to our survey.

It would be remiss of me to conclude without briefly turning to some related
but more important research that we are conducting at the Paul Woolley Centre
for Capital Market Dysfunctionality. The above discussion points out that the
current environment within which active management operates is expensive – we
estimate that it reduces returns by about 1.5 per cent p.a.

We also point out
that other forms of over-servicing in the industry costs us another 1.5 per
cent p.a. Our research suggests that most of these costs could be avoided if
rather than competing to outperform each other; investors cooperated with their
objective being to maximise the size of the pie in which we would all share equally.
We believe that it is this much wider issue that we challenge you to debate,
but recognise that it is not in the interest of the majority of your readers to
do so.

 

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