• Stuart Fowler

Six degrees of implausibility

Most private clients must implicitly believe that investment managers are sufficiently skilled to have a decent chance of beating markets (and therefore index trackers) over time and by enough to exceed the post-RDR cost difference between trackers and active funds of around 0.6% pa. After all, the vast majority invest in actively-managed funds or hire managers that themselves select securities. This is an expensive belief and it needs to be made explicit, or let go.

RDR, by separating advice costs from product costs, reduced the bias in the advice industry to actively-managed funds, a bias resulting from the fact that it was mainly the active funds that paid the advice cost as a commission to the adviser. So the passive share is creeping up to around 20% but is still about half the equivalent share in institutions, where no such bias existed and where investors thought harder about the chances of making up the cost hurdle of active management. This was never a case of ‘the vast majority can’t be wrong’ because that was not how the majority was formed or sustained.

When you disaggregate the different activities that need to succeed for active management to be rewarded as a skill, rather than being simply random, it becomes clearer why it is implausible and why 20% should expand and the majority should let go. There are in fact six degrees of implausibility.

  1. For a portfolio manager to beat the market, he or she needs to be able to make good forecasts of the economic influences on equity markets.

  2. That then needs to be translated into good forecasts of the impact on individual companies’ trading performance.

  3. To turn that into better forecasts of share-price performance requires a correct estimate between the difference between his or her own view and the aggregate opinion of other investors that is already reflected in the current share price.

  4. The final requirement for outperformance is to turn a set of broadly correct opinions about a large number of share prices into the right particular construction of relative weights: differences in exposure to each relative to the proportion each represents in the index.

  5. These are the activities a fund manager needs on balance to succeed in, if they are skilled. But somebody else has to be skilled enough to identify the skilled fund managers and separate skill from luck. That could be a wealth manager, fund of funds manager or financial adviser. But what about the client himself or herself? Don’t they need the same or similar skill in order to identify whether their appointed agent has the right skill?

  6. Finally, each activity will be tested by the way information comes at us about earlier selections, including stuff that looks like it is information but is really just statistical noise. How each agent reacts to that noisy information flow, which is subject to significant emotive pressures (has the manager lost his touch or did I simply make a mistake? will I avoid compounding an error by doing nothing? will I look stupid to the client if this shows up in the ‘dog’ funds list?) will determine whether all five selection skills can be turned into sustainable outperformance for your own portfolio.

Nearly 50% of institutions in the USA and UK have opted out of the six degrees of implausibility. Can we single out any one level of implausibility that was decisive in explaining the shift to passive? I would like to think it was both 5 and 6: the realisation by the end investors that decisions they themselves made (hiring and firing managers or putting their managers under perverse performance pressure) were not only ‘unskilled’ but were actually making matters worse. Opting out therefore reduced their own capacity to harm performance.

Importantly, this insight is independent of whether or not there are managers who can deliver the skills in 1 to 4. The academic debate, whether practical or theoretical, over whether active management is a skill is just that, academic, if turning the security selector’s skill to advantage presumes an equivalent skill on the client’s part. To most clients, who don’t appear to rank this like their driving skills, that is the least plausible of all.

#activemanagement #investmentprocess #performance #rdr #trackers


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