Why it’s even harder for active investors to maintain their discipline
Fund house marketers know just the right buttons to press and when to press them. This is not to judge them — they’re only doing what their counterparts in almost every other industry do — but they play on investors’ emotions. And right now, they’re trying to profit from fear, or at least a general unease that people are feeling about quite how long the bull run in global equities, now in its tenth year, can continue.
The impression they like to give us that in this time of “uncertainty” (the fact is, of course, that there’s always uncertainty), what you need is a fund manager with a proven track record, who can position themselves accordingly and minimise any losses when markets fall.
Messages like that are misleading on a number of levels. For a start, fund managers are notoriously inept at correctly calling a crash or correction. Either they call it far too early, as many have over the last nine years, missing out on large gains; or they don’t see it coming at all, which is pretty much what happened in 2007-08.
The idea of so-called “downside protection” is a marketing myth as well. The evidence shows that actively managed funds tend to fall just as far as passive funds, if not further, in a market rout. Of course, there are some active funds that don’t fall as far, but that’s often down to the fact that most of them hold an element of cash, which is hardly a reason to use them.
Then there’s the notion that investors in active funds are more likely than indexers to stay the course, especially during periods of market volatility. In many ways, in fact, controlling your emotions and sticking with your chosen strategy is even harder for active investors than it is for passive ones, as the behavioural finance expert Joe Wiggins explained in an excellent recent article.
Joe works for Standard Life Aberdeen and the writes an excellent blog called Behavioural Investment. What makes it so readable is that, for a blog that’s written by an active manager, it’s refreshing honest. There’s none of the usual blah about the benefits of active management; on the contrary, he often writes about its shortcomings, and why investors who choose the active route often end up with disappointing outcomes.
Joe wrote the other day about what he calls “the paradox at the heart of active management”, which is this. To justify their existence, active managers need to take a contrarian and high-conviction approach. But “the more genuinely active a strategy is the greater the likelihood that it will experience spells of pronounced and often prolonged underperformance, which will be unpalatable for many investors”.
Joe then gives an example of a fund that outperformed the market by an average of more than 4% a year over a 20-year period ending in 2007. By any standards, that’s an extraordinary outcome. The problem is that, across rolling one-year periods, the fund underperformed its benchmark on 34% of occasions. In 17% of the rolling one year periods excess returns trailed the index by more than 10%.
In other words, in order to reap the benefits of the fund’s long-term outperformance, investors would have had to resist the temptation to bail out time and time again.
Simply put, profiting from active investing is extremely difficult. First you have to identify, in advance, a fund that’s going to outperform the market for a very long time, which is no mean feat. But secondly, you also need to stick with that fund when it’s underperforming, when the manger’s investment style is being scrutinised in the media, and when other investors are deserting the fund in their droves.
So, even if you pass the first test and succeed in picking a long-term winner — and only around 1% of funds fall into that category — it will all come to nothing if you fail the second test.
This is a side to active investing that isn’t talked about nearly enough. Fund house marketers and financial journalists naturally tend to focus on the very few “star” managers who have good, long-term track records. So we hear, for example, about Neil Woodford and his record at Invesco Perpetual up until 2014 (or at least we did until the dismal run he’s been on over the last few years). What tends to be glossed over are all those investors who jumped ship at times when Woodford looked anything but a star and his funds seemed dead and buried.
Fidelity Investments conducted a study on its Magellan fund from 1977 to 1990, when Peter Lynch was in charge. His average annual return during that period was 29%, which makes him one of the most successful active managers of the modern era. You would have thought that investors in the fund enjoyed substantial returns, and yet, shockingly, Fidelity found that the average Magellan investor lost money during Lynch’s remarkable winning run. In other words, whenever the fund suffered a setback, money would flow out, and when it got back on track, money would flow back in, by which time investors would have missed the recovery.
Here at RockWealth, we’re no fans of active management. Unless we see a huge reduction in fees and charges, there really isn’t a case for paying for it at all. But, for those who do use, active funds, then dipping in and out of them, and constantly looking for the latest star is about the worst thing they can do.
Thank you, Joe, for your wisdom and, most of all, your honesty. Active investors might at least stand a sporting chance of a half-decent outcome if they read more blogs like yours.