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Passive Investing? Low Costs, Low Quality

...says this active fund manager...

SUCCESSFUL investing involves having an edge, writes Tim Price on his ThePriceofEverything blog.

If you do not know what your edge is, you do not have one.

There are doubtless many investors who, in the absence of a general strategy, have accumulated a portfolio of sorts more or less randomly on the back of colliding haphazardly over time with motley financial opportunities, some of which have somehow appealed.

The financial media clearly play a role in bombarding their users with arbitrary investment stimuli. Robo-advice may be an improvement on random investing, but it seems to solve one problem (the presumed high cost of investment provision) by creating another (passive investing guarantees mediocre returns, or the market average return, less the cost of fees).

But there is another, more insidious, problem with passive investing, exemplified by the looming flotation of the owner of Snapchat. Snap's IPO offers the hardly alluring prospect of a share class with no voting rights at all. Individual investors are of course welcome to pour their money down whichever drains they choose. But the rise of low cost ETFs – alongside the already substantial numbers of index-trackers, explicit or otherwise – means that there will be plenty of institutional investors obliged to follow them.

The Financial Times cites Anne Sheehan, the head of corporate governance at Calstrs, the California teachers' pension fund, who points out that many benchmark-following funds will be forced to own Snap once it is included in stock market indices, whether they want to or not.

Come to ETFs for the focus on low cost; stay for the guarantee of exposure to low-quality assets.

Active management requires doing something different from the herd. One way in which managers can differentiate themselves is by focusing on what actually works. In a fascinating study by Research Affiliates, a 49 year study of performance highlights the best and worst performing strategies over the longer term for equity investing.

The best performing strategies, compared to a market capitalisation-weighted benchmark, were value, and then momentum, as shown in the graph below. (Favouring low p/e stocks seems to have been the single best factor.) Three of four 'quality' filters ended up detracting from performance – as did every single 'growth' filter. Research Affiliates concluded that 'quality' and 'growth' strategies were "non-robust".

These findings are consistent with a similar study conducted by James O'Shaughnessy in his book 'What works on Wall Street', the results of which are shown below. O'Shaughnessy selected the 50 stocks from the broad market with the most extreme 'value' characteristics (low price / book, low price / earnings, etc.) and the 50 stocks with the most extreme 'growth' characteristics (high price / book, high price / earnings, etc.) and then rebalanced each portfolio annually to ensure that only the 50 most extreme stocks were held over a period totalling 52 years.

A portfolio with a starting value of $10,000 invested in 'growth' stocks – as assessed by high price / book, for example – ended up, after 52 years, being worth $267,147. Which sounds like a good deal, until you appreciate how much a 'value' portfolio (by price / book) would have appreciated – in this case, being ultimately worth over $22 million.

The results of both of these studies are confirmed by SocGen in their analysis of the best performing strategies over the last quarter century, as shown below. Versus either 'quality income' or 'low volatility' approaches, 'value' beat both.

Given the data, why would investors favour any other approach?

Research Affiliates point to an intriguing answer: because investors, or their managers, lack the discipline, or the patience, to stay the course. Although a 'value' approach is statistically the most likely to generate the highest investment returns over the long run, it is also the strategy most likely to get a manager fired for short term underperformance:

Research Affiliates' 'Firing Rule One' amounts to firing the fund manager 'agent' if more than
50% of the funds he or she selects underperform their benchmark in a given period.

This would seem to provide yet another reason to be wary of benchmarks – namely, that they encourage short term behaviour on the part of fund managers, or clients' advisers, that is actively injurious to their clients' longer term interests.

In investment, there is a crucial difference between want and need. What many investors want, as behavioural economists have conclusively shown, is an investment approach that generates the least discomfort from the prospect or delivery of capital loss in the short term.

What most investors actually need is an investment approach that both maximises their returns and minimises the prospect of permanent capital loss over the longer term. What they need, in other words, is value investing. There is no shortage of proof. The difficulty is the inevitable pain that comes with marking to market in the short term. As the financial journalist Jonathan Davis observes:

"Periods of excruciating short-term underperformance are a burden that all genuine value investors have to endure."

But the long term returns are worth it.

London-based director at Price Value Partners Ltd, Tim Price has over 25 years of experience in both private client and institutional investment management. He has been shortlisted for the Private Asset Managers Awards program five years running, and is a previous winner in the category of Defensive Investment Performance.
See the full archive of Tim Price articles.


Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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