Investors are angry. Regulators are in the firing line.
And some ‘brokers’ have many questions to answer. Over the coming weeks and months (and possibly years) the story will rumble on.
We seek stars for comfort, celebrity, wisdom and because they are specialThe damage caused is widespread – across the whole financial services value chain. It is not a good day for any of us.
But I want to focus on the nature of star managers more widely.
Key points
- Performance should be judged over the long term – not based on who is currently considered a ‘star’
- It could take 11 years to prove a manager had skill
- The FCA requirement for fund boards to have non-executives is a step in the right direction
In June 2015 the BBC ran a story headlined ‘Neil Woodford: The man who can’t stop making money’.
What should be the rather boring subject of investment management was making headlines. As be seen from the chart, it did not go to plan.
We seek stars for comfort, celebrity, wisdom and because they are special. They are not.
They are human, fallible, driven by ego, sometimes lucky. Good fund management is dull, studious, steady and rather boring.
So what are they, why we fall in and out of love with them and how can we avoid falling for them before it goes wrong?
What is a star?
Should a fund manager who was trying to deliver 2 per cent or 3 per cent a year outperformance really be a considered a star if they deliver 5 per cent?
No, they have failed (luckily on the upside – but it could have equally been on the downside).
Always be aware that if a fund has outperformed by 10 per cent by getting the “bets” right, it could equally have underperformed by 10 per cent if they had been wrong.
Turn the ‘performance’ chart upside down if you want to see the ‘risk’ chart.
One assumes most investors are trying to achieve growth in their assets or income, above inflation, over a very long period, from age 65 to 90 for example.
That does not require a fund manager to try to shoot the lights out.
We measure stars over three or five-year time horizons – yet are seeking returns over 10 and 20 years or more.
Consistent and steady would seem to be the watchwords – a long way from being a star and being ‘exciting’.
We need to recalibrate. We need a long-term plan – 20 years or more, instead of worrying about who is going to be a star manager for the next year or three.
We need to be clear about what we need from our portfolio.
Then we can build and monitor the whole portfolio over longer periods to see the results.
The industry needs to help with this recalibration. Assets will be stickier, and outcomes aligned to needs.
How many stars are there?
There are not many. According to Morningstar’s recent European Active Passive Barometer they found “over the 10 years through June 2019, active managers’ success rate was less than 25 per cent in nearly two-thirds of the categories surveyed”.
There is no doubt that, looking at the performance tables (on a risk-adjusted basis), some managers have outperformed and done it consistently. But you have probably missed it.
Some studies have suggested it would take 11 years to prove a manager had skill (with a 95 per cent confidence level). It is a long-term occupation and too many managers moved on within the 11 years.
What to look for
A simple set of requirements would seem to do the trick.
- What did the fund manager set out to achieve?
- How did they plan to achieve it?
- What did they actually achieve?
- How did they achieve it?
- Do all the answers tally?
And for the next year, do the same again. This is painstaking, dull stuff – perhaps best left to independent experts.
And when the answers or outcomes do not tally; when the returns are too high or too low; when the outcomes are not what the inputs suggest, it is time to reassess.
What next?
The new Financial Conduct Authority requirement for fund boards to have non-executives is a step in the right direction: someone who is an expert now has some skin in the game. This cannot come soon enough.
It might be in time that UCITS regulations are changed to ban illiquid investments from daily priced vehicles.
That seems draconian. So perhaps we need to only allow illiquid holdings only in monthly dealt vehicles. At least the liquidity risk would be clear.
The rise of passive investing is growing – in part because it is hard to find that elusive, consistent active manager, and in part because of the additional costs of active managers.
Perhaps a blend of active and passive funds is best? Identify those asset classes where active managers have the best record of success and spend your risk budget there.
But if you do not have the time and resource, perhaps passive is the right route.
The fundamentals
It will be too late for some – though many retail investors comments are measured and realistic – but here are some thoughts about long-term investing that might be useful:
- Risk and return are correlated – bigger returns don’t come for free.
- Due diligence is dull and time-consuming.
- Time and money spent on truly independent, expert advice pays dividends.
- Diversification reduces risk.
- Without risk there is no excess return – make sure you understand all the risks you are taking.
Humans seek and create stars. We want celebrity and short-term wins.
But investment is a dull, long-term pursuit. We need a clear plan: sensible long-term objectives and cold-hearted objective due diligence from an independent source.
The Woodford saga is a tragedy. Thousands of investors were burnt and may never return.
The reputations of authorised corporate directors and others will come under scrutiny. Many investors and commentators have learned about a new risk: liquidity. It is a bad period for all our futures.
But it is important to remember, the answer is not in the stars.
David A Norman is chief executive of TCF Investment
