Jack Bogle once described fund management as an industry built on witchcraft. OK, even I would admit he was being a little harsh there, but you can see the point he was making.
Those who manage, sell or advocate using active funds have a vested interest in giving them an air of mystique. What you’re paying for is some unique skill or insight which, they like to imply, will deliver long-term value over and above the market return, even when all the costs entailed are taken into consideration.
To simplify things a little, the industry calls this outperformance alpha — as opposed to beta, which essentially encompasses passive investing or index-tracking. Alpha, if you like, is the active managers’ secret sauce. Or at least in theory. As most people reading this already know, the reality is rather different.
To put it mildly, the active fund industry is under the cosh. The data consistently shows that only about 1% of active managers deliver alpha for any meaningful period of time, and that, as Warren Buffett continues to remind us, the vast majority of investors would be better off keeping their costs down and sticking with beta instead.
I’m certainly not anti-active as a matter of principle. We need active managers to help set prices. So what’s the way forward for active management?
John Authers explored this question in a recent article for the Financial Times. In it he puts his finger on what, for me, is the fundamental problem, namely that active managers’ secret sauce really isn’t a secret anymore.
For more than 50 years, academics around the world have been working to identify the factors that drive investment returns, of which market risk is the most obvious. Other factors include size (small stocks tend to beat large ones), value (cheap stocks beat expensive) and momentum (recent winners tend to keep on winning). To those four factors, Eugene Fama and Kenneth French have recently added a fifth, profitability or quality (that is, companies with strong and consistent earning power tend to outperform).
Those five factors combined, Fama and French have calculated, account for “between 71% and 94% of the cross-sectional variance of expected returns”. In other words, take away those factors and there’s very little alpha left.
The good news for investors is that they now have a wide range of funds to choose from that enable them to capture all of those risk premiums if they want to. Most tend to call this smart beta, although I personally prefer the term alternative beta. The crucial point is that alternative beta funds generally cost a fraction of what you can expect to pay for actively managed funds.
We’re currently seeing a large shift towards alternative beta and, not surprisingly, fund management companies have been quick to capitalise by offering all manner of factor funds of their own.
It begs the question, though, as to how fund houses are going to justify offering both active and alternative beta funds. Why would anyone want to pay a total expense ratio of, say, 175 basis points for active when you can build an alternative beta portfolio for more like 25 or 30 when, in theory, the two types of funds are essentially doing the same job?
This is a big problem for the active fund industry, and I agree with John Authers that it requires a radical solution. Fund houses, in short, need to reinvent active management. Consumers would be better served by far fewer fund managers, earning far less money and (I would hope) offering rather more value than they do at the moment.
In particular active managers need to start looking beyond public markets altogether, and focus instead on areas like real estate, infrastructure or forestry, and also on private equity, where there is more potential to identify value that is not already in the price.
For the people who worked in it, the golden age of fund management was great while it lasted. But the game’s up and the secret’s out. It’s time to adapt or die.