Fund management is traditionally thought of as picking the right stocks and timing market movements. Active fund managers look to protect and increase their clients’ investments by charting a course through market movements. This is how they earn their money, often commanding high fees for access to their abilities. The last year has seen continued political, and therefore market, uncertainty from the shock Brexit vote, to Donald Trump becoming the 50th president of the United States and the Conservative Party slump in the June UK elections. In markets like these, just like a general deciding when to attack and when to retreat, traditional wisdom suggests that timing is very much everything. But is it?
These events provided opportunities for fund managers to test their mettle and trade in and out of the turbulence. Skillful stock picking and market timing should have allowed managers to beat the market and provide extra returns to investors. But it’s increasingly obvious that this isn’t working. One decision leads to another and, if any of the decisions in the chain are wrong, there’s a domino effect that leads to increasingly worse performance. For example, deciding to sell during a downturn to de-risk and protect a portfolio means that at some point a decision needs to be made to buy again. If this timing is wrong, then portfolios often miss out on the benefits of the upturn. Adding fees to the equation only compounds the issue.
Using ‘passive’ ETFs in a portfolio can reduce costs while partially alleviating the reliance on skill: fund managers no longer have to pick stocks. But allocation decisions still have to be made. When should the ETF allocations be adjusted? When should a portfolio be de-risked and then take on more risk? Using traditionally passive products in an active portfolio doesn’t solve all the problems. It does make investing cheaper, and it does provide investors with psychological comfort, but it relies on managers’ ability to predict and / or react to markets – timing is still everything.
Is this reliance justified? Academic evidence further underlines the case against a skill-based approach to market moves. Academics such as Eric Chang and Wilbur Lewellen have argued against it since 1984. Wei Jiang also suggested in 2003 that timing markets is a chancy game. Sparrows Capital have looked closely at this issue and have found data that is even more pessimistic. Recently, we reviewed the performance of several third-party managed portfolios and compared their performance to that implied by their strategic asset allocation over eight to ten years. Even before fees and charges are taken out, performance is just not up to par. More surprisingly, the single largest component of shortfalls has been managers’ intentional deviations from the agreed risk profile through tactical asset allocation and risk reductions. In other words – timing the markets.
Since January, a low-risk, passive portfolio, expressed in dollars, has produced 10% returns. In pounds sterling, that’s even higher at 25.2%. However, if we look at the performance of a hybrid active fund such as the 7IM AAP (Asset Allocated Passives) Balanced Fund, we see a return of only 12.5% in sterling terms. Even worse, it underperformed its own benchmark by 1.2% in the process. This suggests a simple conclusion: a true ‘passive’ investment strategy, which follows strict rules and risk allocations, will deliver the market return and can outperform actively managed ETF portfolios. In other words, timing isn’t actually everything.
Derived from an actual investor portfolio, from 1st January 2016 to 30th April 2017. Performance in USD and GBP, net of all fees and costs. Balances provided by the custodian, Goldman Sachs AM. Past performance is no guide to future performance and returns may increase or decrease as a result of currency fluctuations
This doesn’t mean that there is no skill in passive investing. Properly constructing a passive portfolio must begin with a high-level risk allocation focused on the investor as an individual. A granular set of indices representing the relevant investable universe will then form the benchmark for measurement of performance. The ETFs and index funds that track the benchmark must then undergo a screening process that looks at methodology, tracking error, liquidity, costs, tax efficiency, structure and counterparty risk.
When considering a passive approach, that assessment and screening process is where the adviser earns his money. Ensuring the right skills are used to create and regularly rebalance the portfolio is crucial to delivering the full market return.
Mark Northway is an investment manager at Sparrows Capital
Fixed income disruptions