Most people manage to hide from their own failure, so pity the poor fund manager, whose every wild blast is measured in unforgiving performance numbers. Between 70 and 80 per cent of fund managers have underperformed a passive index over the past five years, a ratio known as the slaughtered three quarters.
Fund managers are exposed by two things — their performance is quantified on a daily basis and there is a non-human alternative to compare them against. This is not the case with a politician or a policeman. Computers are getting better than us at an awful lot of things; the choice between human or computerised investment has implications well beyond the financial profession.
But before we write active managers off entirely, what about the successful 20 per cent? When searching for a good active manager you need to know the types of creature you’re dealing with. First up, the closet indexers, who deliver performance that is suspiciously similar to the index but charge higher fees, thus ensuring mild but continual disappointment. These are a con — a supposedly active fund that really is no such thing. Closet indexers are either clueless investors running with the herd or, more sinisterly, competent investors who have got too greedy. If they’re running too much money in their fund, it is hard for them to buy any but the largest stocks, thus achieving returns that are little different from the blue-chip-dominated indices.
Next up, the asset allocators. These are ‘top down’ investors who get their ideas from changes in macroeconomic conditions. The choice of stock is secondary: their thinking is driven by views on a country’s economy, a central bank policy or an industrial sector. The problem they face is that there are many more variables in the economy at large than in a single stock, so it is almost impossible for them to predict correctly.
If you are searching for an effective active manager, then your best bet is to find a good stock picker. Independent, omnivorous, with no fixed idea of what food he will find, he is keenly aware of the pools of probability in the undulating landscape around him.You can identify him by the high active share of his portfolio (the degree to which he differs from the index): a collection of companies selected solely for their individual merits and limited fundamental risks. And as a stock picker should be, he’s picky: there will rarely be many of these companies and he won’t often trade them. Unlike the asset allocator, he deals with few variables and only those he can understand. The average performance of stock pickers is better than the other two groups and the index, even adjusting for fees. Your chances of success are better.
Yet the most unusual thing has happened. Although you would expect most managers to be stock pickers, this is no longer the case. In 1980, 60 per cent of fund managers were stock pickers and 40 per cent asset allocators. As index funds have (quite rightly) risen, so have closet indexers: the latter are now 30 per cent of the crowd with stockpickers having fallen to a mere 28 per cent. Active management is failing because much of it isn’t really active. One reason for this is greed; the other is the slavish acceptance of modern portfolio theory, which says you should buy the machine as humans cannot hope to win.
Index trackers are a rather lazy, first incarnation of the machine which work on a scorched earth policy: just buy everything. This is still worthwhile because it’s cheap and humans aren’t investing properly anyway. A new Terminator is in the works, however, in the form of ‘smart beta’ strategies which weight their buying towards securities with certain quantitative characteristics. What machines takes out of the equation is human psychology. Anyone who managed money in 2008 knows the weakness of human nature at a time of crisis.
What the machine lacks is qualitative judgement. It cannot form the intellectual mosaic that allows a stock picker to judge the strength of a company’s competitive advantage, to map the changes in an industry or detect the hand of a crooked accountant. Warren Buffett claims barely to use quantitative criteria: he looks at underlying business characteristics, not a spool of numbers.
Humans need to absorb the best of what computers contribute — methodical checklists, the ability to override emotion in ‘hot scenarios’ — while cultivating the qualitative judgments that only we can make, and small-scale expertise. It’s time for the humble stock picker to make a comeback.