Chris Gilchrist: ‘Real’ investment will defeat the paper shufflers

The remorseless advance of the passive investment movement (for such it is, complete with creed and prophets) leaves active fund management businesses with a dilemma.

In theory, they would prefer to fight and claim that their various styles of active management can and do deliver superior outcomes over the timescales that matter to investors.

But for the industry giants, this simply is not possible. The asset-gathering greed of generations of managements required the creation and marketing of funds which seek to generate returns a per cent or two above a selected benchmark index.

This was, from the outset, a policy designed for marketing success and investment failure. Fund managers who spend their time constantly trying to “anticipate the anticipations” of the market will inevitably fail.

All mechanistic processes and filters said to help fund managers “beat the index” will be devalued: If the machine can do it, let’s pay a machine price please. The argument that vast amounts of intellectual firepower are embedded in the algorithms just does not wash in the internet age.

Today, everyone knows the painful truth that, if the marginal cost of delivering a service is zero, its price will also converge on zero. The oligopoly of retail fund management has resisted the trend but regulators finally appear ready to add to active managers’ pain with much harder cost disclosures.

There is a line of defence for the active boutiques. They can remain independent and become elitist, a touch arrogant and “reassuringly expensive”. The likes of Artemis, Lindsell Train and Baillie Gifford should be able to pull this off with some style. On the other hand, boutique purveyors of “smart beta” will probably fail with this image trick and the passive giants will find it easy to eat their lunch.

Is there space between active boutiques and passive giants for mass-market active fund management businesses? Perhaps, but it is unlikely to be established firms that fill this niche; just as it was not carriage makers who ended up making horseless carriages.

It seems a credible prediction most active fund management businesses will die slowly like beached whales. They can still deliver handsome annuity-type returns to shareholders because they do not need to invest in their businesses.

The bigger their historic fat-margin book, the more compelling this model becomes, although I expect most firms to deny this is the only plan they have got. Watch headcount and investment spend as indicators of reality in contrast to their waffle.

It seems a credible prediction most active fund management businesses will die slowly like beached whales.

Behind these trends is a bigger one; nascent but sure to grow exponentially over the next decade: real investment. Most of what the professionals call investment (active or passive) is what Keynes dismissed as games of Snap or Old Maid, in which players shuffle paper around with no net benefit to society.

In contrast, venture capital trusts, enterprise investment schemes and crowdfunding put new money to work to generate wealth and rising living standards. That is a beneficial trend but the paper-shuffling whales deserve to die. Nobody will miss them.

Chris Gilchrist is director of Fiveways Financial Planning