The active versus passive management argument is one that never seems to go away and last week was reignited by research published by Inalytics. According to Inalytics, a specialist firm that helps pension funds to select and monitor equity managers, fund managers typically get only half their decisions correct.
The research, based on examination of 215 long-only funds worth a combined $152 billion (£99 billion), found that the average manager’s ability to identify winners and losers was no better than 50-50.
Put simply, managers would do no worse by tossing a coin.
The finding adds weight to the verdict of Burton Malkiel, an economics professor at Princeton University in New Jersey, that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by the experts”.
Proving that statement true was not the purpose of the Inalytics research. In fact, says Rick di Mascio, the chief executive and founder of Inalytics, the intention was to answer the “perennial question about whether track records are ‘down to luck or judgment'”.
Di Mascio says: “Track records tell you about what happened in the past, but all experience shows they are poor guides to the future as they tell you little about the skills that generated the results, or if they are likely to be repeated in the future.”
The Inalytics research looked at two measurements of fund manager skill: what it terms the hit rate and the win/loss ratio. The hit rate shows the number of correct decisions as a percentage of the total number of manager decisions. The win/loss ratio is a comparison of the alpha generated from the good decisions with the alpha lost from poor decisions.
To judge these, Inalytics daily analysed every purchase/sale, underweight and overweight decision made by the fund managers.
“The industry maxim suggests that six correct decisions out of 10 would constitute solid performance,” says di Mascio. “However, we did not find one manager who got six out of 10. The average was five out of 10 (49.6%) and the really good managers only managed to get a 53% hit rate, which was a surprise as we expected the best manager to be a lot higher.”
However, to compensate for this poor hit rate, di Mascio says, the average manager is able to generate good gains from “winners” to offset the losses from “losers”. According to the research the average win/loss ratio was 102%, which means the alpha gained from good decisions was 2% higher than that lost from the poor decisions.
“The good managers had a win/loss ratio of 120%, with the best getting up to 130-140%,” says di Mascio. “This is where all the skill comes in, running your winners and cutting out the losers. It’s what differentiates the also-rans from the best. There is nowhere to hide with these numbers.”
James Norton, the director of Evolve Financial Planning (which only offers clients passive funds), finds the research interesting because it analyses individual decisions of fund managers rather than the final results.
“There is ample academic research about that suggests all of us, not just fund managers, have an overly optimistic opinion of our own ability,” says Norton (pictured, top). “There is also a lot of evidence that markets are efficient.
“At Evolve we do not avoid active funds because we think fund managers are stupid; it is the opposite. There are so many bright people working in the industry with amazing tools that trying to extract value additional return is very hard.
“The hit-rate research from Inalytics seems to confirm this with a ‘success’ rate of less than 50%. The win/loss ratio suggests that managers are adding some value within their decisions, but the average of 102% is very low. Again this is surely an indication of efficient markets.”
Bob Yerbury, chief investment officer at Invesco Perpetual, says he is not surprised by the 50-50 hit rate. But he makes the point that active management can only truly work if the manager takes a long-term – that is over five years – investment perspective.
“Over short time periods the probability of losing money in the UK equity market is relatively high, ” says Yerbury (pictured, above). “Anyone with a one-week investment time horizon would find that he lost money 42% of the time over the period January 1, 1965 to September 30, 2008. Even on a one-year view the probability of losing money is one in five. There were no 10-year time horizons over that period, however, where equity market returns were not positive.”
To this extent Yerbury says looking at short-term track records tells you nothing of the skill of an active manager because performance can be dictated by random events.
Norton agrees. He says: “It is easy for a manager to be in the top quartile over three to five years through luck alone – mean distribution would suggest that you will get some managers who do outperform for extended periods. I would suggest that unless figures for the win/loss ratio are going back over more than 10 years for any single manager, the answer is probably lucky rather than good.”
To be a successful, Yerbury says managers and the groups they represent, have to tolerate certain positions not working for periods of time.
“This can be difficult because businesses like to see year-on-year gains,” he says, “but to be successful you have to tolerate one to two years of underperformance if the manager has a clear investment policy.”
He adds: “That is why we think it is crucially important to be able to explain the factors behind an investment decision – and to be able to enunciate these clearly even in the face of potential adverse market movements.
“Some claim, of course, that an emphasis on long-term performance is often little more than a camouflage for poor short-term performance. Certainly, for some fund managers that may be true, but it is not the case for us.”
Yerbury says while the group’s long-term investing can be demonstrated by past performance, he notes this is not a guide to the future.
According to di Mascio the real point is that track records may come and go but a manager’s tendencies are more persistent.
“In general [according to Inalytics research], managers are good at buying and going overweight but poor at selling and going underweight. Hit rates and win/loss ratios are a very effective way of identifying these tendencies.”