One dark evening in October 1994, I was standing in a small meeting room that faced on to Fleet Street, waiting for my last interview before I could escape into the rainy streets. Then a young trader strode in and asked me an unforgettably difficult question: why should Goldman Sachs — for that is where I had applied for a job — bother to spend money training a raw graduate like me to become an investment analyst when it could probably make better returns with a trading programme run by a computer?
In light of the awful performance of the investment management industry over the last year and a half, that question has particular pertinence today. It has been debated among finance professionals and academics for many years. Is it worth taking an active approach to investing and trying to beat the market? Or is it better to take a back seat and be content with the returns it provides?
The outlook for equity markets has recently improved, with both UK and US indices rising substantially since March. This move out of the financial doldrums has tempted investors to dip a toe in the waters. But the recovery is fragile and there remain huge doubts about the economic outlook. So those investors who are prepared to invest are going back to basics. And that means re-visiting tough questions like the one I was asked in that small office so many years ago.
For retail investors, the safest active approach to managing your pension or savings is to spread your money around a number of fund managers, rather than trying to pick the stocks yourself. But advocates of passive investing say that it is not even worth trying to pick the right fund managers: it’s better simply to invest in the equities market through a fund that tracks the index.
Gary Reynolds, director of the wealth management firm Courtiers, says: ‘I very much favour passive over active investment. Virtually all academic studies show that active mandates fail to beat passive mandates due to costs or additional risks.’ Andrew Wilson, head of investment at Towry Law, agrees: ‘Active managers have a poor track record, whether in equities or bonds. Even if they manage to generate higher returns than the market from time to time, they rarely manage to do so consistently, year in, year out.’ Statistics on recent market performance certainly support those views. The research firm Morningstar says that, on average, actively managed funds in the UK declined by 20.7 per cent over the past year, worse than the performance of the FTSE 100.
Hedge funds are the pinnacle of active management, aiming to generate higher returns than the market with the use of strategies that include going short, trading derivatives and using debt leverage. They are also able to invest across a wide range of markets, including commodities and foreign exchange. So if anyone can beat the market, it should be the hedge funds. But according to Research Affiliates, their performance was dismal in 2008, with returns sliding by 21 per cent — almost the same as traditional funds that are conservatively invested 60 per cent in equities and 40 per cent in the bond markets. Wilson says: ‘The outlook for some hedge funds is much better this year than last year. But the hedge fund spell has been broken. Investors now understand that they cannot produce better returns than the market every year.’
The active management route also costs more than passive investing. Fund managers have to be paid to pick the right stocks and this is more expensive than setting up a fund that tracks an index through a computer programme.
According to Morningstar again, the average fee paid to an active fund manager is around 1.5 per cent. That doesn’t sound that high but it has to be balanced against the returns active managers are able to generate. If a manager generates returns of 5 per cent, the investor receives only 3.5 per cent. Fees for passive investing, by contrast, can be as low as 0.4 per cent.
Passive investing is a relatively new phenomenon but one that is growing rapidly. Iain Stewart, fund manager at Newton Investment Management, explains: ‘In the past the only way to invest actively was either by buying individual stocks or buying into investment trusts or retail funds. But then technological developments allowed people to invest in indices rather than individual stocks or funds.’
In recent years the introduction of new instruments known as exchange traded funds has made passive investment even easier. Tim Mitchell, UK head of ETF sales at Invesco Perpetual, says: ‘ETFs do not cost much and are easy to buy and sell, so investors can be active about when they buy and sell the market.’
Many finance professionals believe that this crisis really is very different to anything we’ve seen in recent years. ‘We’re now into the biggest cycle that we’ve seen in the postwar period. We have governments intervening in the markets in ways that have not been seen before and massive deleveraging around the globe. If that environment does not cause longer-term economic and financial market volatility, I don’t know what would,’ says Stewart. He believes the global financial crisis has caused a fundamental shift and that markets could remain volatile for long periods.
In these difficult market conditions, a skilled fund manager should be able to excel. There are still excellent investment opportunities out there, and those with the ability to spot bargains will be rewarded over the longer term. There are hundreds of funds available to UK investors and the managers of every one of them believe that they will be able to beat the market — but that’s statistically impossible. So how does an investor go about choosing the managers who will generate the best returns?
Most investment professionals believe the average private investor shouldn’t even try. Nico Marais of Barclays Global Investors says, ‘An investor should always ask themselves: “How much skill do I have when it comes to picking a fund manager?” If the answer is “Not much”, then don’t try. The less you know, the more you should tend towards the conservative end of the market and opt for investing passively.’
Wilson agrees: ‘Picking the right active manager who will do better than the market is incredibly difficult to identify in advance. Even after the event it can be tough to work out if they achieved their returns through luck or judgment.’ He also believes that trying to pick a fund manager based on past performance is a terrible idea. ‘The worst thing an investor can do is to choose a manager who has beaten the market in the past. It would, in fact, be better to select a number of funds that have been down badly in the past.
‘Even though the market has rallied from its low in March, stock markets are substantially below their highs. Investing passively will at least guarantee that an investor will benefit from the eventual recovery,’ he adds.
Marais and Wilson’s advice would have come in useful all those years ago when I was asked that difficult question by a young Goldman Sachs trader. It may have taken almost 15 years, but at least I’m now a little closer to an answer.
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