Sacrificing Some Sacred Cows

Certain combinations of words can be virtually guaranteed to lower the spirits. One thinks of constructions like “Michael Winner”; “diplomatic solution”; “Ricky Martin”; “Big Brother” (the Endemol incarnation, as opposed to George Orwell’s). To which grim list we can now add “academic studies” and “the wisdom of pension funds”.

In a letter to the Financial Times, investment manager Evan Salway alludes to the futility of academic studies when contemplating the benefits of active versus passive management. He goes further and cites the debatable wisdom of those pension funds who, having largely ignored the biggest equity bull market in history (1982-2000), finally took the plunge – at the start of 2000 – and cheerfully switched out of bonds and into stocks just in time to a) get hosed by a catastrophic bear market in stocks, and b) miss out on a monster rally in bonds.

Mr. Salway points out that while academic studies of active versus passive management may suggest that the average active manager underperforms, such studies can easily be challenged, not least because they tend to focus on long-only investing. But regulators have made it increasingly easy for active managers to sell short as well as trudge along the long-only treadmill. It is difficult (though not, sadly, impossible) to believe that there are investors out there who cling resolutely to the “long-only is best” school of guaranteeing sub-optimal investment returns. He also suggests that with much corporate newsflow pointing to the adoption of passive management by pension funds,

“at such an inflection point in capital markets when choosing between active and passive on a historical performance basis, it is [perhaps] just as dangerous as choosing between equities and bonds on that basis in 2000.”

To descend to the ‘policy out of the rear-view mirror’ level of pension funds for just one moment, a comparison between the benchmark hedge fund index and the benchmark global equity index makes a striking argument in favour of the former. Between 1994 and 2008, hedge funds – as represented by the CSFB / Tremont hedge index – returned an annualised 10.7%. Stocks – as represented by the MSCI World index – returned an annualised 6.3%. The data haven’t been arbitrarily “fixed”: the Tremont index doesn’t go back beyond 1994. Not only did hedge funds, in aggregate, deliver 68% higher returns per year – after fees – than stocks, but they did so with significantly lower drawdowns. Hedge funds’ worst period historically (July-October 1998) incurred a drawdown of 13.8%. That is shorter in duration and shallower by comparison with the 30-month drawdown of 48.4% suffered by the global stock market between March 2000 and September 2002. In crude terms, with the benefit of hindsight, which market would you rather have owned?

Some caveats may be required. Survivorship bias – which removes failed businesses from the indices – will be present, but in both indices. And it could turn out to be the case that the hedge fund industry, having seen huge capital inflows during the period as it grew toward maturity, has delivered its best returns. But the single biggest caveat is that we are not realistically comparing like with like: equities constitute a discrete asset class; hedge funds comprise an altogether broader school of disparate individuals who putatively represent talent. Whereas the equities asset class is by definition long-only, the hedge fund sector is effectively unrestrained, whether in terms of investible assets (anything), positioning (long or short, or both), or leverage.

The fragility of academic study of investment is that, as with economics, it presumes the existence of a closed, scientifically rational system. Not only are there multiple players within the markets with multiple approaches and beliefs and multiple relevant time horizons, not even a majority of that varied crowd can ever realistically be described as entirely rational. And whether or not there is an information gap between the academics who study the markets and the professionals who work within them, there is undoubtedly a wealth gap, the existence of which carries its own conclusions.

On the topic of pension funds, Bloomberg’s Caroline Baum (“Pension funds ‘diversify’ into commodity bubble”) quite fairly points out that while other asset classes enjoy metrics that express the degree to which prices have travelled beyond fundamental anchors (earnings, for example, in the case of stocks, and yields in the case of bonds), for commodities “no such quantifiable ratio” (other than the crude measure of the rate of price increases over time) exists. Her implication is that now that pension funds seem to have fully embraced the commodities story, their entry into the market could easily represent a worrisome near-term top. Michael Aronstein of Marketfield Asset Management is cited with the following useful advice:

“If you want to be in commodities, buy a process, not a product.. Own a gas company. Or a forest products company. Buy an entity that extracts value. And you get a free option: the product might appreciate.”

So although the macro picture darkens daily, there are still pockets of promise within the equities markets, even if those markets in aggregate now seem to be trading on nothing more than the fumes of wishful thinking.

And this gets to the heart of the “academic” wrangling over active versus passive investing. Markets and investment products are too complex to be reduced to binary decisions like (higher cost) active versus (lower cost) indexed. Investor expectations, too, are more nuanced than the academics (and consultants?) might care to admit. In broadly efficient and relatively low-yielding markets like government bonds currently, active managers, with all their attendant costs, will have to perform heroically to outperform low-cost ETFs. In the maelstrom of equity markets, however, investor requirements and objectives are likely to be more varied. While some investors will crave outsized returns, others will have a natural preference for avoidance of loss and the pursuit of absolute returns. Both strategies demand active management. Other investors, particularly with a longer and perhaps more disinterested time horizon, will be largely satisfied with low-cost passive management. But passive management comes with its own costs – particularly during a bear market that will doom advocates to tracking that same market lower.

No one approach can possibly suit all. To assume otherwise does a grave disservice to those managers expending valuable intellectual capital to preserve and grow client capital in the midst of a treacherous market environment.