A couple of weeks ago Stuart Kirk proclaimed in his FT Money column: “Active management is a sham”. As I have managed active equity funds for the past 23 years, I thought I should reply.
I am not helped by the fact the funds I co-manage are currently seeing the worst performance against the index we have ever had — nearly 4.5 per cent behind the index year-to-date. And I know my comments may be greeted by a chorus of “he would say that, wouldn’t he?” But, as I am retiring from running these funds later this year, I can at least claim a declining conflict of interest.
Active or passive?
Equity funds that track the make-up of the major indices, such as the FTSE 100 index of UK shares or the S&P 500 index of US equities, are widely available and cheap — they typically charge below 10 basis points (bp) a year — or £1 for every £1,000 invested. This compares with ongoing charges on active equity funds typically above 75bp and sometimes over 125bp a year. So why pay more?
Active managers vote on corporate matters. If you want to limit executive pay or encourage the companies you own to improve their environmental standards, you are more likely to achieve that through actively managed funds. Most people, however, buy them to beat the index or achieve similar performance but with less volatility.
Reduced volatility can be under-appreciated. When markets tumble, investors can do themselves financial harm by panic selling. Reducing volatility reduces panic. It also benefits those who derive their income from savings. To maintain a steady income you must sell more units when markets fall, which undermines your portfolio’s performance in bounceback growth phases. Advisers call this “sequencing risk”, and lower volatility reduces it.
My big concern currently is “bubble risk”. An index fund invests your savings exactly weighted to the current sizes of all the shares listed. Say a company is floated in London (it does happen). Let us call it TotalFantasy Ltd. It has no revenues but a messianic chief executive who sells a good story. When it floats it is a small part of the index, but by the time the boss has spun his tale it might end up a significant part of the index and therefore a significant part of your savings. When TotalFantasy Ltd turns out to be exactly that, this part of your savings vanishes with it.
Active equity managers will not necessarily avoid TotalFantasy Ltd-type companies. Some actually like them and invest in a range on the basis that one in a hundred will defy the name and generate returns large enough to compensate for those that fail. Others feel compelled to buy these businesses because of the momentum building behind them and the enormous pressure that comes from lagging the market if you are underweight fast-inflating stocks. They know a bubble is building but hope they can exit before it pops.
My style (and one my successor shares) is conservative: apply common sense to the markets, plus an element of “safety first”, and don’t get stressed when TotalFantasy Ltd bubbles come along. Fundamentals will reassert themselves in time. When they do, your outperformance against the index can be significant.
I am not a golfer, but someone once proposed that golf offers lessons that can be applied to long-term active investing — winning is often less about driving the furthest off the tee than about avoiding the bunkers.
Avoiding overpriced shares
By avoiding fundamentally overpriced technology shares, many active managers outperformed the index fall between 2000 and 2003 — I remember many saw their funds fall half as much as the index, which tumbled by around 40 per cent. That amount of capital protection left savers much more money in the market to enjoy the bull market that followed.
The bursting of technology valuations last year might suggest this was a period when active managers should have done better. But I believe valuations of many of the largest stocks in the global index are still excessive and the bubble has not fully deflated. In fact, it appears to have reinflated.
Look at the make-up of the MSCI World Index at the end of May 2023. Apple represented 5.26 per cent, Microsoft 4.34 per cent, Alphabet (Google) 2.63 per cent, Amazon 2.07 per cent and Nvidia 1.74 per cent.
So the largest five companies comprised more than 15 per cent of the world index and nearly 24 per cent of a US S&P 500 index tracker.
Bloomberg data, shows how expensive these stocks are, with Apple on 31 times earnings, Nvidia on 55 times and Amazon on 134. Nvidia’s sales are rising so fast that, to be generous/fair, I have used next year’s forecast earnings and sales to calculate its numbers. Apple yields 0.5 per cent, Microsoft 0.8 per cent and the other three zero,
By way of comparison, the UK equity market is priced at 11 times earnings and yields 4.2 per cent; Japan, on 21 times earnings, yields 1.9 per cent.
There is a strong argument for being wary of what is under the bonnet in a tracker fund or passive multi-asset fund, especially one with a high US equity weighting. Perhaps the application of common sense and valuation discipline is about to arrive.
Managers selecting stocks for their fundamental value are likely to hold few of these tech giants or be underweight them relative to the index. While we wait for sense to prevail, their short-term performance will be poor — you should perhaps be disappointed if it was not.
We encourage investors to invest in equities for the long term — 10 years or more. It is over that kind of period that we should judge the performance of active managers. Stuart’s comments are based on research showing consistency of performance over just three successive individual years and measured against an index that is inconsistent — sometimes it is valued sensibly, other times not. Of course, there remains the challenge of identifying a manager you can trust over the long term, but that is a topic for another day.
Since taking over Mid Wynd in April 2014 my team and I have delivered gains of 215.5 per cent in net asset value and 203.4 per cent in the fund share price against the MSCI ACWI return (so tracker return before charges) of 172.3 per cent (to June 8). That with a “beta” of just 0.74. In plain English, that means the trust was 26 per cent less volatile than the index.
In the long run, share performance is related to cash flow. When I buy a share I want more than just a story. I want the comfort of knowing I am buying a company backed with real profits and realistic expectations of growth. I need a decent chance my savings will grow in real terms over time. If the index wants to get excited by a bubble, it is not the end of the world for me to miss out on it.
Those who want their money invested in shares supported by real-world cash flow have no choice but to do it themselves or hire someone to do it for them. And that is just what I will be doing.
Simon Edelsten is co-manager of the Mid Wynd International Investment Trust and the Artemis Global Select Fund
