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Wednesday, November 18th, 2015

Active Asset Management risks mis-selling itself, when it does not need to
posted by Andrew Lilico

The asset management is about to be the subject of a competition probe by the Financial Conduct Authority.
The FCA is seeking to understand whether competition is working effectively to enable both institutional and retail investors to get value for money when purchasing asset management services.  More specifically, the FCA says it is interested in:
how asset managers compete to deliver value;
whether asset managers are willing and able to control costs and quality along the value chain; and
how investment consultants affect competition for institutional asset management.
These topics are important in their own right.  But at this it is less clear to what extent the FCA will probe the really big issue regarding asset management, arguably nothing less than a ticking time-bomb in the financial sector waiting to be either defused or detonated.  Across much of that sector there are funds offering “active management” of assets – they pick when to trade in and out and they pick particular sectors and investment strategies.  According to the FCA, about 78 per cent of funds’ assets are managed this way. The alternative to this is what is called “passive management”, whereby  funds track the FTSE, offer some combination of the stock market and a low-risk asset such as government bonds, or perhaps track some other slightly higher-risk index. In the industry jargon, investors in passively managed funds are said to “buy beta” – i.e. buying a desired level of involvement in the market average risk-return tradeoff - whilst those in actively managed funds are also buying “alpha” – i.e. outperformance of the market average return for any given level of risk.
Actively managed funds cost investors more for the management fees.  There is a standard result in the academic literature that says that, on average, although actively managed funds can outperform the market (they can generate “positive alpha”) the cost, in terms of management fees, of getting that higher return is greater than the return.  In other words, on average investors lose out by investing in actively managed funds. Some folk can get lucky by investing in an actively managed fund early in a fund manager’s career, before his or her reputation is established and the fees go up.  And of course in any one year actively managed funds might get lucky.  But the average is negative.
Why is this a ticking time bomb?  Because although they are familiar with this academic result (which has been around for some 25 years now), much of the funds sector refuses to accept it and consistently markets their actively managed funds on the basis that they can outperform passively managed funds.  So in, say, ten years someone retiring with an actively managed fund could say: “If I’d invested in a passively managed fund, I’d have a £3,000 per month higher pension.  And you knew that that would be likely to be so, because all the research told you that decades ago.  But you told me I would do better by investing in your actively managed fund.  That’s mis-selling, and I want you to make up the difference.”  Whether such appeals for compensation would or should be successful is of course a matter that could be disputed.  But it is a risk that at present the funds industry does not appear to recognise.
And that seems to be a mistake.  Because although the empirical result that active management costing more than the returns outperformance is often presented as either an illustration of markets functioning poorly or of how investors are not perfectly rational, increasing average returns should not be what one would expect active management to do in an efficient market.  Active management should be expected to change the profile of returns  - e.g. by reducing how much funds fall in a modest crash (really big crashes will tend to overwhelm everyone).  By doing things like this, active managers change the shape of returns – in the jargon that’s called the “skewness” – so there is less downside, relative to the upside.  Now in standard finance theory, it is commonly assumed, for simplicity and tractability of models, that investors care only about the mean and variance of returns but not the skewness, so changing skewness wouldn’t be worth anything.  But in standard microeconomic theory (for technically-minded readers, I’m referring to Arrow-Pratt risk aversion), investors should prefer a profile of returns with less downside, even if the average return is therefore slightly lower.  That means that in an efficient market, we should expect passively managed funds (with a market average skewness and downside risk) to have a higher expected return than actively managed funds (where downside risk is reduced).  To put the point more plainly, active management costing more than the returns outperformance it produces should not be a surprise and is not, in itself, an indicator either of bounded rationality or market failure. It is what one should expect if markets are functioning efficiently.
Of course, just because one should expect post-fees returns on actively managed funds to be less than on passively managed funds by some degree, that does not mean that just any degree of wedge between these two returns is efficient.  It could still be that the wedge in practice is higher than the wedge justified by skewness effects – so there could still be competition or market failure or bounded rationality issues to consider.
But even if there are not, there’s still a potential problem for the active management sector.  There should be nothing wrong with active management, per se.  What it achieves is to change the profile of returns.  But active managers need to be careful about how they sell themselves to investors.  At the moment, some may be running the risk of deceiving investors by claiming what they offer is higher average returns, when in fact what they offer is (on average) lower expected returns (after fees) but less downside risk.  That’s worth something. But you need to sell it right.