The Trial of the Century

It is the year 2030; Brexit negotiations have made a breakthrough, after a last-minute concession that allows for both English AND French cheese to be served in the sandwiches being eaten at the next Summit. Prime Minister Alan Sugar calls it a victory for the cheese makers, but in all the excitement, one is tempted to think he has been misunderstood.

Meanwhile, as a result of a Global Decree by newly-elected US President Bruce Willis, Active Management is now illegal (so it’s not just their charges that are criminal). We join the trial as the Defence Counsel cross-examines one of the accused, in an attempt to tease out the justification for their strategies. Active Manager Finder-General Burgess is acting for the Prosecution. Judge Jeremy Paxman presides, with able assistance from Tess Daley QC.

Defence: Could outline your investment philosophy?

Defendant: Certainly; we aim to “beat” the market, outperforming the chosen Benchmark using a combination of market timing, stock picking ability and asset allocation skill to generate ” Alpha”, a return greater than that of the overall market, as a consequence of market inefficiencies. Sometimes we would have a concentrated portfolio, to express our views that only a small number of shares fulfill our investment criteria, such that the portfolios we run will not bear much resemblance to the Index or market that we are benchmarked against. At other times, not so much. Of course, all of that does not come cheap, so we charge higher fees to enable us to acquire the talent and resources to achieve these ends.

Prosecution: Objection your honor! The aim does not follow from the premise, as the premise itself is flawed; markets are not perfectly efficient, but they are close enough that it is not possible for Active managers to outperform in aggregate (especially after their fees). Further, IF markets are inefficient, what certainty is there that these “inefficiencies” will ever be eliminated? Thus, how can we determine that markets are (and then are not), efficient in any given period? There are thousands of extremely well-informed investors all trying to achieve the same goal, with the result being that they are competing against themselves. It is not mathematically possible for them ALL to outperform, since to all intents and purposes, they ARE the market!

Judge: Sustained.

Defence: What are the prospects for the year ahead?

Defendant: We believe that 2031 will be a perfect environment for stock picking, as QE unwinds and correlations between sectors, asset classes and markets fall further. As volatility rises, there will be plenty of opportunities for skilled managers to outperform their benchmarks .

Prosecution: Objection! The industry has said that every year for the last 5! And every year the SPIVA Reports (scorecards), show that they fail to do so. Attempts to pass this under performance off as being “cyclical” suggests a very long cycle is in operation; a rise in volatility also provides opportunities for managers to under perform as they attempt to interpret data etc. in what is inevitably a subjective process. Consistently correct responses to news, events and their investment implications are thus impossible and the more decisions being required the higher the potential for error. The issue of Survivorship bias for funds, in this case with regard to Hedge funds, suggest that a lot of funds don’t succeed and thus close down, for whatever reason, which in turn flatters the performance of those that remain (by as much as 20%), as the worst performing funds are expunged from history. Only about half of UK domiciled funds survived the 10 years to November 2015 according to Ft Adviser, which suggests the same issue is prevalent in this country.

Judge: Sustained.

Defence: What sets you apart from your peers?

Defendant: We have a large team of highly skilled professionals, who have long experience in the industry and are capable of navigating the gyrations of markets, having witnessed both bull and bear markets.

Prosecution: Hmm. I would not expect you to admit your “team” was anything else, but at least we now get an idea of where the high fees go! “Trust us” is not a viable investment strategy but an act of faith and an unfalsifiable hypothesis, (except ex post, by which time it is too late). Investment skill does exist, but in a world of highly motivated, intelligent and hard working individuals, the main determinant of success (as with professional sport, such as a refereeing error or an ill-timed injury for example), is luck. The misalignment of interests between fund manager and Investor, (asset size is important for the former, returns far more so for the latter), means that the fund manager has no incentive to actually use his or her abilities positively, but to keep themselves in the middle of the performance pack, where there is little likelihood of fund outflows. “Closet -tracking ” funds are the inevitable consequence.

Judge: Sustained.

Defence: No further questions your Honor.

Prosecution : One final question: given all of the above, how are investors going to be able to identify in advance, funds that will sustainably outperform their Benchmarks after fees?

Defendant: Errr…

Judge Paxman: Yeeeeess; there will now be a short recess while I consider judgement in this case. Before I do, is there anything the guilty defendant would like to say?