Liabilities beat active management | London Business School

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The stock market plunge of 2008 preceded a recession, which is to be expected; the reason equity investors get a risk premium is that ‘the likelihood is quite high that they will lose’, and almost 100% of fund managers would have had to go out of business had their fees been tied to performance .

There is both bad news and worse news for clients of active investment managers. It is a zero sum game, as each winner must be matched by a loser. Worse yet, it becomes a negative sum game once the costs are factored in.

Professor Eugene Fama, co-winner of the 2013 Nobel Prize in Economics, combines very original thinking with a powerful talent for exhibition.

They awarded him and fellow laureates Lars Peter Hansen and Robert J. Shiller “for their empirical analysis of asset prices,” and perhaps it is for his work on market efficiency that he remains the best known. The judges note that Professor Fama has shown that short-term stock price movements are impossible to predict and that they react almost immediately to new information, “which means the market is efficient.”

Is that still his point of view or has it changed?

“It hasn’t really changed because I’ve never put it forward as an absolute,” he replies. “It’s a model, a very good approximation of reality but not of reality itself. I think this is a very good approximation. In fact, of all the models we have in economics, I think this one has probably performed better than any other I can think of. “

Many observers have found their faith in the efficiency of markets shaken by extreme events such as the stock market crash of 1987, the bursting of the tech bubble in 2000 and the fall in prices of 2008. For them, such events provide evidence that, over time, markets are irrational rather than rational. Professor Fama doesn’t want it.

“The market did what it usually does before a recession: it’s gone down a lot. I think it does its job when it works this way.

“It is historically the case that market volatility increases when we are heading for difficult times and decreases when the good times return. Right now, we are in a period of relatively low volatility. The key point is that none of this is incompatible with the notion of market efficiency. “

Trendy factor investing

When asked if the premiums for factor investing might come down as more and more money is spent pursuing factor strategies, he said, “Finance is no different from other industries. the economy. It’s all about supply and demand, so if demand goes up, the price goes up and the expected returns go down.

Factor investing, he says, has a reputation for “being kind of high tech,” but while not necessarily easy to implement from a business standpoint, it is. brutally simple-minded and not technically sophisticated. “Basically, you’re just following specific rules for forming portfolios. “

He adds, “All this ‘mailman’ stuff hit the market too quickly as far as I’m concerned. It hasn’t been subjected to the kind of robustness checks that I would have liked to see before people got hooked on it.

Regarding portfolio construction, Professor Fama says: “The rule of thumb is that diversification is your partner. Whatever you do, make sure you do it in a very diverse way.

Active management versus passive management

The debate over active investing strategies versus passive investing strategies shows no signs of slowing down, and the UK regulator, the Financial Conduct Authority, has put the spotlight on the asset management sector in Great Britain. Bretagne, concluding that there is little or no relationship between fund performance and fees charged.

In June, FCA said: “Despite a large number of companies operating in the market, [our] the analysis found evidence of sustained and high benefits over a number of years. [We] also found that investors are not always clear what the objectives of the funds are and that the performance of the funds is not always reported against an appropriate benchmark.

Let the market regulate

Some have suggested that regulators, such as the FCA, or even lawmakers should act in this area, but Professor Fama is typically straightforward: ‘Leave it to the market’.

Not that voluntary initiatives like Fidelity’s recent announcement of a major overhaul of its pricing structure to introduce performance-linked fees are safe, he warns. “It’s a good way to go, but if the company had done this historically, it would have gone out of business by now. It would be the same for the whole industry. Ken French and I have estimated that 97% of actively managed mutual funds do worse than you might expect.

Professor Fama’s skepticism about the benefits of active management is well known, but he insists that “this is not skepticism, this is arithmetic”.

While passive investors hold portfolios of stocks weighted according to their market capitalization, they are not dealing with active managers. So if some active managers win by holding imbalanced portfolios, there must be someone on the other side. [who loses] and who is by definition another active manager.

“So active management is a zero-sum game before costs. After costs, it must be a negative sum game.

We need active managers for more efficiency

But suppose all managers become passive index trackers. Would prices remain effective? “No, they wouldn’t. You need good active managers to compensate for bad active managers, to make pricing more efficient. If some of the bad ones give up, you need fewer good ones because there are fewer mistakes to correct. No one knows exactly how many active managers you need to keep the market efficient.

Professor Fama warns that these good managers may tend to keep the rewards for their efforts rather than sharing them with investors. “If I am a good active manager, it is a skill in human capital. The rewards should go to human capital, not the investor.

His advice? “Investors should not only be skeptical, but also very suspicious that they will ever get anything out of this. “

The future of the asset management industry

They should also keep in mind the difficulty of distinguishing between competence and luck in the performance of an active manager. “People don’t understand that the volatility of asset returns is so high that past performance is almost irrelevant in judging what future performance is likely to be. “

What medium-term future for the asset management industry? Is he speculating on the likely shape of the sector in ten or twenty years?

“Not really. The scale of change over the past decade shows how quickly things can change, but efficient markets haven’t really been penetrating for a long time, so it’s a bit daunting. That said, I think active managers are going to have to cut their fees, bringing them closer to those billed by passive managers.

This will be driven, in part, by growing client skepticism about the performance of active managers. “

Adding to the income compression for active managers, he said, is likely to be a shift from active managers to algorithm-based trading, although Professor Fama notes: “There is more marketing in it. financial management than real high-tech stuff. “

He ends on a self-deprecating note: “The excitement in the money management industry is seeing what the surprises are as you go along. I have no ability to predict directions or trends.

“Every time I’ve tried to do this I’ve always been wrong, so I don’t do it anymore. “

Stephen Schaefer and Eugene Fama spoke at the 3rd Annual Insight Summit hosted by the AQR Asset Management Institute at London Business School. The event took place on November 7, 2017 on the theme of Intelligent Risk Taking.


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