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PENSIONS REVIEW – Is that with or without icing?

Active fund managers appear to have consistently under-performed the market over a number of years. Have the index trackers already won the argument? Peter Rice is the corporate development director at Morley Fund Management, part of CGU plc. The group manages £120bn worldwide and has recorded top decile outperformance over the last one, three and five years: I wouldn’t have thought so. What it does mean is that you have to choose your active fund manager with great care, rather than writing off the entire industry. It’s certainly true that it’s very difficult to pick the right active manager at the right time. The key thing, though, is to look at the investment process and the reasons why people have outperformed. Our balanced pension fund has outperformed by 1.9% a year over five years. Charges might be 10 to 15 basis points more expensive per annum than for a tracker. So in relation to the sort of outperformance we’ve achieved over the last five years, that’s not important. If you’re going to outperform by 20 basis points of which 15 are taken up by costs, then you might think twice. But if you’re hopeful of getting half-a-percent or a percent outperformance, then it’s probably worth paying the extra. Barry Holman is the director of index funds at Legal & General, which has £82bn under management, of which £45bn are pension funds, all index-tracking or passively-managed: I think that’s an over-simplification. Active managers tend to have higher management charges because the cost of running their funds is higher. So they start at a disadvantage. You always get a range of results with active managers, obviously: some do very well, some do very badly. The difficult decision for investors is how to select next year’s performing active manager. One of the reasons for the growth in indexation is that many experts have tried and failed. It’s bad enough for investment professionals. Employers who are able to afford expert financial advice find it difficult to select the outperforming active management group. Efficient markets theory says it isn’t possible for an investor to consistently outperform the market other than by chance. Rice: How long is your testing period? All we can do is point to our record over five years, which is a reasonable amount of time, and look at our underlying process. Then you have to decide whether that gives you a good chance to outperform. A passive fund manager is simply tracking an index, so they’re blind. They’re being led along. The active fund manager is examining countries, economies, sectors, individual stocks, management. You could say that in our capitalist set-up they actually play a major role in the efficient allocation of capital. That’s something that the passives don’t do at all. Holman: I have some sympathy with the theory. The problem that active managers have is that a lot of investors have short-term horizons. So if it doesn’t work out within six or nine months, the active manager has to do something – otherwise he gets fired. Index tracking isn’t a competition between index tracking fund managers. It’s a competition between competing stock market indices – FTSE-100, FTA-All Share, Morgan Stanley Capital International, Dow Jones Stoxx, etc. Discuss. Rice: Yes, you’re into the different sizes of markets, and so on, whether it’s the FTSE-100, or the FTA-All Share or the FTSE-250 and so on. And there have been significant differences. So yes, you can get those variations between the passive fund managers. Holman: The actual composition of the index is a big issue and is becoming a bigger issue because of the growth of indexation. When we were looking at launching an overseas fund back in 1988 we were very careful about which index we selected for the overseas equity market because the Morgan Stanley Capital International index wasn’t fully investable at that time. It didn’t allow for the restrictions on foreigners owning shares. There’s competition between the indices and I think the best structured index, which reflects the needs of investors, will win. We’re now having this debate of the free-float, the cross-holdings and domicile. Again, the indices are trying to ensure that they are an appropriate benchmark for most investors. So I think the index you choose is important – it determines a lot of what funds do. Isn’t the shift towards indexation going to follow the shift from defined benefit to defined contribution schemes, given that it will be politically unacceptable to have workers retiring into bottom-decile-performance pension schemes? Rice: I would have thought that the more people are forced to take responsibility for their own financial future, then the greater will be the scope for capital-protected or guaranteed policies or a low-risk approach. A passive fund need not be a low-risk approach: if you’d seen the FTSE-100 index toppling from over 6000 to 4500 and you were retiring at that time, you’d have been a bit concerned. Go back to the October 1987 crash or the problem in 1974. One of the problems with passive funds is, if things do get overheated, they’ve got no means of adjusting. They’ve actually got to pursue the more extreme performers: if a stock doubles, they’ve got to double their weighting in it. Moreover, it’s not all that simple a matter – you can get quite large tracking errors. Holman: Because the member takes on the investment risk, the trustees themselves or employer will be wary of advising something which turns out to be bottom decile. Charges are also important. If the members pay, they should be minimised. So there’s lots of good reasons why you have index funds – or give employees a choice. By sheer bulk, pension funds have a hard time outperforming the market because they are the market. Setting that against index tracking errors that arise from the fact that passive “buy the market and hold” funds don’t buy the exact number of shares in every constituent, it looks as though there is really very little difference between the actives and the trackers. Rice: There are considerable differences in philosophy. Inevitably, with a large portfolio, the likelihood of major statistical deviation reduces quite markedly with the number of stocks, so unless you have an absolutely extreme portfolio that’s concentrated in a small number of sectors, there will be a commonality with the major index constituents, and so a reasonably high correlation of returns. But it’s the ability to identify the changes in the dominant themes – currencies, business cycles, growth sectors – that enable one to re-orientate the overall portfolio. Holman: There are about 806 stocks in the All-Share, obviously 100 in the FTSE-100. You need some flexibility because of the practicality of managing these funds. If you start fully-replicating the All Share you’d have 806 securities. At the bottom end you’d have very small holdings – worth less than 0.005% of your portfolio. Whatever happens to that particular holding, it isn’t going to affect your bottom line. So do I need all these small companies? No. You might perhaps have four or five of them at that size. Otherwise your income has to be invested across all the stocks in the index. So you’d put £1 into your smaller company and £10,000 into your largest company. It doesn’t work! But you need rules in which to operate, so this is where a randomly sampled basis comes in. In practice, you replicate the big companies and sample the small companies. Ethical investment and corporate governance issues are becoming increasingly important. How can passive fund managers cope with this? Is this an opportunity for the active fund managers? Rice: What do you have as an ethical index? You’d need to have one in order to do that. Corporate governance involves studying individual companies and looking at AGM resolutions and so on to see if they’re compliant with the major codes; you clearly can’t do that from a purely passive approach. You would need to have people who are doing that. It’s not a major issue now, but I think it’s likely to become more important. Holman: That’s a fairly recent development and we’re obviously watching it with interest. Because it’s a matter of individual judgement, nobody has yet produced an independent ethical index. We always vote on corporate governance issues. It doesn’t matter to us if their share price underperforms: we have to hold an index weighting. We are well informed because we have the active (non-pension) management side to keep us abreast. But we cannot do the ultimate sanction, to sell our shares.

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