Saturday, July 01, 2006

Tossing a coin could well be as insightful to investors as a fund manager

Tossing a coin could well be as insightful to investors as a fund manager
By Philip Coggan
Published: July 1 2006 03:00 | Last updated: July 1 2006 03:00
Copyright The Financial Times Limited 2006


Is it luck or skill? It can be very hard to know exactly why a fund manager has performed well.

That was neatly illustrated this week with an analysis by New Star, the fund management group. Sometimes press releases do not carry the message companies mean to convey. The reader draws a different moral.

New Star looked at the number of managers who had outperformed the median in each of three (and then five) consecutive years. Only one in eight UK equity managers had done so over three years, for example, while over five, the hit rate was one in 34.

To New Star, the message is that investors need to employ an experienced fund-of-funds manager who can sort out the sheep from the goats.

But take a look at those numbers again. The chances of tossing three heads in a row is one-in-eight; five heads in a row is a one-in-32 shot. so it looks as if the chances of a fund manager beating the average are no better than tossing a coin. In other words, performance is entirely random.

If that is the case, why pay an extra fee to a fund-of-funds manager when you can make the same guess yourself? A higher fee will reduce your long-term return.

New Star would retort that it has shown skill in picking managers, by beating its sector substantially over the past four years. Alas, its record is not long enough to prove that skill, not luck, is involved.

The decision between active management and passive (or index-tracking) funds is not an easy one. Implicit in the index-tracking case is the belief that markets are always efficient, something that is hard to believe after the dotcom boom.

Second, having met many intelligent and shrewd fund managers, I find it hard to believe that there is no skill involved in the record of, say, Anthony Bolton or Neil Woodford.

However, the problem lies in spotting such performers in advance, or at least early enough in their career to take advantage.

Unless you have a lot of time to research the sector, the percentages clearly suggest an index-tracking approach. That is also the conclusion of an informative new book* on investment planning by Tim Hale.

Hale points to a US survey that shows, over the 20 years to 2003, more than 80 per cent of active investors failing to beat the market. A second survey found that the average index fund beat the average active fund by 2 percentage points a year over the long term.

Hale favours using index funds as a building block for assembling portfolios. While he certainly has a case for equities, I think the argument is much less convincing for bonds.

If we are talking about corporate bonds, then an index weighting would mean investing most of your capital in the most indebted companies. If we are talking about a domestic government bond index, then the weighting will be highest in short-dated maturities (where issuance is greatest) rather than in long-dated paper which is probably a better match for the investor's liabilities.

Hale also suggests two rules of thumb for deciding the proportion of an investor's portfolio that should be devoted to bonds. One is to make your bond percentage equal to your age; that is, a 50-year-old should have 50 per cent in bonds. That seems a little conservative for younger people.

The second rule is to multiply your investment horizon, in years, by four to get your equity percentage and own bonds for the rest. So if you have 20 years until retirement, you should own 80 per cent in equities and 20 per cent in bonds. This is not a bad rough and ready calculation, although for those with a 25-year time frame owning no bonds at all feels like too big a bet.

Hale also suggests scope for further diversification into asset classes such as property, index-linked bonds, commodities and funds-of-hedge funds.

All of this makes for sensible advice (and a useful book). Diversification does make sense.

But there is a problem with diversification that has become clear this year. When everyone is piling into an asset class, it ceases to be a diversifier. Thus, according to Société Générale, commodities have recently been more correlated with equities than they have been in decades.

So I believe that, in addition to diversification, investors should be willing to make asset allocation decisions on the basis of expected future returns.

Some will dismiss this as "market timing", an approach that has rarely been known to work. But while it is very hard to guess where markets are going in the short term, over the long run there is some evidence of reversion to the mean.

Saying that the equity markets were overvalued in 1998 looked pretty stupid during 1999 and early 2000. But the scale of the market plunge was such that, by 2003, investors had earned far greater returns from bonds than from equities over the previous five years.

Investors should give a greater weight to those asset classes that have underperfomed their historic trends over the medium term (10-20 years or so) and should underweight those asset classes that have outperformed.

Part of the problem for investors was that earlier this year, it was hard to find assets that looked cheap or below trend.

If there is one good thing about the current turmoil, it is that it may once again throw up assets that look unloved. Then, all investors need is the courage to buy.

*Smarter Investing: Simpler Decisions for Better Results by Tim Hale, FT Prentice Hall, £21.99

philip.coggan@ft.com

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