BizAnalyst Network: Outsourcing Investment Management

Tuesday, May 29, 2007

Outsourcing Investment Management

Outsourcing of funds could be good for investors

As hedge fund and mutual fund managers rely on third parties for risk management and other controls, investors may profit with better products, reduced costs and more transparency. About 31% of investment-management firms expect to increase this type of outsourcing over the next few years, found a survey by PricewaterhouseCoopers.

Market or manager?
- 29-May-2007

The imminent departure of Anthony Bolton, Fidelity's star fund manager, has rekindled the debate about the relative merits of active management versus passive. Should investors put faith in a manager or an index, asks Adam Lewis"A blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by the experts."

That is the accusation made by Burton Malkiel, an economics professor at Princeton, in his classic work A Random Walk Down Wall Street.

Some fund managers, such as Fidelity's Anthony Bolton, could justifiably object to being compared to primates. But the debate between active and passive fund managers remains central to the investment industry.

Given the performance record of Bolton on the Fidelity Special Situations fund, it was hardly a surprise that the announcement of his successor two weeks ago was covered widely in the media. According to Morningstar, the fund, which was split into two last year, grew 160-fold from its launch in December 1979 to May 14, 2007.

As is well known to most readers, Sanjeev Shah, the former manager of Fidelity's UK Aggressive fund and current manager of the European Aggressive fund, will take on the £3.2bn UK Special Situations portfolio in January next year. His appointment was mostly welcomed by the fund industry. But his relative lack of experience means that advisers and fund of fund managers are looking at alternative funds.

On the week of Bolton's departure, Bestinvest, an IFA firm, recommended no fewer than five potential funds that have similar objectives to Fidelity Special Situations, if investors wanted to switch to "a more proven manager".

These include: the £1bn Artemis UK Special Situations fund run by Derek Stuart; Nigel Thomas's £1.5bn Axa Framlingon UK Select Opportunities fund; and the £729m Merrill Lynch UK Special Situations fund, managed by Richard Plackett. It also suggested that clients look at Mark Hall's £632m Rensburg UK Select Growth fund and the £165m Investec Special Situations fund, run by Alistair Mundy.

Not on the recommended list of Bestinvest, advisers or fund of fund managers, was that investors switch their holdings into an index tracker fund. Hardly a surprise given the difference in styles, but according to several prominent investment professionals, buying a fund that tracks the stockmarket is the only way to properly invest for the long term.

John Bogle, the founder of the Vanguard Group in 1974 and author of The Little Book of Common Sense Investing (reviewed in Fund Strategy, May 7, 2007, page 28) is in the Malkiel camp. At Vanguard, Bogle was responsible for the creation of the world's first index mutual fund (now called the Vanguard 500 Index fund) in 1975.

According to Bogle, out of 355 equity funds launched in America over the past 36 years, only 24 have outpaced the S&P 500 by more than one percentage point a year. Of these, he adds, just three have mounted a record of sustained outperformance: Davis New York Venture; Fidelity Contrafund; and Fidelity Mutual Shares. Meanwhile, the only manager to have outperformed the S&P 500 in the past four decades for 15 consecutive years is Legg Mason's Bill Miller. While Bogle acknowledges Miller's ability, he says the odds of owning a consistently successful equity fund are less than one in a hundred. Indeed, Millar's run of S&P 500 outperformance ended in 2006, when in dollar terms his American-domiciled Value Trust returned 5.85% compared with the index, which grew 15.79% over the calendar year, according to Morningstar.

Bogle also makes the point that in America, over the course of the past 36 years, out of 355 equity funds that existed, 223 have gone out of business. "If your fund doesn't last for the long term, how can you invest for the long term?" he asks.

Another problem with active funds is manager turnover. While Bolton has managed his fund for almost 28 years, according to research statistics in the 2005 UK Fund Industry Review, three-quarters of fund managers in Britain have managed their funds for four or fewer years (see pie chart, above).

The message of Malkiel's book, into its ninth edition since first being published in 1973, is similar to Bogle's. That is, investors are better off buying and holding an index fund than attempting to buy and sell individual stocks and actively managed funds. One of his main arguments is that the developed financial markets, such as America and Britain, price stocks so efficiently that strategies designed to beat it are futile.

Malkiel, who sits on the Vanguard board with Bogle, adds that those mutual fund managers in America who have beaten the market over certain periods have typically underperformed it substantially at times.

This is true of Bolton. Mark Dampier, the head of research at Hargreaves Lansdown, says that between 1988 and 1992, and again in the late 1990s, Bolton's style of investing fell out of favour with the market. The fund underperformed substantially as a result.

James Norton, the director of Evolve Financial Planning (which only offers clients passive funds), notes that if an investor had put money into Bolton's fund in 1989, it would have taken them 11 years for their investment to get back to beating the market, such was the degree of the fund's underperformance.

"There is no doubt that Bolton is a star fund manager," Norton adds, "but investing in him was not without risk. Investors would have had to stick with his fund through thick and thin to have made the returns often quoted."

For Bogle, the main reason for the underperformance of most actively managed funds is that they are hampered by expense costs, poor stock selection and market timing, taxes and inflation. He estimates that management fees, operating expenses, sales charges, the cost of portfolio turnover and broker commissions, can come to as much as 3-3.5% percentage points a year for actively managed funds.

However, Dampier says that while the fees on index tracking funds are much lower, investors who use them are "guaranteeing themselves underperformance". Any fee they charge will mean the return for the investor is less than the index.

This is an argument supported by John Chatfeild-Roberts, the head of the Jupiter independent funds team. He says: "Trackers may be cheaper than active funds, but price does not always represent value for money. Passive index tracking funds are almost guaranteed to underperform the index they track by roughly the amount of their annual charges. That can have a significant effect on the value of an investment over time."

Norton agrees: "If the manager of an index tracking fund does their job properly, an investor will be left with the market return, minus the costs. These costs should be more than 0.5% a year and decent funds charge 0.3%. It remains criminal that Virgin still charges 1% for its passively managed tracker fund.

"If you compare this with research conducted by Lipper Fitzrovia last year, the average total expense ratio of an active UK equity fund was 1.63%. This is a 500% disparity in costs and means the average active managed fund will underperform the index by a larger amount than index funds, as their costs are higher."

Chatfeild-Roberts says the contention for arguing for trackers on the basis that active managers cannot consistently beat the market index is "nonsense". He argues: "Good performance is repeatable if you invest with a talented fund manager. There may only be about 100 of them in the UK market place, and if you do not feel you can identify them, that is your prerogative. However, investors should not be fooled into thinking it cannot be done."

So how does an investor go about finding the next Bolton or the next Warren Buffett? Malkiel has in the past conceded that there are individuals who can consistently beat the index, noting that Buffett is "an investment genius". The problem, he notes, is that "trying to find the next Buffett is like trying to find a needle in a haystack. Why not just buy the haystack?"
Norton adds: "The question boils down to how can you pick the active funds that will outperform in advance? You would need a crystal ball. Allacademic research shows that there is little persistency in the outperformance of active managers."

Bolton agrees: "The real question here is, given that so few managers beat the index consistently over time, can a retail investor identify those managers who will outperform in advance? That's why you need to research the manager and the investment house. For most investors, this means consulting an IFA. So, if you do your research you will have a good chance of identifying which managers beat the index."

Not so, according to Bogle. His book not only casts doubt on how much worth advisers add to investors. It also questions whether just because a manager has done well in the past he will necessarily do so in the future. "Every firm in the investment industry acknowledges my conclusion that past performance is of no help in projecting future returns of mutual funds. This is stated in all prospectus'," he writes.

In terms of investors seeking advice to select funds, Bogle writes that a survey by a research team led by two Harvard Business School professors found that between 1996 and 2002 alone, the weighted average return of equity funds held by investors who relied on advisers (American brokers and excluding all upfront or redemption charges) averaged just 2.9% a year, compared with 6.6% earned by investors who took charge of their own affairs.

While Bogle says advisers may provide a valuable service in reassuring clients in helping establish a portfolio that matches their risk/reward appetite, "advisers as a group cannot be credibly relied upon to add value by selecting winning funds for you."

Justin Modray, head of communications at Bestinvest, says that Bogle makes a fair point. "In terms of the entire IFA market, it's fair to say that a number of firms don't put enough effort and thought into the picking of funds. This is why more and more firms are outsourcing their funds selection to fund of funds - it's an admission they are no good at it themselves."

However, he says the larger IFA firms, such as Bestinvest and Hargreaves Lansdown, have their own in-house research teams. This means, he argues, they can add value.

This need to add value is seen as important. Modray says it has conducted research that shows over three-year rolling periods, going back 20 years, more than two-thirds of active managers have failed to beat their index.

So how much of picking the right active manager is luck and how much judgement? Indeed, how much of an active manager's performance is luck and how much is skill?

In the late 1990s Albert Morillo, at the time the manager of the Investec European fund, and Rory Powe, the manager of the Invesco European fund, were two of the big names in the industry. However, at the start of this decade, as the bear market set in, Powe's growth style of investing, with large amounts invested in technology stocks, fell out of favour and his fund underperformed substantially.

Meanwhile, Morillo built his strong track record in the 1990s while at Scottish Widows. He took over the Investec European fund in April 2000 on an outsourced basis, after he joined Blackrock. However, his fundamental value approach to investing in firms led him to miss out on bounces in sectors during equity rallies, and the fund consistently underperformed the sector from the third quarter of 2002 onwards. On January 1, 2007 Investec ended the outsourcing agreement, bringing the fund back in-house to be managed using its four-factor equity investment process.

Malkiel says the same is true in America. He has written that the fund managers who did well in 1998 and 1999 managed to outpace the S&P 500 by more than two times. However, in early 2000 they underperformed the index by about three times. Similarly the top-performing funds in America in the 1970s underperformed in the 1980s and the top funds in the 1980s underperformed in the 1990s.

Dampier also says there are not many decent active managers for British investors to choose from at present. "Putting it in football terms, how many Cristiano Ronaldos are there? There is no right or wrong answer when it comes to this debate. I object to the religious right of those such as Vanguard who think passive funds are the only place to be, but I'm also aware that 90% of active managers are crap too. As a result you have to spend a lot of time to find the best managers," he says.

Dampier argues that investors can pursue a core/satellite approach, in which their core funds are index trackers, then use active funds for satellite holdings. Modray says it uses index funds as he notes they can be sensible core holdings in clients' portfolios.

Alternatively, Dampier says that investors should look for fund managers they believe will outperform. "While you can try and find the Ronaldos, investors have to realise active managers will have times when they don't perform well. It's all about putting the work in and those who can't are better off going down the indexation route," he says.

However, Chatfeild-Roberts argues that truly passive investment does not exist. This, he says, is because investors are always making choices, with there being more than 13,000 indices in existence, each of which he says have different characteristics. "By picking one rather than the other you are, in effect, being forced to take a view. This will have consequences for the returns you make," he says.

Malkiel notes that over the past few years the S&P 500 index has itself become more actively managed, in terms of the amount of changes made to it. However, he says that it is far less actively managed than active funds.

In the more recent editions of A Random Walk Down Wall Street, Malkiel recommends investors use an index that offers a broader representation of the American stockmarket. These include the Wilshire 5000 or the Russell 3000. This is primarily because he says the S&P 500 only represents the larger American firms that make up three-quarters of the total market. As a result, investors who only invest in an S&P 500 index fund do not have exposure to smaller or mid-sized companies.

In 1981 David Booth and Rex Sinquefield, former students of Eugene Fama, a leading American financial economist, founded Dimensional Fund Advisors. Its business was based on Fama's hypothesis that markets are efficient: prices accurately reflect intrinsic value. It rejects not only the idea that active managed funds can sustain long-term returns through exploiting mispriced stocks, it also rejects the purely passive management concept.

Instead, it uses a third way called "value added management". It has identified three equity and two fixed-interest "factors", or core elements, to its strategy. The equity factors are that shares will return more than fixed interest and that small company and value shares will return more than large company and growth shares. The fixed interest factors are that longer-term and lower credit quality instruments incur greater risk. Indeed, Dimensional's name reflects these three factors or "dimensions" to its approach.

Its strategy also aims to minimise portfolio turnover (which Bogle argues is a hidden cost in active funds) and therefore beat active and passive approaches on dealing costs. Worldwide, the group manages $136bn (£69bn) of assets under management. Most of these assets are run in its so-called "enhanced index funds". The goal of these enhanced index funds is to add 100-200 basis points a year over conventional benchmarks, while tracking their benchmarks almost as well as index funds.

Samuel Adams, the vice-president of financial adviser services at Dimensional, says its primary goal of its funds is to deliver the return of the asset class every year. "If we can add 100 to 200 basis points over the benchmark that would be fantastic, but people buy our funds because we deliver the return of the asset class," he says.

In Britain the group manages six Oeics, with assets under management totalling £750m. The most recent, the UK Core Equity fund, was launched in June last year and now has assets of £170m. The fund provides a broad exposure to the FTSE 350 index and has been designed so that it is not concentrated on just the large cap names.

Adams says: "The fund takes weights out of the top 10 stocks and buys more outside, buying more small cap and value companies, as these are the areas that traditionally provide stronger returns. However, the funds we run are 100% passive and remain within 1-3% of the FTSE 350."

As Dimensional funds are designed for long-term investing, all discretionary IFAs who want to sell its funds must attend a two-day training course.

Ian Shipway, the director of investment at Thinc Group, has used Dimensional's range of UK Oeics ever since it first launched at the start of 2004. Thus far he says he has been happy with the results. "Dimensional is not an index tracker, it engineers passive portfolios. Using its funds allows us to gain pure exposure to the asset classes we want at very low cost."

The obvious presumption is that despite the benefits listed of passive funds, most investors in Bolton's fund will continue to want their money managed in an active manner. Whether or not this is the best way to invest in stockmarkets is a debate that will continue for a long time.

Dampier says: "If everyone agreed that indexation was the way to go and money was invested in size in index tracker funds, the result would be more capital becomes misallocated. This happened in the late 1990s to 2000 when there was a gigantic misallocation of capital to large caps, purely because of their size, rather than the fact they were good businesses."

Chatfeild-Roberts concludes: "On the upside, I would argue that passive funds are great news for active investors, as the more money that becomes passively managed, the more potential profits there are to be made by the best active investors."

However, whether or not there are the active managers to pick up on these returns, consistency remains the big question.

Hot fundsOne criticism often directed at the active funds industry by advocates of passive investing is the propensity of group's launching funds based on the short-term performance of certain sectors in stockmarkets. These are the so-called hot funds. In Britain, a classic example of this was during the technology boom of the late 1990s.

As the tech bubble grew and grew, ever more fund management groups cashed in the sector's popularity by launching dedicated technology portfolios. In May 1999, Framlington launched its NetNet fund and Gartmore created its Techtornado fund in February 2000. Jupiter, meanwhile, launched its Global Technology fund right at the top of the cycle in March 2000, with the fund taking in £132m in its offer period.

Indeed, in March 2000 some £877m of Isa money was invested into the technology sector, with the money flowing into a 28-strong fund sector. However, since the dotcom crash in the same month, only 14 funds remain. In May last year, Axa Framlington merged its NetNet and Nasdaq funds into one portfolio, AXA Framlington Global Technology, while Gartmore merged Techtornado into its UK & Irish fund in February 2003.

The most recent fund to announce its impending closure was Aegon Technology. Launched in 1985 it was one of the oldest tech portfolios, but its assets peaked in October 2000, reaching £341m. Since the tech crash, however, its assets have fallen to £8m and the group announced at the start of this month its intention to close the fund on July 31.

Following the bursting of the tech bubble, commentators have consistently looked for the next potential bubble, and one such sector could be property. Buoyant demand for commercial property and the launch of real estate investment trusts has seen several groups launch dedicated property portfolios over the last couple of years.

The IMA specialist sector, which contains all the commercial property and global Real estate investment trust funds, was the best-selling net retail sector for the whole of 2006 and the first quarter of 2007. And in March this year, £471m was invested into property funds according to the IMA.

John Bogle, founder of the Vanguard Group and author of The Little Book of Common Sense Investing, writes: "There have been many new paradigms over the years. None have persisted. The "concept" stocks of the Go-Go years in the 1960s came and went. So did the "Nifty Fifty" era that soon followed. The "January effect" of small-cap superiority came and went. In the late 1990s, high-tech stocks and "new economy" funds came as well. Today, the asset values of the survivors remain far below their peaks. Intelligent investors should approach with extreme caution that any new paradigm is here to stay. That's not the way financial markets work."

Diagram: Length of Fund Manager Service
Diagram: Active Funds vs. Trackers

hedge funds, investment management, business process outsourcing

Labels: business process outsourcing, hedge funds, investment management