The Credit Suisse Global Annual Investment Returns Yearbook and other studies have shown that over the best part of 100 years, simple “value filters”, such “buy high-yield stocks and avoid high P/E stocks”, have beaten the market consistently and by a large margin. None of the attempts to explain away this or the “smallcap effect” are at all convincing.
To my mind, that should be it – game over for any “efficient market” theory. Short-term data is irrelevant when set against simple methods that generate extra returns of 1 to 2 per cent a year over 100 years. Not a bit of it for the MPT theologians, though. They continue to make bold pronouncements about how active management is a waste of time, effort and money.
I would have some time for such people if they did not then proceed to tell me that because asset allocation is the real source of investment returns, active tactical allocation between markets using low-cost ETFs is superior to bottom-up stock selection.
Clearly, there was a large part of MPT they chose not to read. That market timing does not add to returns is probably the most robust of all the academic conclusions about the stockmarket. It is inevit-able that after accounting for trading costs, most active managers will do less well than a representative market average. But one thing most people overlook is just how much the so-called representative market index has changed.
Do you really believe there is no difference between an index dominated by today’s “weightless” IT and IP stocks, with their tiny numbers of employees and minute capital bases, and the indices of the 1920s through to the 1980s dominated by real-world doers and makers, with giant capital bases and hundreds of thousands of employees? This looks like a prime example of theorists deciding what is important – market cap – and fitting the world to their view.
Many of the purveyors of “smart beta” have numbers that show that allocating portfolios by “value” or other metrics beats traditional market-cap indices. They are, of course, active managers wearing woolly cloaks because to succeed, they have to wear the same uniform as the pension fund consultants.
Most of these smart-beta guys tinker with their formulas, so in effect they are adopting a set of trading rules they alter from time to time. Some of them are probably smart enough to beat the average sheep. And if they are cheaper as well as smarter than the average sheep you might decide to put them in your pie. This tells you very little about the relative merits of active management and index tracking.
The ships designed by algorithm engineers don’t steer themselves. Human judgment has to be applied, which is why smart beta is a misnomer for most funds of this type – they are just another variety of active management. In contrast to engineering, though, the defining quality of successful active managers is not intellect or maths but character, as Fidelity’s founder Ned Johnson used to say.
You should not expect to find such people in big risk-averse asset management businesses. Increasingly, you will find them in boutiques that impose tight limits on the amount of money they run. Small adviser firms can hitch a ride with these dolphins and leave the gorillas to sink their own canoes.
Chris Gilchrist is director of Fiveways Financial Planning, a contributing author to Taxbriefs Advantage and edits The IRS Report