Once upon a time a clever, handsome and well-paid fund manager, dressed in a fine handmade suit, was walking along Cornhill in the City of London when he stumbled upon a lantern. A curious sort of fellow, he gave the lantern a rub and a genie materialized. “Listen,” said the mischievous apparition. “If you believe all that three wishes tosh, you’re more stupid than you look. You get one wish, sunshine, so make it quick!”
The fund manager thought for a moment. Calculating the potential size of his bonus and the opportunity to impress his colleagues, he asked: “What will be the level of the FTSE 100 12 months from now?” The genie sneered: “Look, mush, it’s not my job to make your life easy, but I will tell you that there is a 70% probability that cash will outperform equities.”
How would a rational fund manager use this magically sourced information? He is a good son, so he telephones his mother and tells her to sell all her shares. He is confident in his own investment skill, so he sells only half of his own equity portfolio. However, he keeps the equity funds he runs for Acme Investment Management fully invested. Why? There is still an almost one-third chance that equities will beat cash. If his funds hold a lot more cash than his peers they will perform badly and he will risk losing his job.
The agency-principal problem exists not only in the world of drear textbooks on economics or latter-day fairy tales. The fund management business is replete with agency problems. Even blessed with perfect knowledge of expected returns, fund managers will often prefer to cuddle up to the consensus, to paraphrase that most sage of industry commentators, Peter Bernstein. However, the responsibility for many of the problems that beset the fund management business rests with the principals (such as pension funds) as much as the agents.
In the institutional arena the rise of specialization means that each manager has a narrowly defined investment mandate, usually accompanied by a tightly specified tracking error. A US mid-cap growth manager has no incentive to tell the truth about the investment opportunities in his particular pigeonhole. His job is to keep the mandate at all costs. Even if he did want to be honest, the manager does not have the training to make an objective assessment of the relative opportunity offered by other parts of equity market, let alone other asset classes.
Further, as the world moves to defined contribution, the asset allocation decision is often left to an individual who probably has little appreciation of the right asset mix for his own circumstances, let alone a detailed knowledge of likely future returns and risks in different markets. A recent survey by DC Link in the UK revealed that 89% of participants in defined-contribution plans opted for the default “lifestyle option”. In all likelihood this means they made no choice at all.
When retail investors do make decisions, they are often the wrong ones. In the first four months of this year US individuals poured $9 billion into emerging market mutual funds, $2 billion more than for the five years between 2000 and 2005, according to Boston-based Financial Research Corp. We all know what happened in emerging markets in May and June.
The industry does not help by advertising hot funds. Usually, when a track record is worth boasting about, the fund manager is primed for a period of bad performance. He or she is probably invested in an area of the market that is about to tank, or their ability to perform will soon be impaired because their hot status means they will be managing too much money.
The arbitrage mechanism, the recycling of capital to assets with the best risk-adjusted return profile, has arguably been impaired. The TMT bubble was perhaps one manifestation of what a wall of retail, momentum-driven money can do to asset prices. The recent swoon in emerging markets suggests it is unlikely to be the last such event.
In the past, defined-benefit plans paid balanced managers to make asset allocation decisions. Now, the defined-benefit funds that are left have specialist managers and strategic asset allocation benchmarks that are set in stone for years. Many funds, compelled by meddling regulators, are adopting a liability-driven approach. Buying long-dated UK gilts for a few basis points of real yield is probably no more sensible than buying a TMT fund in March 2001.
There are too few people in the asset management industry who are paid to move money around. But dumb money creates opportunities for those that do. Global tactical asset allocation is surely a strategy to back. Or, if you like your investments with steroids, a basket of global macro hedge funds will do the same job with dialled-up risk.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own.
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