Josh Lyman and fund managers’ Gordian knot
“We got momentum, baby! We got the big mo!”
Josh Lyman in the TV series ‘The West Wing’ may have wanted it in a presidential election race, but what of fund management companies? Do asset managers want investors to buy and sell their products as the momentum of fund returns ebbs and flows?
I began wondering about this when faced with comments from two well-respected figures in the funds industry. First, Marcus Brookes, Head of Multi-Manager at Cazenove Capital, so no slouch when it comes to picking funds:
“Some fund managers’ and IFAs’ approach to picking funds is usually quantitative to begin with and it is obvious most guys begin with the stuff that has just done well. It also means you are discounting three-quarters of the sector.”
Next the thoughts of Edward Bonham Carter, Group Chief Executive of Jupiter Investment Management: “You shouldn’t seek that level of consistent outperformance, it doesn’t exist except as a statistical fluke… The industry is flawed, in my view, by implicitly promising or expecting that.”
From this perspective, one of the industry’s main shortcomings – the apparent promise of consistent outperformance by fund managers – becomes more intractable because it is accompanied by investors’ continued willingness to buy funds on this basis. Fund managers’ Gordian knot, if you will.
Mythical side-note: The ox-cart that once belonged to Gordias, king of Phrygia, was tied up with an intricate knot that had no end and so could not be undone. When Alexander the Great found that he could not untie it, he chose to slice the knot in two.
Fund buyers wanting to cut the knot could simply ignore fund managers’ potential ability to outperform and instead choose index tracking funds, be they mutual funds or ETFs. Interestingly, Europeans remain far less enamoured of passively managed funds than investors in either the US or Asia Pacific. Among equity fund assets in these three regions, Lipper data reveals that the proportion invested in passives in the latter two regions are 32 percent and 30 percent respectively. In Europe it is just 16 percent.
This may well become more of a challenge for European asset managers in the years ahead – there are already signs of this in the UK in light of the changes brought about by the Retail Distribution Review – but for now active managers can continue to scrap amongst themselves and still have a much larger investor base.
An alternative is to ignore the Gordian knot – who cares if there’s an ox cart knocking about the place anyway – and embrace momentum investing. In the words of Dennehy Weller, a firm of independent financial advisers, “this means buying an investment (in this case a fund) which is already performing well, the likelihood being that it will continue to perform well.” This firm is one that has turned such a philosophy into a process that self-directed investors can experience for themselves, or what they call Dynamic Fund Selection.
They are not alone among professional fund selectors in using momentum to improve returns for clients. Juan Vicente Casadevall of financial advisory firm Kessler & Casadevall says “there are a number of factors we have learned through the years that lead us to have some biases in our research process. One of them is momentum which seems at odds with a financial product that is aimed at investors for the medium and long term. But we have identified that placing a higher weight to the most recent performance of funds relative to their benchmarks can add value.”
The knock-on effect of ‘hot’ money flowing between funds, driven less by a view of the long-term prospects for the fund and more by shorter term factors, is that asset managers will sometimes lose the “big mo” as swiftly as they got it in the first place.
Sure enough, many international fund managers have to manage high levels of volatility in sales flows. Lipper’s historical analysis of fund sales suggests that European groups selling their funds cross-border have to manage redemption rates typically twice as great as those found in the U.S., averaging 66 percent for the former (using Lipper data) but just 29 percent for the latter (using ICI data) in recent years. So there is a real incentive for fund managers to change the status quo.
Clearly this situation is not simply the result of momentum investors, but both Brookes’ “quantitative lemmings” and Bonham Carter’s characterization of fund managers’ implicit promises, will have played their part.
Seeking sympathy for fund managers will always be a thankless task, but for those active fund managers in Europe selling their funds internationally the pressure to perform seems to be increasing at a time when the use of passive funds is rising. The Gordian knot is getting tighter.