Author: Ed Moisson

“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.

The tumult caused by Richard Buxton’s move from Schroders to Old Mutual in March highlighted the veneration of “star” fund managers, those select few who apparently rise above the crowd to shine their light upon adoring investors.

We don’t need to dwell on Buxton’s track record (annualised return on his UK Alpha Plus fund of 13.7 percent over 10 years), but combined with Mark Lyttleton’s departure from BlackRock – his own star rather faded of late – I am drawn to ponder the funds industry’s views of, and hunger for, stellar talent.

It is attractive, and reassuring even, to believe that the people running our money are blessed with some innate skill for playing the markets, but I recently had to re-consider my own views on natural talent when talking to Matthew Syed, now a journalist and author, but previously England’s number 1 table tennis player for a decade. A competitor at two Olympic Games and winner of three Commonwealth Gold medals, Syed has some experience of being praised for his apparent natural ability.

He contends that some of our most cherished notions about natural talent are misplaced. Instead he argues persuasively that practice, opportunity and belief are far more important than genetics in determining success.
In a nutshell, Syed asserts that “when you look at the science rather than our own implicit biases, you arrive at the conclusion that champions are not born, they are made.”

Rather than going through these arguments in full, which Syed does best himself in his book ‘Bounce’, I will focus on a few aspects that have direct relevance for the funds industry and the cult of the star manager.

FEEDBACK

Exposure to the right opportunities is obviously vital for an Olympic athlete or a top fund manager to succeed, but Syed’s most consistent theme is a simple one: practice.

Not hard work for building character, or for some other honourable good, but because purposeful practice is far more influential in determining an individual’s success than a reliance on genes. “Those who believe in talent tend to lose motivation. Why work hard if it is all about having the right genes?”

Commodities guru Jim Rogers’ recent comments on his own experience are interesting here. “To the extent that I had any success, it was from homework,” he said. “I was willing and able to work harder than other people, but I was also willing and able to think differently from other people.”

Of course Syed’s emphasis on practice over talent does not mean that he believes effort alone guarantees success. The right mentor – perhaps the right investment manager – to learn from is vital. Intertwined with hard work is the often discomforting task of learning from feedback.

This has the potential to be a huge issue for star managers if the culture in their company is not conducive to giving (or receiving) constructive feedback, or to “think differently from other people,” in Rogers’ words. Not having your ideas challenged by colleagues, or believing your own billboard ads, is surely a slippery slope for a star fund manager.

As Syed puts it, “For those who are already ahead of the pack, it is vital they are pushed. If they stay within their comfort zone, they will not learn.”

The perils of lacking feedback, of not continuing to learn, can be seen in a striking example that Syed offers of research by Jeffrey Butterworth in 1960. This examined the ability of doctors to make diagnoses using heart sounds and murmurs over time. He found that while accuracy increases with experience as a person progresses from student to certified cardiologist, he also found that accuracy actually diminishes over time for doctors in general practice.

The explanation for this apparently surprising finding? GPs encounter cardiac cases relatively infrequently, and they have relatively limited feedback on which to base their judgments and diagnoses. How to improve? Well, after short, targeted practice, “their diagnostic accuracy soared,” says Syed.

This suggests a parallel with fund managers diagnosing, and dealing with, financial crises – even rarer than heart complaints, but also with devastating consequences. In turn it would be interesting to delve into the planning fund managers undertake for dealing with future crises of different shapes and sizes.

There is some evidence that fund managers have already learned to use their experience effectively. Analysing mutual funds registered for sale in the UK in preparation for this year’s Lipper Fund Awards, we compared winning funds against their peers and found that the average tenure of the winning fund managers is longer than the rest. From this initial examination the evidence was pretty consistent, suggesting that the fund management community may actually be a good example of practice in action – and of seeing experience make its mark.

BELIEF

Building success over the long term brings us to another aspect to consider, and something someone like Jim Rogers has in abundance: belief. Any individual has to be motivated enough by their profession to persevere with the hard work needed to succeed.

There are many extraordinary examples of the scale of hard work undertaken from an early age. Mozart had clocked up 3,500 hours of music practice before his sixth birthday, according to Michael Howe (‘Genius Explained’, 1999), while Geoff Colvin (‘Talent is Overrated’, 2008) estimates that Japanese ice skater Shizuka Arakawa fell over 20,000 times while practising her skating (starting at the age of five), but ultimately won an Olympic gold medal in 2006.

As Syed puts it, “When you appreciate that it has taken many thousands of baby steps by world-class performers to get to the top, their skills do not seem quite so mystical after all.”

This highlights the need for perseverance, underpinned by a real belief in what one is practising and trying to achieve. As the statistics above illustrate, the sheer volume of work involved in reaching the highest levels of performance is difficult for outsiders to comprehend.

But this also hints at a classic conundrum for the fund management industry. Mutual funds are designed as long-term investments, but investors often buy and sell them far quicker if they do not think returns have been good enough over shorter periods. “Baby steps” can be too small or too slow for many investors.

To a certain extent this simply underlines some of the pressures that asset managers have to deal with. But taking this aspect together with the others from Syed, one finds a well-rounded case for fund businesses to build structures which give opportunities to those willing to work hard, provide constructive feedback throughout the organisation, and create a company culture that really motivates people.

Before ending, the number cruncher in me cannot help but ask Syed about those who practised hard but failed. Is there a survivorship bias in the statistical evidence?

“I am glad to say that I found no evidence of this,” he says. “With deliberate and purposeful practice, we are all transformed with dramatic implications.”

Encouragement then even for those less-than-starry fund managers currently languishing at the bottom of the league tables.

((This is the third in an occasional series of interviews offering alternative insights for the fund management industry, which have also looked at betting on horses and charitable donations. ))

So far the impact of the financial crisis has not hit the wealthy as hard as many protesters would like. Even French millionaires have a found an escape from the modern-day guillotine that is a 75 percent tax rate, in the shape of Russian president Vladimir Putin.

But what about the level of charges that high net worth individuals have to pay for investing in hedge funds? Even though there has been some downward pressure on the annual management fees charged, the most common model remains “2 and 20” — 2 percent of the fund’s assets and 20 percent of its performance every year.

In real terms, for a 50 million pound hedge fund that returned 8 percent this could mean an annual fee of 1.8 million pound. The equivalent mutual fund in the UK would typically charge less than half this amount. Perhaps this should be a reason to consider switching to a different fund manager. But European investors have traditionally been more persuaded by the argument that you have to “pay more to get more” than by the notion that a fund manager should minimize costs in order to maximise returns. (Having said this, institutional investors are clearly more savvy when it comes to fees; it helps that they have the clout, through the volume of investable assets, to negotiate).

Yet perhaps the winds of change are blowing. Cantab Capital Partners has launched its Core Macro Fund with a “1/2 and 10” fee structure. The management fee of 0.5 percent (which also covers back office costs) applies to those investing at least $50 million. Those investing less money will pay more, but still enjoy the 10 percent performance fee. It is hard to argue with Cantab Capital Partners’s assertion that this is “exceptionally low cost” for institutional investors, not least when considering that the fund has daily liquidity and there are neither redemption penalties nor gating clauses. But for performance fee savvy investors, the fact that there is no High Water Mark nor a hurdle rate cannot be ignored. And for those looking for signs of a revolution, Cantab’s other funds have not changed their fees to move in line with the new fund.

There are others that have grappled with the issue of fairness in performance fees, either through the way the fund itself is structured, as with Optcapital, or Aquamarine Capital’s variation on the level of the performance fee. The Aquamarine Fund charges either “1 and 20” or “0 and 25” depending on the share class, with the performance fees subject to 4 percent and 6 percent hurdle rates respectively.

Products with a “no win, no fee” structure are not unique to the hedge fund arena, with mutual funds from the likes of Vinculum entering the fray last year and Bedlam manning the barricades ten years earlier. The Bullhound technology fund also tried this back in 2000 and subsequently closed. Of course mutual funds are also open to the ‘hoi polloi’ who, as we all know, are already revolting, not least in Greece.

PERFORMANCE FEES

There are some signs that millionaires are taking steps to move away from hedge funds. Reuters recently reported that Deutsche Bank’s Alternative Investment Survey showed that family offices and high net worth investors now account for just 4 percent of industry assets, down from 18 percent in 2002.
Having said this, this looks to be a move in search of higher returns, rather than away from higher fees.

In the UK, the blow being struck against high performance fees has come from a more surprising quarter. Here Independent Financial Advisers (IFAs) are those with both the clout and, it seems, the inclination to discourage use of such fees among mutual funds. Their use is most common among funds seeking absolute returns in all market conditions. Many of their strategies mimic traditional hedge fund strategies, and many of them have mimicked hedge fund fees too.

IFAs, most notably Hargreaves Lansdown, have been publicly sceptical of performance fee structures and it looks as though asset managers in the UK have responded. Since the fee structure was first allowed for open-ended funds in 2004, the number of funds being launched with the fee rose to a peak in 2006, but has since declined to the point where only two funds with this structure were launched last year.

Lest we lose sight of the millionaires, it is worth casting an eye to Switzerland, where the Swiss Federal Supreme Court has apparently taken up the mantle of the 1789 Assemblée Nationale and stated that retrocessions, or trail commission, received by banks for asset management services belong to the client.

Although the full implications of this move are still being considered, Ernst & Young have helpfully carried out a survey where respondents generally believe that the Court’s move will improve transparency in the industry, but still the price of bank services (including private banks) are not expected to fall.  The experience in Switzerland so far sounds a lot like that in the UK with the Retail Distribution Review (RDR), which was originally aimed squarely at the man in the street. Perhaps millionaires and the downtrodden retail investor do indeed have common cause.