The Academic Pejorative

In last week’s essay we summarised the development of the funds management industry in New Zealand.   The rationale being an explanation for the ‘investing’ publics conviction for remaining focused to that which they know and understand (direct shares in some instances – but predominantly residential investment property and banking products especially term deposits).  The funds management industry took seed in the 80’s however with the arrival of KiwiSaver the seeds have more profusely germinated and progressed the industry, for which the banks are now the major supplier, 65% and climbing.  That means at best only a third of KiwiSaver account holders are receiving advice.  Those not, are at worst in (conservative) default funds and at best in balanced funds.

The same issues which prevented investment into unit trusts and managed funds for the previous 30 years are evident with today’s KiwiSaver investors and with today’s investing retirees.  (Those lump sum investors with a bundle of cash but only a pocketful of knowledge)  Lack of financial literacy will come at a huge cost to both, unless they take advice and even then the process of determining trust and belief in an environment of volatility, is proving stressful to them.

But what’s the academic pejorative – why have academics slam dunked the investment community?  It comes down to active vs passive management.  Active management is the art of stock picking and market timing.  Passive management refers to a buy and hold approach to money management.  For example the S & P 500 is a measure of the top 500 companies in the US (large capitalisation index).  There are many types of passive funds: big stocks, small stocks, value or growth, foreign or domestic – in 2014 Growth stocks (S & P 500) out performed all.  Neither ‘label’, active or passive is perfect and there will not always be a dichotomy between them.  In between we have the world’s greatest investor – Warren Buffet.  Some might call him a stock picker but he’s definitely not a prolific trader.  He buys and holds.  New Zealand’s active funds managers are stock pickers and ‘market timers’.  According to their thesis, prices (shares) react to information slowly enough to allow some investors, presumably professionals, to systematically out- perform markets and most other investors.  The academics (and passive fund managers) believe that prices are always fair and quickly reflective of information.  They believe that neither professional investors nor small investors will be able to systematically pick winners or losers.  The critical measures or outcomes are: cost and performance.

The problem with the ‘active’ funds management industry and stock broking in particular in New Zealand is that they are afflicted with small man’s syndrome, local bias, a remuneration model based on trades (stockbrokers) or short term performance (fund managers – star ratings) and a transient market personnel.  Not only is there a continuing coming and going of funds, the fund managers are predominantly head hunted by their competitor if they are good marketers and if they are poor ‘short’ term managers – they will be moved on or perhaps even worse, maintained.  Internationally there are exceptions with historical experts such as Keynes, Buffet, Munger, Ruane and Simpson – each of whom would be classed as ‘focus’ investors – the buy and hold type with minimal holdings (say 15 securities) and a long term outlook.

                                                (UK) Keynes 1928 – 45                    Average return                 13.2%

                                                                                                                Market return                   -0.5%

                                                                (this included WWII and the great depression)

                                                (US) Charles Munger 1962 – 75   Average return                 24.3%

                                                                                (Dow Jones)       Market return                     6.4%

                                                (US) Buffet Partnership 1957 – 69 Average return                30.4%

                                                                                (Dow Jones)       Market return                     8.6%

                                                (US) Bill Ruane 1971 – 97              Average return                 19.6%

                                                                                (S & P 500)          Market return                   14.5%

                                                (US) Lou Simpson 1980 -96           Average return                 24.7%

                                                                                (S & P 500)          Market return                   17.8%

                                                (US) Berkshire Hathaway 1988 – 97 Average return            29.4%

                                                                                (S & P 500)          Market return                   18.9%

(No wonder followers of Buffet have become multi millionaires)

These experts did not dip and dart, pick stocks and time markets which active fund managers get paid high fees to do.  Their point of difference – due diligence (intensive analysis over time) patience with markets and a complete disregard for short term market noise and commentary.  In contrast (1950’s) the early work of academics, Markowitz, Miller, Sharpe and Fama was transforming the field of finance.  They spelled out the idea of market efficiency and provided evidence that free and competitive markets work. 

Studies provide a fifty year history of professional investment management in US.  The message is clear: The beat the market efforts of professionals are impressively and overwhelmingly negative.  In any asset class the only consistently superior performer is the market itself.

Of course active fund managers point to the few exceptions – the Buffets of this world – they ride the coat-tails of the exception but here’s the rub.  Do we follow the modern Buffets hoping they too can beat the markets or do we follow the recommendations and methodologies of the academics – and why or why not?

Next week – The summary – what’s our recommendation.