| Management styles: The lane is now clear for active managers to express themselves |
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| 04/04/2004 | |
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The second longest bear market in financial history lasted for exactly three years, from March 2000 until March 2003. Depending on their investment strategy equity investors typically lost between 50% and 90% of their portfolio value during this period. However, some fund managers were able to partially limit losses. All of them were following investment strategies without any benchmark restrictions. Since they were not required to achieve any target tracking error relative to the benchmark those managers were not obliged to invest in all the stocks included in the index. As the speculative bubble originated in the technology sector, managers who stayed away from the general hype and refrained from packing their portfolios with Nokia, Cisco and Amazon.com were particularly successful. Therefore many active managers were able to limit the damages – unlike their passive colleagues who had to either replicate or to follow closely their indices. Nevertheless, it has always been an established fact that very few active managers are able to outperform markets on a regular basis. It seems, therefore, that there were more active managers able to outperform the indices during the bear market than in the 1990s. Also, the steadily growing number of hedge fund managers, among active managers, did reasonably well on average. Will the trend be ongoing? In order to answer this question it is helpful to look at the history of financial theory. The founders of modern financial theory, William Sharpe and Harry Markowitz, introduced the concept of market efficiency in their "Modern Portfolio Theory" in the early 1970s. According to this theory, any new information concerning a company is immediately reflected in its share price. As an investor, it is therefore impossible to have a competitive advantage over another, unless one has access to illegally acquired insider information. Pricing is thus always fair and according to this theory it does not make sense to try to outperform the market through active management. The average return, before fees, for all investors will thus inevitably equal the whole market. However, given that active management gives rise to fees, the average active investor or fund manager will under-perform market indices. According to "Modern Portfolio Theory" then, it is not worthwhile to take the risk of investing with one of the many "bad" managers. Instead, it is better to choose a low-cost fund that tracks an index and replicates its performance. Since the launch of the first index fund by John C. Bogle at the beginning of the 1970s, an "index industry" on its own has developed. Today, the index funds-specialised Vanguard Group founded by Bogle is the second largest asset manager worldwide. Investments in index funds were extremely successful during the 1980s and 1990s, with an index such as the S&P 500 gaining 12% per year on average. Admittedly investors had a few bad experiences, such as the 1987 crash, but losses always were short term and usually settled after one or two years at the latest. A bleak scenario for investors who entered the index-fund market at the inception of 2000 How many years will those investors have to wait in order before recouping their initial investment, let alone achieving an average annual return of 12%? The hasty conclusions of certain supporters of the "efficient market theory" partly explains why the financial world was so slow in picking up on the speculative bubble in the technology sector. Passive managers had basically overlooked two things: First; in history there have always been and will always be periods of overvaluation and undervaluation by the markets. Second, the 1980s and 1990s were extraordinary years for the stock markets. Historically, there have always been long hard hauls, where returns on the stock markets have not been more than 10-14% per year on average. According to Sharpe and Markowitz, speculative bubbles like at the end of the 1990s cannot occur. It is probably true to assume that information is reflected in prices immediately and that investors behave rationally since they interpret the news correctly. However, there is an essential psychological factor. In a generally positive environment good news will have a stronger impact on share prices than in periods of general disillusion and vice versa. Over the past few years several financial theories have been developed, partly based on "Modern Portfolio Theory", partly going in completely new directions in order to explain the phenomenon of "overshooting" and "undershooting" prices for tradable goods be it tulips, property or stocks. All these theories draw in psychological factors as well. Now that the technology bubble has burst, can we expect extended upward trends as we saw in the 1990s? The research team at Fund-Market, an independent investment advisor, shares the opinion of many other analysts, and expect that the stock markets will substantially under-perform the 1990s. There are several reasons to believe this. Despite the three-year correction, price earning ratios are very high again following the upswing in 2003, especially in the US, and leave little room for further gains. The risk premium for shares in relation to bonds is far above its historical average. In stock markets and foreign exchange markets high volatility is likely to continue. The increasing imbalance of trade between the USA and the rest of the world is very dangerous. Long-term structural trends are associated with significant risks that are likely to lead to market upheaval in the future. Amongst the various trends, there is the IT-revolution, which is far from over, the rise of China and India to worldwide leading economic powers and the difficult demographic situations in Japan and Europe. All of these factors will contribute to large fluctuations in the stock market indices and to rather limited upward potential. Index funds will therefore bring little joy to investors. Active managers can however reduce portfolio volatility and at the same time use imbalances to generate profit - provided they make the right decisions. Good traditional equity fund managers will be able to outperform by effective stock picking while hedge fund managers will use market inefficiencies and overreactions for their own purposes. For the investor life does not become easier though. He will need good advisers to assist him with fund selection since at least one of Sharpe's principles is still valid: the market will always be the sum of all investors and only very few will outperform. In future the investor's main priority will be to avoid risk rather than wishing for unrealistic returns. Henri Reiter, Director, Fund-Market |
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