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Is capitalism flawed at its financial heart? Many people claim it is. They say financial markets are not efficient and investors herd or act irrationally. One of the most commonly-quoted examples concerns active and passive funds management. “Funds management” is the name given to the management of pensions funds and other similar assets. A “passively managed” fund is something like a stock market tracker fund, where the assets held automatically adjust to mirror some stock market index or other similar index. All the investor in a passive management fund does is to decide how much risk she fancies taking. The design of the fund does the rest. An “actively managed” fund, by contrast, is the typical and best-known kind of investment management fund one where the fund manager analyses companies or bonds or currencies and trades in and out of them to try to get the best returns.
It’s long been known that, although the average returns on actively managed funds can be higher than on passively managed funds before fees, on average the gain is less than the fee – i.e. net returns, after taking account of fees, are systematically lower on actively managed funds. But despite returns on actively managed funds being systematically lower, around three quarters of UK investors’ money from pension funds and similar investments, is in actively managed funds.
Many people claim that just goes to show that investors are irrational. Indeed, this is one of the main “facts” quoted by those that claim financial markets don’t work and capitalism is flawed at its heart. Others think it shows that competition doesn’t work properly in the fund management sector.
Either of those claims might be true for other reasons, but active funds being heavily invested in despite lower average returns doesn’t, in itself, show either of those things. Net returns from actively managed funds being lower than for passively managed funds is exactly what theory predicts should happen if markets are working efficiently.
Why? Well, what active managers do is to try to get out early if assets are falling in value and get in early if assets are going to rise. Insofar as they are successful at doing that, that will indeed raise average returns (before fees), but that’s not the only effect. The other key effect is that it changes what is called the “skewness” of returns.
Returns are “skewed upwards” if, relative to a normal “bell curve”, there is less downside and more upside. Standard theory says that risk-averse investors will prefer a distribution of returns that is skewed upwards, even if there is no difference in average returns. Similarly, they will regard a distribution that is skewed upwards but has slightly lower average returns as just as good as a normally distributed bell curve distribution with a slightly higher average. Empirical studies suggest that, although when crashes are really bad, active managers do not produce more favourable skewness of returns, under more normal circumstances they do provide some insulation against downside risk and better upside opportunities (i.e. they have superior skewness, from an investor’s point of view).
That means we should expect that, if the market is working properly, investors should regard slightly lower returns on upwards-skewed actively managed funds as just as good as slightly higher returns on more normally distributed passively managed funds. So the fact that this is actually so does not, in itself, show that investors are irrational or that financial markets, and capitalism more generally, are flawed.
However, that’s not quite the end of the issue. For those that sell actively managed funds to investors routinely appear to claim that what they are selling is some kind of outperformance of the market. They talk of the “alpha” of their fund (alpha is a measure of out-performance) or how this or that fund manager has outperformed its “benchmarks” for the past few years. But that cannot be right. On average, actively managed fund must (and ought to) provide lower average returns, after fees, than passively managed funds, and it has been known, for decades, by those working in funds management that that is in fact true. So when actively managed funds are sold to investors as offering out-performance, that must be close to mis-selling.
Given the £7 trillion invested in pensions and other parts of the funds management sector, a mis-selling scandal in that sector (which is an issue waiting to happen) could dwarf PPI, endowment mortgages or all the other mis-selling scandals we’ve ever seen put together.
Active fund management does offer something valuable. But it needs to be sold correctly. If it isn’t, the mis-selling scandal that will eventually arise could be the source of a serious financial crisis.