Wazza Buffet created a stir in his last letter to shareholders recommending how cash should be invested after his death. “My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”
The idea that institutional fund managers, mostly because of fees, underperform markets is not even a moot point as study after study has proved this to be the case; but hold on a moment. Most of these studies were conducted using data from the most efficient equity market in the world. What happens if we look elsewhere? The answer should be of interest to anyone (myself and most readers I expect) who invests outside the US.
In the paper I’m highlighting today, Does Active Management Pay? New International Evidence, Mr. Alexander Dyck and Mr. Lukasz Pomorski from the Rotman School of Management at the University of Toronto and Mr. Karl V. Lins from the David Eccles School of Business at the University of Utah find that it does; and how.
Using data for the period 1993~2008 they compare returns achieved by institutional managers in the US, EAFE (Europe, Australasia and Far East) and Emerging Markets and discover an active versus passive advantage of a whopping 180bp per annum (after expenses) for EM returns and 50bp per annum for EAFE. By comparison active management in the US cost investors in those strategies 28bp per annum. Wazza is right therefore about his home turf; but not about markets where efficient operation is still the exception.
Ah but I. That’s just an efficient-market-theory-effect of more risk producing more reward right? Wrong. The authors had the same concern so looked at returns in bad markets. If it were all about risk then managers should be hit hard in down markets; but it seems that’s where they really earned their crust in many cases managing to significantly mitigate the full impact of these downturns.
Ah but II. If the effect is material and persistent how come it’s not been arbitraged away? The authors aren’t sure but suggest the biggest pool of institutional capital i.e. the US is constrained in how it allocates beyond its borders. The better managers seem to have noticed the phenomena and do more actively manage their non-US exposure but the problem is they may not be free in terms of how much capital they can allocate to those markets.
The bad news for retail investors is if they want to invest in non-US markets the higher fees associated with products that give them access to these markets wipe out all the additional benefits. The worst combination for them would be expensive passive management in non-US markets (of the kind the Hong Kong MPF scheme and to a lesser but still significant degree European UCIT structures condemn investors to!).
Happy Sunday
[In going through this paper I was reminded of a classic sent me by a friend a while ago, ‘The Losers Game’, and although written in 1975 it identified then the problem for active managers of increasing efficiency in the US market. It also has some invaluable advice on how most of us should play tennis or golf. You can get a copy here The Losers Game]