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Wednesday, November 18th, 2015

Active Asset Management risks mis-selling itself, when it does not need to
posted by Andrew Lilico

The asset management is about to be the subject of a competition probe by the Financial Conduct Authority.
The FCA is seeking to understand whether competition is working effectively to enable both institutional and retail investors to get value for money when purchasing asset management services.  More specifically, the FCA says it is interested in:
how asset managers compete to deliver value;
whether asset managers are willing and able to control costs and quality along the value chain; and
how investment consultants affect competition for institutional asset management.
These topics are important in their own right.  But at this it is less clear to what extent the FCA will probe the really big issue regarding asset management, arguably nothing less than a ticking time-bomb in the financial sector waiting to be either defused or detonated.  Across much of that sector there are funds offering “active management” of assets – they pick when to trade in and out and they pick particular sectors and investment strategies.  According to the FCA, about 78 per cent of funds’ assets are managed this way. The alternative to this is what is called “passive management”, whereby  funds track the FTSE, offer some combination of the stock market and a low-risk asset such as government bonds, or perhaps track some other slightly higher-risk index. In the industry jargon, investors in passively managed funds are said to “buy beta” – i.e. buying a desired level of involvement in the market average risk-return tradeoff - whilst those in actively managed funds are also buying “alpha” – i.e. outperformance of the market average return for any given level of risk.
Actively managed funds cost investors more for the management fees.  There is a standard result in the academic literature that says that, on average, although actively managed funds can outperform the market (they can generate “positive alpha”) the cost, in terms of management fees, of getting that higher return is greater than the return.  In other words, on average investors lose out by investing in actively managed funds. Some folk can get lucky by investing in an actively managed fund early in a fund manager’s career, before his or her reputation is established and the fees go up.  And of course in any one year actively managed funds might get lucky.  But the average is negative.
Why is this a ticking time bomb?  Because although they are familiar with this academic result (which has been around for some 25 years now), much of the funds sector refuses to accept it and consistently markets their actively managed funds on the basis that they can outperform passively managed funds.  So in, say, ten years someone retiring with an actively managed fund could say: “If I’d invested in a passively managed fund, I’d have a £3,000 per month higher pension.  And you knew that that would be likely to be so, because all the research told you that decades ago.  But you told me I would do better by investing in your actively managed fund.  That’s mis-selling, and I want you to make up the difference.”  Whether such appeals for compensation would or should be successful is of course a matter that could be disputed.  But it is a risk that at present the funds industry does not appear to recognise.
And that seems to be a mistake.  Because although the empirical result that active management costing more than the returns outperformance is often presented as either an illustration of markets functioning poorly or of how investors are not perfectly rational, increasing average returns should not be what one would expect active management to do in an efficient market.  Active management should be expected to change the profile of returns  - e.g. by reducing how much funds fall in a modest crash (really big crashes will tend to overwhelm everyone).  By doing things like this, active managers change the shape of returns – in the jargon that’s called the “skewness” – so there is less downside, relative to the upside.  Now in standard finance theory, it is commonly assumed, for simplicity and tractability of models, that investors care only about the mean and variance of returns but not the skewness, so changing skewness wouldn’t be worth anything.  But in standard microeconomic theory (for technically-minded readers, I’m referring to Arrow-Pratt risk aversion), investors should prefer a profile of returns with less downside, even if the average return is therefore slightly lower.  That means that in an efficient market, we should expect passively managed funds (with a market average skewness and downside risk) to have a higher expected return than actively managed funds (where downside risk is reduced).  To put the point more plainly, active management costing more than the returns outperformance it produces should not be a surprise and is not, in itself, an indicator either of bounded rationality or market failure. It is what one should expect if markets are functioning efficiently.
Of course, just because one should expect post-fees returns on actively managed funds to be less than on passively managed funds by some degree, that does not mean that just any degree of wedge between these two returns is efficient.  It could still be that the wedge in practice is higher than the wedge justified by skewness effects – so there could still be competition or market failure or bounded rationality issues to consider.
But even if there are not, there’s still a potential problem for the active management sector.  There should be nothing wrong with active management, per se.  What it achieves is to change the profile of returns.  But active managers need to be careful about how they sell themselves to investors.  At the moment, some may be running the risk of deceiving investors by claiming what they offer is higher average returns, when in fact what they offer is (on average) lower expected returns (after fees) but less downside risk.  That’s worth something. But you need to sell it right.
11:56 AM | Permalink

Friday, October 30th, 2015

Return on infrastructure assets vs. equity
posted by Europe Economics

At the UK governing Conservative Party’s annual conference on October 5th, Chancellor George Osborne announced that 89 of the UK’s local government pension schemes (LGPS) would be consolidated into six new “British wealth funds”.

At present only around 0.5 per cent of £180bn in LGPS assets are in infrastructure, or around £2bn. The government believes that this is partly because LGPS are too small to invest properly in infrastructure.  It notes that in countries with larger pooled public pension schemes, typical infrastructure investment is around 8 per cent — or around £14½bn, some £12½bn more than at present.

The following table shows recent determinations of the allowed return on capital for infrastructure assets by European regulators.  If the newly created British wealth funds were to move their capital into infrastructure, they will need to move them out of some existing investments. It is likely that they would need to sell some of their current equity to invest in infrastructure. If they want to keep the same overall portfolio return they would need to move some other funds into riskier equity since allowed returns on capital are lower than returns on equity, as illustrated indicatively in the table below. 

Table 1: Recent determination of the cost of capital for infrastructure

Source: regulators’ websites.
Note: return on capital showed in the tables are set on the basis of different assumptions (e.g. pre/post-tax) and should thus not be compared across countries. In jurisdictions where the return on capital is set on a pre-tax basis, the overall pre-tax weighted cost of capital may be smaller than the post-tax return on equity showed in the table. 

03:21 PM | Permalink

Thursday, October 1st, 2015

Re-repricing of risk for commodity dependent sectors
posted by Europe Economics

Figure 1: Rolling Asset Betas (2-years of daily data)

EE calculations based on Bloomberg data.

In the figure above we can notice that, over the last month, the asset betas of the materials and energy sectors have experienced a sharp increase, whilst the beta of the industrial has decreased.  Such changes can be rationalised as indicating a re-pricing of risk for commodity driven sectors (i.e. sectors that benefit from rising commodity prices) and industrial sectors (i.e. sectors that benefit from falling commodity prices).  More specifically, markets now perceive the former as riskier than the latter (whilst these sectors were perceived as equally risky in August).

Such re-pricing of risk might be due to the poor performance of commodities in September, after a rally recorded in the second half of August.

02:07 PM | Permalink

Friday, August 28th, 2015

Trends in perceived relative risks across UK equity sectors remains intact
posted by Vasileios Douzenis

Figure 1:  Rolling Asset Betas (2-years of daily data)

EE calculations based on Bloomberg data.

The “beta” of an asset tells us how the riskiness of that asset changes relative to the sum of all assets in the economy. Therefore, for a given equity sector, an increase in beta is interpreted as an increase in its risk relative to the equity market as whole. As noted in our previous newsletters, the general trend since 2014 has been a steady increase of the beta of relatively safe assets (e.g. utilities), and a decrease of betas of sectors perceived to be riskier (e.g. financials). In particular, the financials sector appears to be diverging from the other main equities sectors in moving to lower risk relative to the pack. We have interpreted this as a sign of potential normalisation of financial markets and a move away from “flight to safety” effects.
Since June 2015 financial markets have been subjects to at least two relevant events. The deterioration and subsequent resolution — at least temporarily — of the Greek crisis and, more recently, the sharp sell-off in equity markets across the globe amid fears of a slowdown in Chinese growth. It is of interest to notice that, despite these developments, the overall trend trajectory and momentum of UK equity beta have remained perfectly intact. 
10:47 AM | Permalink

Friday, July 31st, 2015

Financial markets see sectoral risks becoming more similar over time
posted by Vasileios Douzenis

Figure 1: Rolling Asset Betas (2-years of daily data)

EE calculations based on Bloomberg data.

In the last two months’ entries we explained how during periods of market turbulence a “flight to safety” effect is often present among market participants.  Last month, in particular, we noticed how despite what was perceived as an increased probability of “Grexit”, the core identifiers of a “flight to safety” effect were not observed.  UK utilities maintained their positive momentum while, on the other hand, the asset betas of companies in the UK financial sector maintained their somewhat negative trajectory.

July has been an eventful month for financial markets with major developments for the European Union and the Eurozone.  The stalling negotiations between Greece and its creditors, delayed, among other reasons, because of a referendum, appeared to be progressing when preliminary steps for a third bailout package were agreed.  While this can be seen as a positive step, it raised concern regarding decision making at the Eurozone level and highlighted some of the system’s structural weaknesses. At the same time, things are taking a negative turn in China with the stock market experiencing significant volatility and some rather significant day-to-day drops and triggering concerns among investors.

Data presented in the above graph highlights the persistent reversal in the “flight to safety” effect, with utilities’ beta increasing and financials’ falling, while other sectors appear to be more or less stable.  The visually striking convergence in the figure can also be confirmed statistically.  The coefficient of variation across these ten sectors (into which Bloomberg subdivides the FTSE as a whole) has fallen from 35 per cent in January 2014 to 17 per cent in July 2015.

04:15 PM | Permalink