Asset management: as one elephant vanishes, at least two others appear
These disappearing acts are the industry’s way of losing its black sheep
We have written about the “elephant in the room” before – the self-serving investment practices that benefit service providers at the expense of their clients. Burying poor past returns falls into that category.
Asset managers tend to offer a range of funds. A few do well and attain flagship status, but others perform poorly and settle at the wrong end of the rating table. They suffer outflows and do nothing for the manager’s reputation.
It makes no business sense to keep these going, yet simply closing them down comes with reputational risk. Instead, the underlying investors are transferred to a more “appropriate” fund and assume that fund’s track record. This also enables the manager to retain the assets, and the associated fee income, before the remaining clients move their money elsewhere.
In a rare mea culpa, Stanlib recently announced it would close 15 unit trust funds because its range was “too complex” and no longer appropriate. South Africa’s third-largest asset manager hopes to curtail duplication in its multi-asset funds and consolidate funds in the same category. So, for example, individual funds targeting financial, resource, industrials and value stocks will all amalgamate into its SA Equity fund.
While a large-scale consolidation of this nature is unusual, the concept itself is not. The investment industry regularly launches and closes funds.
Alternatively, it’s asset managers themselves that vanish, usually by merging with other players. Older readers may recall industry “stalwarts” that have gone missing in action over the past 20 years – former household names such as Alliance Capital, BOE, Fedam, Fedsure, Fraters, Gensec, Libam, Real Africa, RMB Asset Management, Metropolitan, SCMB and Southern Life, to name just a few of the larger ones.
These disappearing acts are the industry’s way of losing its black sheep, those awful relatives no one dares mention or parade on the mantel shelf. In the investment industry, unsightly funds are also taken off the shelf. Most eventually merge into other funds that have a more respectable track record.
The people who were invested in the underperforming funds immediately lose sight of their historic returns and are instead presented with the more palatable performance of their new fund. They may soon forget they did not actually share in those returns. From that perspective, inattentive investors are a boon to the industry.
More importantly, though, removing the laggards improves the average return of the funds that do remain. This is referred to as survivorship bias, and it always overstates the average return – the “casualties” are invariably the funds that have performed poorly. It helps put the fund management industry in a better light.
A 2006 study by MG Pawley (published in the Investment Analysts Journal) concluded that such bias could cause data to overstate the annual return by more than 1 percentage point per year.
Pawley’s data was based on unit trust returns between 1973 and 2005, but if anything, this habit of losing the losers has become more pronounced since then as the competition for assets intensifies.
On average, 15% to 20% of funds disappear over a five-year period
Ten years ago, the Alexander Forbes Large Manager Watch survey included 21 funds in the prominent multi-asset survey category “Global: best investment view”. Only 13 of those funds remain in the survey today. Three of the 12 funds that joined since then have also left again.
The funds that exit the survey, without fail, rank in the third or fourth quartile on their longer-term (five-year) performance. They don’t disappear because they are doing too well.
On average, 15% to 20% of funds disappear over a five-year period. According to the mid-year 2017 Spiva SA Scorecard (a performance report updated every six months by S&P Dow Jones Indices), 23 of the 134 South African equity unit trusts listed at the beginning of the latest five-year period did not survive. At this rate, more than half the funds will disappear within 20 years.
Such fund closures mean underlying investors lock in their losses. Those who were prepared to take a long-term view and ride out their fund manager’s period of underperformance are forced to sell low. And, invariably, they are then required to buy high because their money is transferred to a fund that has just done well.
Another evident trend is that the outperformance of the best funds, net of fees, is considerably lower than the underperformance of the worst funds. In other words, the manager selection risk is skewed to the downside. By removing the laggards, the industry downplays the risk of choosing active management.
The investment industry is extremely complex, with thousands of options – but no solution. 10X has no options, and one solution.
But, says Steven Nathan, chief executive of 10X Investments, there is a way to protect yourself.
“Index investors avoid manager selection risk, the risk of choosing a manager that ends up near the bottom of the rating table and is eventually forced to close,” he says.
They simply earn the benchmark return, at low cost. Net of fees, they will fare better than the average active investor.
“When their returns flag, they don’t have to worry, because they know it’s the market, not their fund manager,” adds Nathan.
He says index investors’ returns do not depend on the craft of a few individuals who go home every night. There are no size constraints. The investment process can be repeated almost indefinitely. On transfer to a corresponding index fund, they won’t be selling low and buying high.
“For the rest, be aware that what you see is not what you get,” says Nathan. “The average fund manager return is perpetually overstated. It measures the performance of the surviving funds and ignores the investment casualties.
“The people who owned those funds are still around, but they earned a much lower return than the industry lets on.”
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This article was paid for by 10X Investments.