Matter of Style – The Management of Investment Funds
Author:
Steve O'Callaghan
The management of investment funds in Ireland is a lucrative business both for the management firms themselves and for the intermediaries who market the investment products. Total funds managed by Irish investment management firms for Irish residents as of December 2005 were €101bn and of this 57%, or €58bn, was invested in equities.1 These assets are managed according to various different strategies. This article outlines some of these strategies and looks at some of the evidence on their performance.
The basic division between investment styles in equity portfolio management is between passive and active management of portfolios. Funds which follow a passive management strategy aim to mirror the returns on a particular benchmark index whereas actively managed portfolios aim to exceed the return on a particular benchmark index. Most of the major asset management firms in Ireland offer both passively and actively managed funds.
PASSIVE INVESTMENT
The fundamental economic theory relating to security prices, The Efficient Markets Hypothesis, in simple terms states that security prices rapidly assimilate all relevant, available information and therefore any price changes in the future, because they will result from new information, are inherently unpredictable. This theory implies that no investors (including highly paid fund managers) will be able to consistently earn returns superior to the market as a whole, other than by chance, unless he or she takes on a greater level of risk.
If the stock market is efficient then equity investors’ best course of action is to hold a portfolio which earns the same return as the market whilst minimising fees. This is the aim of passive management, or indexing. The portfolio manager will create a portfolio that will track the relevant index by purchasing shares in the constituent companies of an index in the proportion that they make up the index. So, for example, to create a FTSE 100 index fund the fund manager will buy all the shares in the FTSE 100, in proportion to their market capitalisation (the FTSE 100 is a value, or market capitalisation, weighted index). As the constituents of the index change or their weighting within the index changes the fund must rebalance its holdings to eliminate discrepancies between the fund and the index its tracking.
This requirement to rebalance in reaction to changes in the benchmark index causes two difficulties for the fund managers:
- firstly, frequent portfolio rebalancing involves frequent trading and the incurring of relatively high transaction costs in the form of bid-offer spreads and broker commissions, and
- secondly, portfolio managers will never be able to exactly match the performance of a benchmark without incurring prohibitive transaction costs so a small difference between the performance of an index fund and the relevant benchmark index is inevitable – this difference is called tracking error. Because minimising tracking error requires very frequent rebalancing and so is expensive there is a trade-off between minimising tracking error and minimising cost.
The success of a passively managed fund is not measured in terms of absolute returns but in how closely its net returns mirror those of the benchmark. So if an investment is made in a 5 year FTSE 100 Tracker or Index fund and the FTSE 100 declines by 18% over the term of the investment the value of an investor’s capital should decline by 18%, plus any management fees charged.
The major attraction for investors in these fund products is the low level of fees charged compared to fees charged by actively managed funds. Funds which track the FTSE 100 for example generally charge in the region of 0.2% to 1.5% annual charge without an initial entry charge. These funds charge relatively low fees because they trade much less frequently than actively managed funds and don’t have the same research and fund management costs that actively managed funds do. Since the primary attraction of these funds is their low cost, investors main focus in selecting an index fund should be the level of fees charged both on the initial investment and annually. Passively managed funds can generally be identified by the use of the words ‘Tracker’ or ‘Index’ in the title or description.
ACTIVELY MANAGED FUNDS
Active portfolio management on the other hand aims to consistently generate net returns superior to a stated benchmark index, on a risk adjusted basis. They attempt to achieve this goal by timing investments in the market and actively picking shares which fund managers believe will out-perform the market. Active management by definition implies a disbelief in the Efficient Markets Hypothesis. A major feature of actively managed funds is the high level of fees charged to investors in the funds. These are justified primarily on two grounds. Active investment management costs more to implement than passive management both in terms of transaction costs (because there is generally a higher turnover of holdings and thus more trading involved) and research and management costs. Also these funds claim to add value to a portfolio by aiming to beat a particular benchmark. There are innumerable individual investment styles under the ‘active’ rubric but most fall under a few broad categories – three of the most popular are outline here.
GROWTH VS. VALUE
Two of the most common active management styles are growth and value. The difference between these strategies can be illustrated by focussing on the Price/Earnings ratio (P/E) and how it is interpreted and used by the opposing camps. The p/e ratio relates the current market price of a share (p) to the current earnings per share (e) for that company. It is a measure of how much the market is willing to pay for a unit of the company’s earnings.
Value investors
Value investors focus primarily on the ‘p’ in the price/earnings (p/e) ratio, shares which are trading at low p/e ratios relative to some benchmark ratio (usually a sectoral or historical benchmark). So for example if ABC plc is trading at a p/e ratio of 11 and the average p/e ratio for that sector is 15 then ABC plc would be a potential target for value investors. The rationale behind this style is that these shares are in some sense ‘cheap’ and the market will, in the future, recognise this and revalue them upward – rewarding the value investor who spotted this discrepancy with a capital gain.
Growth investors
Growth investors on the other hand are concerned primarily with the earnings in the p/e ratio. Companies which are expected to deliver strong earnings growth in the future because of new technologies, expanding markets or some other competitive advantage are favoured by the growth investor. The implicit assumptions in this approach are that firstly the expected growth in earnings will materialise and secondly that it will translate into growth in price over time – again rewarding the investor with capital gains.
INCOME INVESTING Income investing focuses on the dividend yield of shares. The objective is to select equities which pay a high dividend relative to the current share price and thus create a portfolio which will generate a significant portion of its returns from income (dividends) rather than capital appreciation. Since high dividend payouts imply lower investment within a company, firms with a high dividend yield tend to be concentrated in mature industries without significant potential for expansion, a good example being the regulated utilities sector. These funds distribute income to investors, in the form of a dividend, who then have the option of retaining or reinvesting this income. Two factors are particularly important for investors considering an income based investment style; firstly the level of dividend payout must be sustainable for the firms concerned and secondly dividends are subject to an investor’s marginal income tax rate in Ireland whereas capital gains are taxed at 20%. This difference in tax treatment introduces a hurdle which income funds must clear to compete with funds based primarily on capital appreciation.
RESEARCH ON INVESTMENT STYLES
One of the most active fields in academic finance research since the 1950s has been the investigation of the extent to which stock markets conform to the Efficient Markets Hypothesis. From the perspective of this article the most important question this research poses is: Is there a strategy an investor can employ that will consistently earn him returns above the level justified by the systematic risk of his portfolio?
Unfortunately the answer is not simple. Broadly speaking stock markets appear to be efficient although some deviations from efficiency have been found. Market capitalisation appears to impact on returns, small capitalisation shares have generated greater returns historically, although some attribute this phenomenon to extra risk inherent in smaller shares that is not captured in currently used risk measures. Another significant deviation is the performance of value strategies. A number of studies have found that investing in shares with a low p/e ratio will generate superior returns. An important point to note is that all of the research on investment strategies is by definition historical i.e. it examines past price movements, there is evidence which suggests that once these opportunities are discovered and publicised these anomalies disappear as investors factor them in to their investment strategies.
Burton Malkiel, author of A Random Walk Down Wall Street, which discusses investment in an efficient market,, claimed: “[the efficient market hypothesis] means that a blindfolded chimpanzee throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by the experts.” The Wall Street Journal, sceptical of this claim (quite naturally since most of the maligned ‘experts’ were among its readers), instituted an ongoing competition which pitted a rotation of fund managers against a portfolio selected using a dartboard. Academic analysis of the results has shown that the dartboard portfolio out-performs the expert’s selections more than 50% of the time after taking trading costs into account. Another study examining long-term active investment returns found that between 1962-1995 only 23% of US actively managed funds were able to beat their benchmark index.
What the Efficient Markets Hypothesis does not claim is that individual fund managers won’t be able to beat the index in any one year or series of years, just that they won’t be able to do it consistently. This point is somewhat grudgingly alluded to in the mandatory warning that accompanies fund marketing literature and ads ‘…past performance should not be seen as an indication of future performance’
What conclusions can investors draw from this research? While several departures from the Efficient Markets Hypothesis have been identified, which could potentially earn superior returns fund managers remain unable to consistently beat their benchmarks. Paying significantly higher fees for the active management of your money, and at best matching the returns generated by passive funds isn’t a very attractive proposition and one which investors are increasingly declining – while traditionally active investment funds have dwarfed passive funds in terms of total funds invested the proportion of funds invested in passively managed is increasing annually.
Notes
1 Source: Irish Association of Investment Managers.
Steve O’Callaghan is a Lecture in Accounting & Finance at University College Cork.