Fund management needs more better Woodfords, not fewer
Less momentum investing would benefit everyone
Last week saw the forced closure of Neil Woodford’s high-profile fund management business in Britain. At the same time, in the US, money managers were marking the passing of one of the founders of the index-tracking movement: William Fouse, creator of the world’s first passive fund in 1971.
While very different in their styles, both were big names in their chosen business. Woodford was a celebrity, a Porsche-driving stock picker who courted media attention and once ran £32bn of savers’ money.
Fouse was the opposite, being unassuming and studious. But he was far more influential. Not only did the business he co-founded — Mellon Capital Management — end up running a cool $521bn; but the ideas he promoted about efficient markets and capital asset pricing transformed the fund business. Passive equity funds now account for 43 per cent of all investment fund assets in the US and 30 per cent in the UK, having doubled their share over the past decade.
It’s a trend that doubtless will be strengthened by the implosion of Woodford’s operation. Savers have long bridled at the relatively high cost of active funds and the indifferent performance they provide.
Going passive may seem a rational response to the difficulty of knowing in advance whether a stock picker’s skill is worth paying for. But it also begs a big question. Does the market structure we have really advance savers’ interests as a whole?
The answer lies buried deep in the dynamics of the industry. Fund management’s mighty growth over the past 60 years has depended critically on savers’ willingness to delegate control of their investments. In return, those savers need a method of keeping tabs on what is going on. The system that has evolved involves benchmarking against an appropriate stock index. Managers that outperform get more money; those who undershoot get the chop.
Now consider the perverse effect this mechanism has on equity markets. For instance, take a situation where a sector starts rising, in which our manager is underweight.
Whatever their view of the fundamentals, they cannot afford to underperform the benchmark. Which means they are forced to buy at the new higher prices. Meanwhile those fortunate funds that were already overweight have no incentive to sell. Prices get squeezed up further. (Interestingly, this issue is more pronounced on the upside, as when shares fall in value the “weighting” problem shrinks with them).
In extremis, this “momentum” effect can lead to the sort of madness that occurred in the dotcom boom, when benchmark-hugging fund managers were sucked wholesale into worthless tech stocks. But the underlying effect is, while less dramatic, no less pernicious, leading fund managers to herd into structurally overpriced stocks. As a recent paper from Ricardo Research shows, this can even result in an inversion of risk and return, with high-risk stocks offering lower returns than low-risk ones, contrary to conventional finance theory.
So how does this all fit into the asset management market? Well, it results in a model that leans heavily on price-based momentum investing. Specialist quants (another Fouse innovation) and AI funds spot emerging spikes in prices and drive them up, sucking in conventional active fund managers, who, being late to the party, buy at higher prices. The need to sell those same stocks when prices have later fallen is what contributes to the actives’ lacklustre returns.
That’s not the only problem caused by momentum. The widespread mispricing of assets that results carries undesirable social costs. For instance, it encourages corporate boards to pursue strategies that drive up short-term prices, and can also, in the case of, say, capex reductions, prejudice the long-term success of the firm.
Fouse may be responsible for much of the innovation in fund management. But his ideas, however influential, scarcely provide a solution. Quants actively seek to benefit from momentum. Meanwhile, index-trackers, are just a cog in the process. As their goal is to avoid so-called tracking error, or index divergence, they dumbly eat what they are served. Mispricing persists.
Less momentum would benefit everyone. But how to get there? The answer, oddly enough, may lie not in fewer Woodfords, but precisely the opposite: in more of the style he imperfectly espoused. That is buying shares not on price-based strategies, but based on assessments of the asset values and expected future profits of the firms whose shares are bought. These are held for the long term, taking no account of the ebb and flow of investment funds.
So-called cash flow investing is the only real alternative to momentum. The shortcoming with Woodford was not the underlying strategy but indifferent stock picking and a fondness for unquoted shares which sat ill with his promise of instant liquidity. Long-term funds cannot offer savers instant access to their cash.