FCA Asset Management Market Study - Investors don't get much from managers

I may not have read every page in detail, but the new FCA Asset Management Market Study presented some conclusions that were loud and clear. Investors do not get a lot of value from their active asset managers. Matched up against passive indices as an alternative, you pay more in fees but get less return which translates into significantly lower wealth for investors. Yet, don't cry for these poor asset managers. Active managers make good operating margins and any economies of scale they gain are not passed back to the consumers through lower prices. The only losers are investors.

Investment consultants, who are supposed to be the great givers of advice, don't do a good job at picking managers and may not do a good job of highlighting costs of active management. So much for talent helping to guide investors. Institutional investors may be getting better at measuring what asset managers provide, but even here there could be better work at demanding more competition through pricing that reflect value-added.

I will highlight three graphs that tell the FCA story. The first is the compounded return of active versus passive management after accounting for fee differences. The cost of choosing expensive managers is significant.

Now you may say that the cost could be worth it if the managers perform. A good manger may, during any short period underperform a benchmark but do better over the long-run. This argument would be based on the fact that the active manager takes active bets against a benchmark. Unfortunately, a close look at some active managers is that they don't vary from the benchmark but still charge higher fees. You pay more for the same performance. There are few managers who take large active bets. Simply put, why take active bets when you can hug the benchmark and charge large fees and still have a successful business? Tracking error has too much downside. 

You would think that larger managers who cover their fixed costs would be able to reduce their fees to clients. Don't bet on it. Active managers don't think that lowering fees will attract business and investors are not demanding a discount. Now management fees seem to be an important issue when selecting managers for institutional investors, but retail may not be as aware of these issues. 

The FCA study highlights some key issues with the industrial structure of asset management, but I want to be careful before I agree with any specific solutions. Clearly, the first issue is whether investors have the proper information to compare costs with different investment products. Second, do investors have the right education to understand the information that is provided? On the first issue, more could be done to provide information in a simple direct fashion that includes all costs and their impact. On the second issue, there could be a strong argument that retail investors need more education, but institutional investors should have the ability to assess these issues. Clearly, the role of the investment consultant should be to highlight these costs issues relative to performance. 

I always come back to one of my favorite quotes:

It is difficult to get a man to understand something when his salary depends upon his not understanding it.  - Upton Sinclair 

Hedge fund performance stronger but not enough to make a good year

A US equity rally after the election and a major bond sell-off highlighted the month for traditional assets. Many hedge fund strategies were able to exploit these moves and generated gains especially in fundamental value, market directional and relative value strategies. The big losers were fundamental growth and emerging markets. Global macro and CTA strategies also generated loses for the month. 

These hedge fund loses were surprising given the disruption in global markets. It is unusual to see the equity-based strategies not gain more during the month. The small cap and value indices saw double-digit gains which are supposed to be the sweet spot for many equity hedge fund managers. Perhaps more managers were hedging risk going into the election, but hedge fund returns did not reflect the level of positive market disruption in equities.

The year to date returns showed general improvement, but it is still looking like a disappointing year for most hedge fund strategies. With one month to go for the year, market neutral, fundamental growth, global macro, and managed futures look like having little chance of turning positive for the year. The real winners were distressed, event driven, and market directional which implicitly is a market beta bet. Distressed and event driven are very situational, so it is hard to say whether their performance will be repeated again in 2017. For the remaining strategies, the end of the year will be a period of reflection on how to generate future gains.

CTA performance - On average, could not take advantage of "Trump Effect"

A large sell-offs in bonds both domestically and around the world, a strong US equity move, and a strong dollar trend that changed perceptions on currencies, did not create an environment where managed futures were able to generate positive returns. I don’t want to be accused of hindsight bias, but a review of price trends in bonds and the dollar going into the election suggested that post-election moves, while extended, were not inconsistent with longer-term trends. Still, an early review suggests that there have been some major winners in this space who will end the year with strong positive gains. Careful CTA manager selection has meant the difference between success and failure in 2016. 

Granted managed futures did better than bonds by over 6%, but the ability to short this sector should have been better demonstrated in performance. The SocGen managed futures index has declined in lockstep with the bond sell-off since July. What has been disappointing is the inability of some managers to fully exploit these bond market sell-offs. Systematic managers historically have had a hard time profiting from yield increases.

At current levels, it looks as though it will be difficult for the index to show a positive gain for the year. December is usually considered a short month given the Christmas holiday. Liquidity and trading volume declines after the December Fed meeting. Given an expected rate hike, there may be more positioning after the Fed meeting, but commodity volume will slow and equity moves are usually muted. Our expectation is that profits will have to be generated before December 22.

The Big Bond Break and Equity Revival - November Performance

For those who had a "safe" portfolio skewed to bonds before the election, it was a disaster month. For those who were stock-pickers in value and small cap, it was a dream market. The return differential between bonds (TLT) and value (IWN) was more than 20% in one month. Call it a "Trump Rally / Trump Bond Sell-off", but the financial world changed beyond politics. This sound bite story may be getting old, but there is a lot going on in markets beyond being long stocks and short bonds. 

What is noticeable is that the equity gains in the US were not a global phenomenon. Some of the global underperformance was clearly dollar related, but the US election rally was not shared by the rest of the world or by the large cap firms that are more active in global trade and have more earnings from overseas operations. The large cap/small cap return differential as well as the value and growth differentials were all especially strong. Respectively, small caps, value, and growth indices beat the SPY monthly return by approximately 7.5%, 9.5% and 5%. This is consistent with an economic growth rally and a reduction in regulation rally. 

Bond duration hurt all investors with TLT underperforming the Barclay Aggregate (AGG) by over 5.5%. High yield demand increased and higher spreads cushioned the duration risk for this sector; however, higher quality corporate bonds saw a strong decline. This is consistent with the small cap return skew in equity returns. International and emerging markets bonds both lost money from the global rate rise and a strong dollar.

The year to date performance does not do justice to the wild swings we have since the first two months of the year. After impending disaster with a strong equity sell-off, stocks have done well and have clearly outperformed bonds.