“A bull market for assets but not for asset managers”, is how we might look back at the past few years. The active fund management industry has been in trouble, caught in a pincer movement of pressure on fees and higher regulatory costs. Moreover, the bull market in assets has been concentrated in the US and specifically its technology stocks. As investors could just access beta to this phenomenon more cheaply through passive products, they did not need active managers who charged a higher fee but whose returns were more unpredictable, and in any case just clustered around the market return.
The fund management industry has largely ducked the issue of whether their products are sufficiently differentiated from passives to command an active premium fee. The common reaction, as with most industries in trouble, has been to merge with other asset managers who had the same problems, to defend profit margins by eliminating cost duplication. Experiences of mergers in other industries suggest that it is wishful thinking to presume that merging two bad companies will create a good company. As a vision of the future this seems like prolonging a slow death rather than a real shot at glory.
We have recently witnessed the steepest falls in equity markets since 1929. This has highlighted the folly of assumed diversification through exclusively long only equity products which have all fallen off the proverbial cliff with passives. It has also demonstrated that most investment products are dependent on positive economic outcomes, but that people often need access to their savings at the weakest point in the economic cycle. The existentialist crisis of the traditional active fund manager, over-charging for beta, has been magnified by the impact of the virus. Now that the market tide has gone out, to paraphrase Buffett, we see who’s been swimming naked - it appears that almost the entire industry has been on the nudist beach.
Equity funds which hedge their market exposure aiming to be genuinely uncorrelated have been shunned until recently, as in bull markets short books are a hand brake on overall returns. But in a few short weeks the market has plunged back to levels last seen in 2012, whilst our long/short strategy has powered to new highs with a record quarter. At all times our short book has used single stock shorts as a hedge, rather than a directional negative bet. This has confirmed in my mind that the future of active fund management will not be in packaged beta but rather in more alpha: in fact, double alpha.
The “Absolute Return” fund label continues to confuse. The dictionary definition of “absolute” is “not relative or comparative”. This means a return profile that should not be measured against or dependent on market returns. It is not appropriate to compare with the return profile of cash, which will never drawdown, at least in nominal terms. Cash is not a return profile which the fund management industry can replicate in a cost-effective manner. Investors should now end this tiresome debate: either go to the bank for cash or choose the greater ambition of uncorrelated equity long/short returns.
Many active fund managers like to claim they are “contrarian” but too often this is confused with buying rubbish stocks rather than thinking independently. For fund managers with immunity from herd mentality there have been some spectacular recent opportunities: institutional group think first underestimated the impact on the global economy then subsequently became apocalyptic through naïve faith in the veracity of official scientific opinion. Quant funds have often just been a levered algorithm of this collective muddle. In the financial world we are all too familiar with “rubbish in, rubbish out” models, together with the cognitive biases of expert opinion. We all know the saying that economists have predicted nine of the last five recessions but are less familiar with the epidemiologist who forecast five of the last one pandemics.
Trading floors now lie empty. The cultural epicentre of fund management may now also be an unlikely victim of the virus. If employees can be trusted to work at home with no aggregate loss of productivity, it is unlikely that everyone will need to return. Institutional money has previously been comforted by big investment teams, which populate an organogram with a depth of talent and decision making which is often simply illusional. In the crucial days of the Battle of Britain the Royal Air Force switched away from Leigh-Mallory’s “Big Wing” to defend against the Luftwaffe with smaller, nimbler squadrons. In a similar manner, perhaps the virus will now lead to a renaissance of the boutique fund management model.
Plato once said: “necessity is the mother of invention”. It remains to be seen whether the industry will recognise it has been caught with too much beta and too little alpha, particularly short alpha. If governments soon exit the lock-down and economic activity can resume, then a risk asset recovery may act as an undeserved industry bail out. If the crisis endures, however, then active fund managers must reinvent their products or face extinction.
Barry Norris
CEO Argonaut Capital,
Fund Manager of Argonaut Absolute Return
April 2020