Active Investor

Confessions of an Active Manager

Active Investor

Recently, one of our fans in India sent us a fascinating article by his fellow countryman, Mehrab Irani who has had the responsibility of managing active mutual funds for a large fund family. As we have noted in prior articles, indexing in India is still in an emerging stage, but it is definitely making significant inroads, and this article will hopefully nudge things in the right direction.

Irani starts with the fundamental question of why, if active managers have the advantages of education, experience, and access to resources unavailable to the general public, do 75% underperform the indexes over a ten-year period? Irani answers his own question by quoting William Bernstein, Merton Miller, and Rex Sinquefield to the effect that no person, no matter how talented or knowledgeable, can have a reasonable expectation of outsmarting the market, and once costs are factored in, the odds become overwhelmingly against it. Irani summarized it best when he quoted Bethany McLean of Fortune who said, “That’s why building a portfolio around index funds isn’t really settling for the average. It’s just refusing to believe in magic.” Irani must have visited our web site or read Index Funds: The 12-Step Recovery Program for Active Investors, since all of those exact quotes are in both. 

Irani notes that the fundamental conflict of interest between investors and fund companies is that while investors wish to maximize returns for the risk they take, the goal of fund companies is to maximize their assets under management, and these two interests do not always align. A few years of highly successful returns will often be followed by a marketing campaign to attract more assets to the fund which can make the fund’s strategy more difficult to implement. A related problem is the plethora of new fund offerings that occur whenever a particular investment style has done well and has attracted the attention of the talking heads of the financial media. In particular, Irani calls out the marketing of bond funds after interest rates have gone down which means that they have abnormally high recent returns but with absolutely no basis for expecting those types of returns going forward. Unfortunately, this can lead to managers reaching for yield, thus exposing their shareholders to more risk than what they had anticipated.

One underlying problem for fund managers is that they tend to be evaluated based on short-term results such as quarterly, monthly, or even weekly. Unfortunately, it often takes much longer to capture the returns offered by value investments. Thus, there is a strong incentive for active managers to herd together which is harmful to their investors.

Although most fund managers will readily admit that neither they nor anyone they know can successfully time the market, they still engage in market timing via “dynamic” or “tactical” asset allocation funds. These types of products have been gaining in popularity in the U.S. as well, and we address them in this article.

Irani acknowledges that investors themselves are not blameless for the sorry state of affairs. Their never-ending quest for alpha encourages fund managers to take unwarranted risks. Irani summarizes his prescription (aside from advocating index funds) for what ails the mutual fund industry when he says, “The fund managers also have to assume more responsibility and take utmost care while managing funds – finally they are not just dealing with other people’s money but also trust – money lost can be earned back but trust lost might never be able to be earned back.” We could not agree more.