PERFORMANCE OF THE INVESTMENT INDUSTRY.

HIGH PERFORMING INVESTMENT INSTITUTIONS - LUCK OR JUDGMENT?

NEW RESEARCH.

Or, take a deep breath and stop worrying about the future of your investments - it's time to become terrified instead!!

Readers of this website may have developed the impression that we have a 'thing' about the investment industry. And it is true that we are fast developing a very sceptical view of the skills and behaviour of this important industry.
It is, of course vital to national well-being in many ways:

• It is the medium through which the savings and pension contributions of millions flow in order to provide for their future financial security. The industry therefore holds the well-being of many millions of ordinary people, who are not at all well informed about finance and investment, in its hands.
• It is a major judge and arbiter about corporate performance and governance, having been handed the latter role by politicians.
• It is a primary source of funding for innovation, high-tech and knowledge-based enterprise - the well-springs of the future success or failure of the economy.
• It is the most important industry in the country in terms of size, 'clout' and earning power.
• It has enormous political influence, to the point that mainstream politicians seem unable to comment on its faults and foibles - thus leaving the field open only to a few brazen children who occasionally embarrass their elders and betters by pointing out the manifest lack of clothing worn by this veritable emperor of industries.

Even Gordon Brown, the longest-serving finance minister and arguably one of the most successful, seems to feel the need to lavish praise on the financial industries: "At the forefront of world financial services, Britain exports four times as much financial services as we import".

The stance of this website has been that the investment industry is in need of radical reform, and that this is unlikely to come solely from within because we are talking of markets employing a massive number of people, clustered into relatively small geographical areas, closely in touch with others of their ilk around the world, possessing a very strong culture, subject to rooted beliefs, aggressively resistant to 'outsiders' bringing change and sloshing with massive wealth.
Some might claim that we are simply biased, suffering from envy or individual bad experiences. Certainly, we wrote 'Having their Cake' and then this website on the back of personal experience and our own subsequent investigations.
But, as time goes by, serious research amasses more and more evidence of the fact that something is seriously amiss in the heart of the City.

Readers may have read of the research by Prof. Andrew Tylecote and Dr. Paulina Ramirez into the effects of the UK investment industry on companies that depend upon innovation for their futures - Why the FTSE is the worst investment market in the world for high-technology and knowledge-based companies - Investment section.

New research.

Here are some more serious research findings, this time about the skills and competence of mutual and pension fund investors.
This research was led by Professor Keith Cuthbertson and Dirk Nitzsche of the Cass Business School, London, with Niall O'Sullivan of University College, Cork, Ireland. The results of their research are very significant for all those interested in pensions, savings and investment and the future of industry, and resonate very positively with the experience of many who have had dealings with investment institutions and brokers.

Before starting into the results of the research, let us say that there is no doubt in our minds that there are very good investors. In particular, two come to mind : Warren Buffett and Anthony Bolton, both of whom have been the subjects of much public acclaim. Bolton is a contrarian value investor - in other words, he looks for shares that have been overlooked by a less than perfect investment market, evaluates their prospects carefully and bets on those that he thinks will perform well. His strength is in seeing potential before others and in the care and professionalism of his work. Bolton combines the best of investment technology with rigorous analysis and mature judgment.
Buffett, on the other hand, studies companies very carefully, gets to know their businesses and their managers very well, waits patiently until a target company's share price indicates good value, and invests heavily. He holds a relatively small number of companies and develops close relationships with their managements.
The styles of these two are radically different, but both have been consistently successful, because they seem to be wise, stringent and very professional.
As all of this is rather well known, we should be able to expect that all professional investors might be seeking to emulate the best and to be practicing at a high level of skill.

Not by any means enough, according to these researchers. Here are extracts from what they have to say:

MUTUAL FUND PERFORMANCE: SKILL OR LUCK?

Keith Cuthbertson, Dirk Nitzsche and Niall O'Sullivan

POLICY BACKGROUND
The absolute performance of mutual (and pension) funds and the relative performance of active versus passive (index) funds are central to recent policy debates, particularly in Europe. With increasing longevity and given projected state pensions, a 'savings gap' is predicted for many European countries in 20 years time (Turner 2004, OECD 2003). Will voluntary saving in mutual and pension funds over the next 20 years be sufficient to fill this gap, so that those reaching retirement age have sufficient savings to provide an adequate standard of living? A key issue is the attractiveness of savings products in general and also the choice between actively managed and passive (or index/tracker) funds. This was the subject of the Myners (2001) and Sandler (2002) reports, where it was noted that a high proportion of retail investors choose actively managed mutual funds (93% in 2001), compared with institutional investors (70% in the UK and less than 60% in the US), even though one might think that retail investors have less resources to devote to an active strategy.
The behavioural finance literature has provided theoretical models and empirical evidence which suggests that active stock picking 'styles' such as value-growth and momentum, as well as market timing strategies can earn abnormal returns after correcting for risk and transactions costs. Large sections of the mutual fund sector follow these active strategies and more recently there is an ongoing debate on whether mutual (and pension) funds should be allowed to invest in hedge funds, which also follow a wide variety of active strategies. The question is therefore whether one can find 'active' funds which outperform index funds (after correcting for risk and transactions costs).
In the UK, the continuing switch from defined benefit to defined contribution pension schemes will strengthen the argument for a closer analysis of active versus passive strategies. In the US, Elliot Spitzer the New York Attorney General, uncovered 'market timing' abuses by mutual funds and investment banks, which has reduced confidence in the financial services sector's ability to provide adequate and fair treatment of retail investors.

The Financial Services Authority (FSA) in the UK is concerned that (retail) investors may be misled by mutual fund advertising - this is what lies behind its proposal for a 'simplified prospectus' for mutual fund investors. Allowing mutual funds to advertise their fund's ranking vis- a-vis competitor funds, in terms of (raw) relative returns, is likely to encourage more investment in funds which may simply have high returns because they are more risky. To the extent that any savings gap is to be filled by investment in mutual funds, the need to evaluate risk adjusted performance in a tractable and intuitive way, while taking account of the inherent uncertainty in performance measures, is of paramount importance.

RESULTS

Using a comprehensive data set for the UK, April 1975 - December 2002, with over 1500 mutual funds, our research throws some light on the above issues since we are able to separate 'skill' from 'luck' in the performance of individual 'active' mutual funds.......
For the active fund management industry as a whole, our findings are something of a curate's egg.
Our research indicates that after accounting for 'luck', there are only a small number of 'top ranked funds' which have genuine skill. For example, of the top 20 ranked funds, only about half (11 funds) exhibit levels of performance which is not simply due to 'good luck' (at 95% confidence). But as we move further towards the centre of the performance distribution (e.g. from the top 10% to the top 50% of funds), these funds have positive risk adjusted returns but this can be attributed to luck, rather than skill.
We do find that some top ranked equity income and equity growth funds show genuine stock picking skills, whereas such ability is not found among small stock funds and general equity funds. We also find some genuine outperformance amongst some top onshore funds, whereas for offshore funds, positive performance is due to luck.
Unfortunately, 'genuine' top performers are not necessarily those with an ex-post ranking right at the 'top'. This makes it extremely difficult for the 'average investor' to pinpoint active funds which demonstrate genuine skill, based on their track records.
At the negative end of the performance scale, our whole analysis strongly rejects the view that poor performing funds are merely unlucky. In the left tail of the performance distribution, from the worst (ex-post) fund manager to the fund manager at the 40th percentile, we find that an economically significant negative abnormal performance cannot be attributed to bad luck but is due to 'bad skill'.

There are a large number of truly appalling active funds in the UK -
like horse racing there are some 'old nags' who continue to race, even though they continually lose.
The strong message from these results is that there are a few 'top funds' who have genuine skill but the majority have either no skill and do well because of luck or, perform worse than bad luck and essentially waste investors time and money. Only with a careful analysis of performance, taking full account of luck across all funds can we identify with reasonable probability, those few funds with genuine skill.
The above conclusions suggest that at the present time many UK equity investors would be far better investing in index/tracker funds, with their lower transactions costs. On the policy side the UK government seems likely to want to encourage long term saving via mutual (and pension) funds (Turner Report). So perhaps it is about time the UK government increased its 'health warning' on investing in equity funds from, 'The value of your investments can go down as well as up' to, 'Active management can damage your wealth'. (passages in bold picked out by website authors)

Well, what can we possibly say?
Let us try to summarise our views in our own words:

• A study of the performance of over 1500 mutual investment funds indicates that, even where there has been apparent good investment performance, this is more likely to be as a result of good luck than skill, except in a small minority of cases. This essentially means that individual investors and pension funds which invest in actively managed equity funds are in general, gambling their money on investors who are themselves no better than gamblers.
• It also means that the 'beauty parades' conducted by financial advisers for pension funds and individuals, based on 'track records' are likely to be misleading and risky.
• The levels of skill and understanding of business and companies possessed by the majority of investors are grossly deficient, but many investors continue to practice despite this.
• Equity investment funds have a major influence on the survival of companies and the careers of many top managers. If they are incompetent, what does this mean for the future of industries and companies, especially those that are in any way complex?
• The investment funds in question form a major part of the banking and investment industry, which is hailed by many as a jewel in the UK economic crown - but apparently has the worms of massive incompetence in its entrails.
• The researchers' findings tally at the common-sense level with experience of other parts of the investment industry, especially brokers. Sell-side analysis (which of course is used by pension funds and institutional investors to guide their investment decisions) is in general appallingly deficient in measured and subtle understanding of the factors that will distinguish high performing companies from the average or below average. The Enhanced Analytics Initiative demonstrates the dissatisfaction of some pension funds with the quality of analysis.

The combination of this and other research, together with the history of scandal and malpractice of the financial services industry, demonstrate a need for root and branch reform of the whole industry. This will only happen when the customers and victims of the industry become mobilised to force changes and (probably) create alternative institutions through which ordinary investors' funds can be channelled in a competent and ethical manner.

MUTUAL FUND PERFORMANCE: SKILL OR LUCK?
February 2005

Corresponding Author:
Professor Keith Cuthbertson
Cass Business School
106 Bunhill Row, London, EC1Y 8TZ.
Tel. : 44-(0)-20-7040-5170 Fax : 44-(0)-20-7040-8881