Today I received a press release which, at first glance, looked like one any self-respecting financial journalist should ignore. An active manager says its response to the Local Government Pension Scheme consultation was to warn against local authorities shifting into passive investments. Well, you wouldn’t expect a turkey to vote for Christmas would you?
It might be unrealistic to expect Threadneedle to encourage the government to close down a significant chunk of its business, but that doesn’t mean the proposals to use passive investments are the right course of action.
The debate over whether active or passive investing is more effective has been raging for many decades. Those in favour of investing passively point to the low cost of buying equity indices. They say it’s not worth paying the higher active manager fees because it’s impossible to choose which active managers will consistently outperform in the future.
There’s no doubt this is persuasive argument. But, as you would expect in the world of investment, things are not quite as straight forward as they first seem.
There is no such thing as “passive” investment. Even if the local authorities are forced to dump all their active managers in favour of passive managers, they still need to decide which proportion of their fund should be invested in equities – they need to make an asset allocation decision.
And getting the asset allocation decision right is a far more important than deciding which manager to allocate. Asset allocation is the most important driver of the overall performance of a fund. This is a decision that must be “actively” made – whatever proportion is chosen, it must be based on an informed investment choice.
The other, slightly more subtle point, about the argument in favour of passive investment is the implication that equity indices are an unblemished investment vehicle. Yet there is plenty of academic research illustrating the flaws in market-capitalisation weight indices – they end up being highly concentrated in the companies which prices have risen the most rapidly. They are highly exposed to market momentum, which is enjoyable when markets are rising but very painful when they are falling.
Perhaps a more intelligent approach for those who are adverse to active managers would be to invest instead in an equally weighted index or choose one that is weighted by other factors such as price to book. But these indices can have higher transaction costs and will underperform market-cap weight indices in certain market conditions.
Enlightened fund managers incorporate all of these investment realities into their portfolio design. They focus hard on trying to get the asset allocation right. They take an informed approach to appointing passive or active managers – using passive where there is no particular advantage to an active approach. Some might use a combination of both traditional and alternative index approach. And they appoint active managers where they are confident they can generate above market returns, net of fees.
We live in a complex and sophisticated financial world. To be successful at managing their pension schemes, local authorities need to take a sophisticated approach to investing. Being told that they must dump actively managed equity assets in favour of passively managed indices is the very opposite of a sophisticated investment approach.
The National Association of Pension Funds said in a recent press release that the government’s focus on how local authorities can reduce costs rather than looking at how they can secure liabilities and reduce deficits is a “narrow vision”. It added: “These savings are substantial, if fully realised, but represent only a tiny proportion of the LGPS’s £47bn deficit.”