In 1998 billionaire entrepreneur Sir Richard Branson challenged City superwoman Nicola Horlick to a bet that his Virgin investment fund could beat her new SocGen investment fund.
You don’t have to understand anything about stock exchanges or capital markets to enjoy a good wager. And with typical bravura, Branson, the biggest star in British business life for decades, had picked on the one person who, briefly, gave investing in the City of London a personality.
Horlick was a successful fund manager and leader in her own right; a mother of five children; the daughter and wife of successful people; and someone strong enough to challenge her employer in the City in the process of establishing her own fund management firm.
The bet was on, and the protagonists agreed to compare performance after three years, when the loser would cough up a neat sum of money for the winner’s favourite charity. The bet was not merely entertaining because of the two personalities involved: Branson and Horlick had completely different investment styles. Virgin’s tracker fund follows the fortunes of companies listed on the UK stock exchange mechanically. The aim is to get almost the same return as the index of stocks (but the fund will always be lower because of charges).
SocGen sought to outperform the same index even after fees. The Virgin style is called passive or index-tracking; the SocGen style is called active management.
Why does this matter? The answer regards fees. Passive management can be up to 100 times cheaper than active management (although fee comparisons in investing are notoriously difficult, and that ratio did not apply in the Branson v Horlick wager). That extra cost of active management can be a real drag on the amount of money ordinary people who buy into the fund actually get back.
Active managers such as Horlick aim and claim to be smarter than any index – which by definition represents the aggregate views of all other investors – and thus make their extra costs worth bearing.
The world by and large believes them. About three-quarters of major markets such as London and New York are actively managed. And if we fast forward to 2001, active management won the day. Or at least Superwoman did. Branson duly paid out to Horlick’s charity although he declined her offer of lunch (don’t tell Branson that any publicity is good publicity).
The moral of the story would seem to be: don’t mess with really bright fund managers. Even canny billionaires like Richard Branson can’t beat them. Trust swashbuckling City types: active investing rules!
Except it doesn’t, for two reasons. First, over time, the index outperforms most actively managed investment funds because stock markets are pretty efficient. Everyone involved – traders, stock analysts and fund managers – wants to make money. That can at times mean greed comes before accuracy, but not that often. Which means beating the consensus is darned difficult; most academic evidence says so. For the 11 years of its life, the SocGen UK Growth Fund did not beat the index.
Second, the business of passive management tends to be quite stable. This is the utility end of investing, managed by a handful of big firms. The Virgin tracker fund is still in operation today.
Active management, on the other hand, is far more volatile. This is the Premier League end of investing where star names move around every few years and houses open close, rebrand and refocus strategies frequently. It doesn’t take a genius to realise that most of these changes are exercises in covering up disappointment. Horlick’s SocGen fund was new in 1998 but she left the firm in 2003, a couple of years after the Branson wager. Peter Seabrook, the actual day-to-day manager of the SocGen fund in competition with Virgin, had departed a year earlier in 2002.
The SocGen firm continued until 2009 with other personnel in charge, but performance of most of its funds was disappointing so in the end the operation was sold. Almost all the founders, like Seabrook and Horlick, had already left by then. Under new management and a new brand, the UK Growth Fund did outperform the index; but after fees were taken out, the result wasn’t deemed satisfactory enough (some clients were charged 5 per cent of their wealth just to get into the fund). So after four years the Growth Fund was merged with another. From the beginning of the Branson bet until its closure, the fund gave back to those who’d stuck with it just over 75 per cent of what the index had scored.
The moral of the story now becomes: if you believe in active management, you’d better be extremely vigilant or lucky (or both), and be prepared for a lot of chopping and changing. You might be saving to pay off a mortgage or build up a pension for decades, but the person managing your money could change job after a few years; the firm itself could be sold. Active management is a phrase that applies to the business of investing as much as the occupation itself. And successful investing is as likely as failure to herald such disruption.
True, some active managers do not change employers. A few of those even outperform the market over the long term. But to choose active investing – as the majority of ordinary savers who bother with stock markets do – can be likened to giving oneself the lead role in the fairy tale of the Emperor’s New Clothes. Too many clients of active funds believe they are doing well by themselves while too few people point out how out-of-pocket their choice has made them. Financial advisers and fund managers make for convincing courtiers who pretend being “in the altogether” is just fine.
All the while, the stock market – which per se is a mere representation of aggregate opinions on the worth of companies and has no ego to feed, envy to arouse or quick profit to make – bowls along dispassionately. For those who have to go near stock markets, think of index-tracking, like democracy, as the least worst option.
In Hans Christian Andersen’s fairy tale, it takes the naivety of a child to point out what everyone else chooses to ignore. In the debate on investing, stating the obvious has come from a rather more surprising source. The UK’s coalition government has put down legislation to switch management of local government pension funds to passive. These funds are worth £180bn and benefit 4.6 million people.
The plan rightly terrifies active managers in the City of London, Edinburgh and other financial centres. Academics pointing up their weaknesses can be ignored – they certainly cannot afford to buy space on taxis, billboards or rugby shirts.
The government, on the other hand, is a rare thing for fund managers: difficult to buy. This is the Emperor himself realising the error of vanity.
It is pertinent to ask, however, why a Conservative-led government would take such a measure. The Liberal Democrats, maybe. Labour, probably (Unison, the biggest union in the public sector can’t wait for the move). But promotion of the City and the Conservatives seem to go hand-in-hand.
There is a direct benefit to Her Majesty’s Treasury from active management: a 0.5 per cent stamp duty on every UK-registered company share bought. That adds up to a hefty £3bn per annum, as much as the State earns from taxing air passengers and 50 per cent more than outright gambling.
Passive manager won’t bring anywhere near that sum. It’s not uncommon for active managers to turn over (buy and sell) 100 per cent of their portfolio a year: the index tends to be far less volatile, at less than 10 per cent. So George Osborne and his successors would be giving away a chunk of easy revenue straightaway if passive gets the nod – the move won’t be debated until after the General Election of May 2015.
But more profound are the messages this policy move sends from a right-wing government overseeing the world’s second largest asset management centre. The coalition is admitting that active management doesn’t give investors what they need, even while welcoming and accommodating more active managers and affiliated services than any other city in the world bar New York.
Not immediately will every other type of client or provider care how money is run on behalf of librarians in Northampton or civic surveyors in Aberdeen. But in time, the UK could find itself in an anomalous position of promoting the full heterogenous spread of asset management while rejecting many of the current forms of their offerings for the good of its own public servants.
Because the second targets of the independent report behind the move to passive investing are funds of hedge funds and private equity – the really expensive, swashbuckling end of active management. The authors do not reject these types of investing per se. They do warn that so far, they’ve not been worth the candle because of the costs involved in accessing the strategies. In other words, come to London and set up shop but don’t expect our employees to buy your pricey wares.
The next time someone tells you that London is turning into a playground for wealthy bankers, fund managers and hedge fund operators, mention local government pensions. It is not the end of capitalism as we know it. In fact, querying whether fund managers are worth their fees seems to be what every true capitalist should do. Would Alan Sugar (or Richard Branson) give away more of his own savings in fees than is absolutely necessary?
The policy over local government pensions can be seen as the Conservative Party finally treating financial services to the same medicine it has applied to other industries ever since Thatcherism took hold. If markets are efficient, then let them decide. For investors, this means going passive.
