Don't risk missing out on the upswing

By MIKE NEWTON*

I you invest in an actively managed fund, you must have a fundamental belief that investment markets are "inefficient" and that professional managers can find those inefficiencies, exploit them and "add value" - earning a higher return than the overall market provides.

Chicago finance professor Eugene Fama developed the Efficient Market Hypothesis (EMH) in 1970. His central argument was that, in an active market, with many well-informed investors, the market will always be appropriately priced - neither "cheap" nor "expensive".

Because all the information that could influence prices is available to everyone, there are no opportunities for even the most astute managers to exploit.

The hypothesis is based on perfect conditions, so you would expect it to be hard to replicate in the real world. However, there has been substantial research on the issue (such as Professor Burton Malkiel's bestseller, A Random Walk Down Wall Street) and much evidence that suggests this hypothesis has serious merit.

Are fund managers who consistently beat the market a statistical aberration? So many try that there's a good chance a few will succeed. Or are they truly uncovering market inefficiencies and profiting from them? There is no easy answer to that, and any supporter or detractor can present data to back up or refute EMH.

Unquestionably, however, EMH becomes harder to support when you are dealing with less sophisticated markets.

Not all markets have the conditions that Fama's argument needs - ready information flows and enough willing buyers and sellers.

On that basis it is reasonable to argue that some markets are less efficient than others. For example, you would expect the Chinese stockmarkets might be less efficient than United States markets. The "risk premium" or extra return that investors demand to participate in these "higher risk" markets is ample evidence of this.

The table (above) shows the percentage of active fund managers who have outperformed different markets over the past five years. While the results are not conclusive, they suggest that active management may have a greater role to play in less sophisticated markets.

Interestingly, as we move from left to right in the table, the rates of added value by managers generally increase and the number of active managers who can outperform the market increases.

In New Zealand, all fund managers in the survey outperformed the market, suggesting that the market is indeed inefficient. This is not to suggest that the New Zealand sharemarket is inefficient in terms of its rules or operations, but rather a reflection of its size, liquidity and makeup. The Australian market is bigger, but it still suffers similar issues when compared with the US market.

For an investor, the figures raise an immediate question; would it be a good idea to invest in the index only (and at a lower cost) in sophisticated markets and use active management for the rest?

This looks like a reasonable strategy, but the difficulty lies in determining where to draw the line. More importantly, is it a practical approach?

Like all theories, EMH sounds good but in practice the arguments are not that convincing.

For example, the table shows that the average active manager still does 1.1 per cent a year better than the S&P500 index, which measures the overall return on US sharemarkets, arguably the most efficient in the world. This does not include any managers' fees or tax. We can assume that the managers' fees reduce this value added to 0 per cent. In other words, after fees, the average active manager achieves the same return as the market overall.

If we instead invest through an index fund, the cost of about 0.25 per cent will reduce the return to slightly below the index. Although it is a marginal argument, the active fund manager is still ahead, before taxes.

So, even investing in the most "efficient" market in the world, the median manager has delivered returns equal to the overall market or slightly better. It should be remembered that there are also many examples of managers who consistently deliver returns better than the overall market.

While the evidence suggests that active management may deliver less value in sophisticated markets than it does elsewhere, you would have to be convinced that EMH is dominant to pursue a passive strategy for all international share investing.

Is the difference in returns worth the risk of potentially missing out on the upside of active management?

At BT we remain convinced that markets are not fully efficient and that active management can play a meaningful part in generating returns above the index over the longer term.

* Mike Newton is executive vice president, BT Funds Management (NZ).

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