Fund managers too scared of underperformance

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The portfolios of the main UK fund managers cling increasingly to their benchmarks - the stock market indices - because managers have become so frightened of underperformance. All the talk is of portfolio construction and risk control. What this means is that, however much a manager may dislike the prospects for one of the bigger stocks such as Vodafone or Glaxo, he will never dare to hold more than a smidgeon under the market weighting. These managers are clinging to the coat-tails of a lunatic theory.

The lunacy was manifested most clearly in what happened to the FTSE 100 UK stock market index last year. In March 2000, 10 rather old-fashioned companies, led by Whitbread, were cast out of the index because their market capitalisations were now below the threshold - in other words, their prices had fallen.

Ten companies, with not an ounce of profit between them, were added to the index because their market capitalisations had grown. The share prices of these 10, mainly technology companies, fell by about 50% over the next six months, while the share prices of the 10 old lags rose by more than 20%.

Because of the change in market capitalisation, the movement then had to be reversed: old lags in, new economy out. Index funds followed every step of the process and index-clingers many of the steps.

The Unilever/MLIM settlement is hardly likely to encourage the main institutional firms to revert to the more traditional style of investment management in which the managers hold companies each of whose share prices they expect to go up. Meanwhile, the more talented managers, thoroughly bored, have been jumping ships to start hedge funds.

The range of options available to investors has therefore polarised between the index-clingers on the one hand and the hedge funds on the other.

In the world of long-only fund management, it is generally accepted that there is what one guru has called a 'loser's game'. Since professional fund managers effectively constitute the market, over the long term the performance of the average manager is likely to be below that of the market index - by at least the extent of fees and costs.

Much of the starry-eyed discussion of hedge funds seems to assume that their game is different and hedge fund managers in aggregate have a systematic ability to beat benchmarks.

But if there is a loser's game in long-only management, there is the same game for hedge funds. Even if once - when the hedge fund arena was sparsely populated by an arguably select breed of talented people - this was not so, it must be so now when the field is crowded with 6,000 hedge fund managers. The average hedge fund manager is therefore unlikely, over a sustained period, to outperform.

The typical long-short equity fund now has rather conservative positions - about 35% long, 20% short: so 15% net long.

If the average manager can do no better than achieve an index return, the overall return will be 15% of the index return, plus the cash return on 65% of the portfolio, less dealing costs, including securities lending. From this has to be deducted his management fee of 1% and his performance fee of 20% of profits. Assuming a market index return of, say, 10%, the result is a return well below cash.

It will be argued that hedge funds generally will get more fully invested than they are now, and leveraged, when prospects improve. But this implies again, against all evidence, that there is no loser's game in market timing.

Of course some hedge funds will do much better: not every investor is being sold a pup. But there are plenty of pups to go round. For every hedge fund manager who does much better than average, there will be one who does much worse.

The polarisation between index clingers and hedge funds has left a huge gap, and that is the good news. In the old days, talented people who left the big investment management firms started what were called 'boutiques' - specialist fund management operations that they owned, investing with conviction, rather than overwhelming emphasis on portfolio construction and risk control. They charged around 1%, without a performance incentive.

There are now few of these boutiques as it is much more attractive to set up something called a hedge fund, which necessitates having some short positions, and in which investors tolerate a 1% management fee and 20% performance fee. The absence of these boutiques means that there is a wonderful opportunity for the rebirth of investment management in London.

Richard Oldfield manages a private office and worked at Mercury Asset Management.