How good is your asset manager at predicting the future?

During a recent visit to the British Museum, at the request of one of my children, I spent some hours immersed in the ancient Assyrian empire, geographically now Iraq.

The particular area of interest was the Ashurbanipal's library; one of the oldest libraries in the world, consisting of intricately carved stone tablets around 2,700 years old. These preserved masterpieces contain detailed information about the life and times of the ancient civilisation a portion of which are on display at the British Museum. One of the key learnings from these documents that caught my eye was that in those times, a huge amount of labour was spent on predicting the future. The techniques used included examination of organs and entrails from sacrificial animals.

My first thought was what a waste of effort. After all, what scope was there to have any idea of what the future held without the technology, scientific insight and artificial intelligence we have today? But then I reflected on whether we’re any better at predicting the future, even now?

The folly of calling the markets

In my role as an investment consultant, I’ve often challenged myself on whether I should have foreseen certain specific market events, as the signs always seem so clear afterwards. The dot com crash following a clear bubble in tech stocks, the global financial crisis following excessive debt… the more recent rally in gilt yields. There’s never a shortage of people saying “I told you so”.

Hindsight is a wonderful thing, but statistics are fiendishly devious things, and many an honest stat has been used to sell a mistruth. For example, if you look at the historical annual performance of the equity market going back 50 years to the end of 2022, the mean calendar year performance was 13%pa. Now take that data and look only at the years where the prior year saw a decline of more than 20%, and the average return for this sample is 33%. This would seem to tell you that if you adopt an annual trading strategy where you only invest for the year ahead if the market fell by more than 20% last year, you can make more money. But it doesn’t work. There are only 3 years where this happened and so if you traded on this pattern you will have spent 47 out of those 50 years out of the market, waiting for your moment, missing out on the average return of 11% in those more moderate years.

Fortunately despite the many and varied behavioural finance traps, the finance industry is wise to this and calling the market is widely considered a mug’s game. Therefore, it’s all the more puzzling why we seem to forget this and innately judge asset managers by their ability to predict the future.

The odds are you’ll underperform

The chances of picking an active manager in public markets that can outperform on a risk adjusted basis is well below 50/50. This is not based on a study of asset managers, it’s based on maths. As explained by William Sharpe in 1991, the explanation behind this statement is reassuringly straight forward. An index tells us the return you would have earned if you owned the whole market. We also know that passive managers can replicate this return reliably, by holding a bit of all the stocks in the right proportions.  That must mean that all the other investors in that market, by definition all active investors, will also collectively perform in line with the overall index, before costs and fees that is. It’s costs and fees that push it below 50/50 but it’s the maths that means it’s not higher than 50/50 to start with. I should note that active institutional investors are a subset of all active investors, so there could be scope for institutional investors to outperform at the detriment of other active investors, although they mostly don’t.

But this is not to say active management is a zero sum game, far from it - it’s the process of active management that creates the value in the first place. If active management didn’t diligently go about its business competitively putting a price on all the different listed assets, known as ‘price discovery’, there would be no trust in market prices. Critically active management is the only reason that passive management can work.

The world needs great active management

What would happen if there weren’t enough good active managers in the market? This would lead to inefficient allocation of capital across the real economy. In other words, huge amounts of money would be invested into lousy companies with poor business plans. It would manifest itself as poor investment returns for the whole equity market. This would be a world where all 18 contestants in the BBC’s “the Apprentice” get the winning £250,000 investment from Lord Sugar. By finding a great investment and allocating capital to it to help it grow, the index return benefits too. In public markets, great active management floats all boats.

Whilst active management serves a public service in terms of facilitating passive management, it also can serve a number of other purposes for the end investor. By appointing an active manager you may be delegating the decision on which asset classes and regions to invest in, currency hedging decisions, geopolitical risk, stewardship and sustainability considerations. 

We know less than 50% will outperform, but this doesn’t mean that only 50% are any good. Actually, in my experience of meeting and researching managers across pretty much all asset classes, I can honestly say that 90% of them are truly excellent. These investors are extremely capable, and unlike some of the more questionable practices of the Assyrian empire, demonstrate considerable insight into the future. Their understanding of economies, growing businesses and how to allocate capital to productive uses is second to none. The proof of this is the strong returns that have been achieved in public listed markets historically. But despite all their collective foresight, they can’t break the laws of Sharpe’s’ arithmetic and convert this to outperformance on average.

Great expectations?

In making the choice between active and passive it’s about weighing up what services you require and what you value. Neither is right and neither is wrong. However, it’s important that expectations are realistic, as if you do choose active management solely in the pursuit of generating outperformance, the odds are that most managers will disappoint. This is because correctly predicting the future is easier than generating outperformance, but outperformance is only one of many ways that active managers can add value.

The last word goes to the Assyrian empire, the inspiration of this piece, as despite their relatively rudimentary methods of futurology, their work has undeniably stood the test of time… for over 2 millennia. Much longer than is likely to be said of anything written by Chat GPT.