FTfm’s Steve Johnson looked into the debate over active vs passive management in our last issue, with reference to Norway’s state pension fund. He also interviewed Yngve Slyngstad , chief executive of Norges Bank Investment Management, the arm of Oslo’s central bank that manages the fund. Mr Slyngstad thinks there is no debate. Here’s Steve’s investigation for FTfm’s Big Picture.
By Steve Johnson
Like death and taxes, the debate over the relative merits of active and passive investment will probably always be with us.
But the spat in Norway over the future direction of the Nordic country’s NKr2,500bn (£266bn, €307bn, $433bn) oil-powered Government Pension Fund has helped illuminate the debate, at least as it applies to large institutional funds.
Adherents of the efficient market hypothesis argue that it is impossible for any investor to consistently outperform the market, except as a result of inside information or luck. The higher cost of active management would appear to tip the balance in favour of the passive approach.
Yet most money is still run actively; only last week a survey of 420 pension schemes conducted by Pyramis Global Advisors found the vast majority in agreement with the statement: “actively managed equity strategies will deliver alpha in the foreseeable future”.
Into this breach has stepped the Norwegian ministry of finance, which oversees the Government Pension Fund and was not overjoyed to see the fund report an investment loss of 23.3 per cent in 2008, when its equity/fixed income benchmark was down “only” 19.9 per cent, with active managers responsible for the underperformance.
The ministry commissioned two reports to help inform the debate into the future direction of the fund.
One, conducted by Mercer, the consultancy, analysed the track record of 14 large public pension schemes and sovereign wealth funds, such as ABP and APG of the Netherlands, Calpers and Calstrs of the US and France’s Reserve Fund.
Mercer found active management, which typically accounted for a little over 60 per cent of all assets, on average bolstered the returns of these funds by a modest amount in each year from 2004 to 2008, peaking at 0.94 percentage points in 2005, although the median was negative in two of these years.
The picture was less pretty in 2008 and the first half of 2009, when active management typically subtracted 0.94 and 0.65 percentage points respectively from fund returns.
The bulk of the positive excess returns appear to emanate from bond managers, who added value in every year bar 2007. The record of equity managers was more patchy, with an excess return of 0.38 percentage points in 2008 outweighed by larger losses in 2006, 2007 and the first half of 2009.
In spite of this somewhat underwhelming evidence, Mercer found the majority of the funds believed parts of their investment universe were inefficient and thus offered the potential for skilled active managers to consistently outperform.
The second report, an evaluation of the Norwegian scheme itself by Andrew Ang, William Goetzmann and Stephen Schaefer, of the Columbia Business School, Yale School of Management and London Business School respectively, went further.
It found that, from 1998 to 2008, the mean active return from active management was 0.02 per cent a month, rising to 0.03 per cent if the relatively extreme underperformance of 2008 is expunged, a figure described as “highly significant” statistically.
Within this, messrs Ang, Goetzmann and Schaefer found “no evidence that active fixed income management has added value”. But active managers of equities, where active returns were 0.05 per cent a month (0.06 if 2008 is stripped out), fared better.
“Active management of the equity portion of the fund has, in a small way and on average, added value since the inception of the fund,” the report said.
Yngve Slyngstad, executive director of Norges Bank Investment Management, which manages the fund, describes the gains from active equities as “a small number for a small fund but a huge number for a huge fund. Relative to the risk that has been taken, we think the excess return is very significant.”
The academics drilled down into the active returns in an attempt to identify any systematic factors that may be responsible for them.
They calculated that 70 per cent of all the active returns could be explained by exposure to a handful of systematic factors.
Thus, for equities, much of the excess return above the benchmark derived from the fact the fund was overweight small-cap stocks, which generated superior returns in the decade to 2008, and underweight worse performing blue chips.
A modest predisposition towards value, rather than growth stocks, weakened returns.
On the fixed income side, the value subtracted by active managers during the financial crisis largely stemmed from the portfolio’s high exposure to factors such as liquidity and volatility.
The report concluded a “significant fraction” of the active return component of the fund could be replicated by constructing portfolios designed to mimic the behaviour of the factors messrs Ang, Goetzmann and Schaefer identified, which also included exposure to credit spreads, duration and the FX carry trade.
In other words, NBIM and others could enjoy the bulk of excess returns that active managers have appeared to generate by investing passively, as long as the benchmark used is sophisticated enough to incorporate systematic factors.
Mr Slyngstad is supportive of the idea that the benchmark of the Norwegian fund should be redrawn to incorporate some of these factors, but stresses this would need to be agreed by the country’s politicians first.
This analysis may also not aply to smaller investors. NBIM enjoys economies of scale and its annual management costs (excluding performance fees) are limited to 10 basis points and are running at 7bps.