Can monkeys make better investments than humans? There are numerous press reports of randomly generated investment decisions leading to better performance than professional fund managers. Can this be true? If so, why should charities pay investment managers healthy fees when cheaper index funds that replicate market performance are increasingly available?
Index approaches can be very useful to have in the armoury as a relatively cheap way of getting exposure to an asset. But I do challenge the suggestion that charities should throw in the active management towel and invest all of their assets in cheaper index funds.
First and foremost, asset allocation should not be passive. One of the biggest decisions a charity can make is how it allocates its assets. Even the best bond fund manager might underperform the worst equity manager in a strongly rising equity market. Many studies show the asset allocation decision is the most crucial determinant of long-term returns. It is also inescapably active – however a charity chooses to manage a portfolio, it cannot avoid making a decision about which broad categories of assets to use. Once that course has been chosen, the charity must decide between active or passive management.
Investing using passive indices can certainly have benefits, including diversification, transparency and low costs, but these strategies carry their own risks. As equity indexes are weighted by company size, bigger companies dominate. It seems intuitive to weight equities in this way, but there are a number of problems. One is that investors are buying into yesterday's winners, which are companies that are now more prone to underperformance. Active managers are able to capitalise on these biases and select from the areas of the market that are expected to outperform in the long term.
At the end of 2013, the top 10 companies made up 36 per cent of the UK market, meaning that charities that chose a UK equity index approach had more than 8 per cent of UK equity exposure in BP and Shell, and almost 6 per cent in each of HSBC and Vodafone - a significant concentration risk. Index investors are prone to a lack of breadth, which restricts investment choice and creates a bias against mid-sized and small companies, which can outperform larger firms in the long term.
It is true that active manager performance tends to oscillate with market cycles. The recent past has been a strong period for active managers, with the average UK equity manager 10 per cent ahead of the FTSE All-Share Index in the 2008 to 2013 recovery. This is not always the case. However, one type of manager has been consistently more likely to outperform, even after fees and transaction costs. These are the stock pickers – those managers whose portfolios diverge markedly from the index.
So although index funds hold many attractions, I still believe that there are managers who can capitalise on index biases and clever analysis in order to put together portfolios of companies likely to outperform. In the current market environment, which is likely to be characterised by divergence in fortunes, I would rather have a professional than a monkey looking after my charity's assets.
Kate Rogers is client director at Cazenove Charities