Investment Insights: April 2015

The Arithmetic of Active Management

2015-04-30

Hello and welcome to this month’s edition of Investment Insights
 
This month’s article is a piece from the New York Times that highlights to all the impact that fee’s can have on a portfolio. The article can be found here, however the salient points are summarised below

  • An internal analysis was conducted by the Comptroller of the New York City Pension fund;
  • They looked at the fund’s returns over the 10 years to 31 December 2014;

  • During this period the fund generated a gross return of $2.5billion;

  • Fees paid to generate this return totalled $2 billion. 

The conclusion of the review was that for the fees paid the pension fund had “received virtually nothing in return” To add insult to injury (because of the way many U.S. pensions operate) the shortfall in funds required to meet pension obligations will likely be met by the taxpayer.
 
The fund hired active managers over this period, who charged a higher fee in order to beat the market, however it was these very fees for potential outperformance that reduced the return to below the market, leaving the fund with only $500m to show from $2.5b of earnings. This article highlights an excellent point which has been pointed out by many people over the years, including by Nobel Laureate William Sharp who’s piece for The Financial Analysts’ Journal back in 1991, titledThe Arithmetic of Active Management, noted that
 
If "active" and "passive" management styles are defined in sensible ways, it must be the case that:
 

  1. Before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar; and

  2. After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar 

These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.
 
Of course everyone has to pay some form of cost including compliance, administration, tax and brokerage, however the essence of generating long term performance consistent with the market is to minimise these costs, focus on the things that you can control (the market not being one of these) and ensure that you have a well-diversified portfolio of passive investments or a long term portfolio of blue chip stocks.

If you would like to discuss your portfolio or any aspect of your financial affairs, click on the links below to contact one of our advisers today.

Daniel Minihan
David Foord
Matthew Baum

If you would like to read more regular posts you can follow us at http://www.thehyperioneffect.com or via your favourite social media platform: