Anthony Hilton: Fund managers need to ditch football-style attitude for long game

American marketing pioneer John Wanamaker once said that half the money he spent on advertising was wasted but his problem was that he did not know which half.

The problem is similar in investment management.

The laws of arithmetic virtually dictate that half the funds invested will fail to beat the index, but unfortunately no one can know in advance which half that will be.

It’s like football. Everyone cannot be in the top half of the table, and we all recognise the stupidity of sacking a football manager after four or five poor results.

The obsession with having to win every game means managers constantly search for quick fixes but most never find them.

To build a winning team takes several seasons — and even then requires a strong streak of luck — but it is very rare for anyone to be given long enough to achieve results in this manner.

Fund management has gone the same way.

Like football, it has bought into the belief that no one is allowed to be a loser.

The interactions of performance measurement, consultants, benchmarks and independent financial advisers have created an industry that rewards only those in the top half of the table. Success requires above average performance all the time.

Behaviour and business models are tailored to this end, and arguably the distortions that result have created a far more mediocre industry than need be the case.

Fund managers are obsessed with not being among the losers. Thus, even in actively managed funds, it is commonplace to find 90% of the activity is in benchmark stocks where the ambition is to be the same as everyone else — the no score draw.

Their hope is that the 10% they hold back and tweak might deliver just enough success to put them ahead of the pack.

It is fine if it works — but, if not, a poorly performing 10% slice will not be enough to make their underperformance so obvious it will attract attention.

Benchmark-hugging is far more pernicious than it appears. The basic tenet of investing is that if you want a higher return, you have to take a higher level of risk.

No one in their right mind and investing their own money would be tempted to buy a high-risk share if it promised a lower reward than you could get from something safe.

But that is what happens when benchmark-huggers invest other people’s money.

Research a year ago by Paul Woolley and Dimitri Vayanos at the Centre for the Study of Capital Market Dysfunctionality at the London School of Economics showed that benchmarking to market indices distorts incentives and prices across all securities markets.

“At the individual fund level, benchmarking over time requires fund managers to commit the largest weights to the least attractive investments, those offering high risk combined with low expected returns,” the authors said.

Benchmark-hugging means mediocre performance is built into the system.

This raises questions about the whole industry in terms of the personal motivation of those who work there, its business model, the service it provides and the role it fulfils in society.

Given that the UK fund management industry controls £6.6 trillion of assets, this is a lot of money to be systematically mis-allocated.

The Financial Conduct Authority last week announced an investigation into the way fund management works.

Its terms of reference suggest it will focus on the costs of fund management and the difficulty from the outside of knowing what the costs are and how performance should be measured; what costs and services fall on the investor which ought perhaps to be borne by the manager; and the role of investment consultants in giving advice to pension funds and others.

These are important issues. If UK pension fund investment managers operated with the same level of charges as their Dutch equivalents, British pension pots at retirement would be a third to a half as large again.

Mediocrity starts with investment consultants who screen out new and different fund managers as being too risky and only begin to recommend them when they are old, boring and like all the rest.

But solving these problems won’t solve those of fund management.