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Luck might run out for passive managers

PM Capital's Paul Moore reveals why he believes passive investing is reaching peak momentum and why that should throw up more opportunities for active managers.

Wednesday, July 19th 2017, 1:53PM

You’ve been out here doing a lot of roadshows around New Zealand and you’re basing your presentation on the movie Moneyball. What's that about?

Moneyball is the story of the Oakland A’s – they’re a team that went on to have the longest winning streak in American League Baseball. It’s really just highlighting how they went about that. The reality is, they were a small club and they had a limited budget, so they had to think and act differently from other ball clubs. They basically had to find the mispriced ball players; in other words, the anomalies. That’s pretty much what we do in the investment world. If you want to be a successful investor, you have to be doing something that others are not. It’s really taking advantage of people’s focus on the short-term and other factors that produce these genuine long-term anomalies. That’s how we believe you can really add value to the longer-term.

Do you think PM Capital is a little bit like the baseball team?

It’s really more about highlighting that you have to think differently, and the patience and conviction that is required. Prior to that 20-game winning streak, they had quite a few losses and people had given up on them. One of the points we make in our presentation is the reason that you need patience and conviction in this game is because if you’re actually going to go back and look at every great investment you make over time, at the time of purchase, you’re always questioned and sometimes ridiculed. There’s an interesting clip in the film where just before they start winning, everyone has given up on them, and there’s one person in the stand holding a sign saying, “We’re still proud of you!” There was one person left, and then they went on and became the famous name.

And they nearly won the league?

They didn’t quite get all the way, but they did create a record winning streak.

A bit like funds management – you should be aiming to be in that top quarter, rather than being number one all the time?

True, but to be honest it’s not even a matter of aiming to be in the top quarter. What we try and do is go out there and find investments that will meet our criteria.

It’s a pretty interesting market at the minute with all the changes going on. What are the sorts of things you’re looking for?

It’s a little bit harder at the moment. Most of our investments have been made over the last seven or eight years, and they are anywhere from halfway through their investment cycle to three quarters of the way through their investment cycle. We’re sitting on our current investments and letting them play out. Then we’re looking for what we think might appear in the future.

In terms of looking for opportunities, the one thing we need to be really conscious of is the fact that long-term government bond rates have bottomed. Over the next three to five years, if there’s upward pressure there, it will put certain businesses that have benefited from those lower rates in a more difficult position. We want to avoid those, and look for opportunities where companies can grow their earnings. Short-term, the markets have done well. It’s more a question of trying to work out what will occur over the next 18 months to two years, and see what sort of opportunities might be present.

Do you have any ideas on how it might pan out over the next few years?

I think it’s somewhere in the third quarter. I still think we have the full earnings cycle to come through. People are still underestimating the ability of the US economy to continue on and Europe is recovering a lot more strongly than most people realise. Until that earning cycle has played out, and you get a re-rating on those stocks that benefit from that, you’re really not going to come to the end of the market cycle.

I know a lot of people look very nervous at the moment, but I don’t think you’ve got that euphoria that you typically get at the top of the market. Over the next 18 months to two years, we can get acceptable returns, and then we’re going to have to think hard. By then, if the economies continue to tighten – unemployment has fallen 0.5% in the US – we might start getting a bit more entrenched inflation and that’s when you might get interest rates starting to genuinely pick up -  or the risk of it – and markets might adjust on the back of that.

There’s a big flow of money going into passive funds at the moment. How is that going to play out for active managers?

It’s interesting, because passive dominates flows at the moment. It dominates free flow. The interesting point that no one seems to have observed or commented on is the fact that all that passive investment decision-making, in terms of the stock market, is not based on valuation. That’s crazy from an investment point of view. You’re making decision that have nothing to do with valuation. What typically happens when you get the majority of flows going to any one particular sector or asset category is that the majority of investors usually have a bad experience from it. My thought process is that passive is actually getting to peak momentum. When you get that sort of domination of flows, like TMT back in 2000, it actually distorts asset prices. If you’re an active, genuine, long-term investor, it should throw up more opportunity. But for the investment community as a whole, I don’t think they realise that they’re heading into a suboptimal outcome. It’s going to be because index returns are actually going to be quite low, because the market, overall, is well-valued. If you look at it in the context of a blended portfolio, then you take away fees etc. There’s not going to be much return left for the end investor. At a time when you get maximum amount of flow into passive, the future return prospects are the most subdued. It’s something to think about.

There’s still a role for passive though, isn’t there?

There is a role. It’s a funny one, because we’ve always said if you want to be a successful investor, you have to be doing something different from others. You’ve got to be active. I’ve always argued that the best approach is a focused portfolio. Why would you want to own everything? It doesn’t make any sense. You want to own the real anomalies.

What’s happened, though, over time, is that the industry has turned investing into a process. They’ve put all these restrictions around fund managers, so a lot of fund managers are running funds that are effectively index funds in drag. If you’re going to do that, it’s obvious; you may as well take the real thing at a lower fee. The bottom line is that the industry has created this situation, forcing people into passive. It looks as though it’s a sensible operation and for most people, if you just want general market exposure, take a passive fund. If you want to get better than the market, and you want to be a genuine investor, you’ve got to be active.

There’s a lot of talk going around about roboadvice and technology and how that’s going to change the way the funds management industry operates. Do you have a view on that?

Yes and no. If you think about the first stage of passive, that was people being index plus or minus – what I call index funds in drag. Then people realised that if that’s what they really are, why are we paying a higher fee? We’ll go to passive. That whole process has made it very mechanical for a lot of the funds management industry. If you make it very mechanical, you make it very easy for technology to be a substitute for it. There’s all this talk about artificial intelligence and roboadvice. All it is, is an evolution of what the industry is already doing themselves. The more mechanical you make it, the more you’re going to put yourself out of business. Genuine active investment is not just numbers, but judgement and intuition. They’re the sort of things you can’t put into an algorithm or mechanical process. For us, it’s not going to make any difference, but for the middle part of the industry? Replace them with a computer.

Do you think over time there will be a flow back to active managers?

I think there will. Personally, I think that passive is correlated with interest rates, because we’ve had a 30-year cycle of lower interest rates and once interest rates go down, all asset prices go up. But, if you believe we’re at an inflection point of interest rates, then the correlations are going to break down. Also, you’re going to have much more subdued returns from passive investing. I think we’ll get three to five years down the track, and everyone will wake up to say, “Hang on, we’re not meeting our investment objectives.” Then they’ll start going and searching for the active managers and the trend will start to move back towards active, but as it took a long time for passive to become dominant, it will take a long time to go back. It will probably go full circle. In 20 years’ time, we’re going to start to embrace that you’ve got to be active. That’s just the way markets work!

Tags: Active v Passive funds management investment Markets PM Capital roboadvice

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