A recipe for trust in asset management

Each mouthful was an explosion of flavours. It was overwhelmingly tender and succulent and married amazingly well with the wine. I savoured every second, hoping the moment would never end.

It was the best steak I had ever had.

We talked for hours, laughed together and became pleasantly tipsy. And, as the evening wore on, we retreated to the sofa, curled up together and switched on the TV.

“How romantic”, she said as I flipped over to the news.

“What? Would you like me to switch it off?”, I asked.

Of course, I had no intention to do so.

 She whispered softly into my ear, “It’s ok. I want to see the headlines too” as she rested on me.

We had missed the headline. The news was now in full flow:

“In a new twist to the Horsemeat Scandal, The French government announced today that a meat processing plant in France, known as ‘À la Table de Spanghero’, knowingly sold horsemeat labelled as beef”.

“That has well and truly spoilt the moment”, I laughed.

It was 2013 and it was Valentine’s Day. We were living in London in our cosy apartment in West Hampstead with our young daughter sleeping in the bedroom next door. And, we had decided to stay in for a romantic dinner.

The horsemeat scandal had been headline news for about a month and had hit many large supermarkets: Tesco, Asda, Morrisons, Iceland, Aldi and Lidl. That evening, discovering that the French had sold the English horsemeat wasn’t too shocking for either of us. Appropriately named meat processor Spanghero, had ended our evening on a farcical note.

We of course consumed only beef during dinner. Earlier that day, I walked up the hill, to The Hampstead Butcher and bought two very fine pieces of rump steak (I couldn’t afford a fancier cut and I like rump). This upmarket butcher was a pleasure to visit. The meat looked incredible and the butcher certainly knew his meat. When I spoke to him, he knew the farm the cow came from. He probably even knew the name of the cow the steak came from and the area of her backside my steaks were carved off.

Of course, this was not a typical purchase for me. Most of the time I stuck with Tesco, Asda and Morrisons for my week-to-week supply of meat. And, until the meat scandal erupted, the issue of trust and traceability in the food they provided my family was never questioned.

Like many other people, my focus was elsewhere. At the time, sugar-loaded soft drinks were out of fashion – women drank Diet Coke and men drank Zero. Everybody was counting calories. There was the Atkins diet. News reports highlighted the horrific levels of fat, sugar and salt found in school dinners. People were following weight-watchers and taking slimfast plans. I remember at one time watching this programme ‘You Are What You Eat ‘ with both great hilarity and disgust as the host of the show, Gillian McKeith, examined the human-excrement of people to show them how bad their diets were.

Of course some argued that horsemeat was better for you nutritionally than beef. It’s probably true and cheaper, as the infographic below shows. However, even if it is technically better for the waistline, eating horsemeat just doesn’t feel right.

In some ways, the asset management industry is experiencing something similar. Investors are calorie counting on the fees they pay because it eats into performance. They are pouring into cheap index funds that replicate – or partially replicate – an index like the S&P 500 or the FTSE 100.

I don’t blame them. I wouldn’t want to pay a premium for the skills of a fund manager when there is no guarantee that they will deliver superior returns. After all, in the last decade, over 86 percent of active equity funds underperformed their comparative index (FT, 20.03.2016). Moreover, these fund managers still charge a fee, well in excess of what index funds charge.

It’s just not fair, which is why there have been huge inflow is into index funds in recent years. The exchange-traded fund (ETF) is one of the most popular forms of this type of investment because they are extremely cheap.

To give you an understanding of the scale of the revolution underway, consider the chart below. Financial advisors are now using passive products to build up the bulk of their portfolios. And, this is set to increase with the rise of robo-advisors coming online.

I have a lot of sympathy for investors. However, I’m uncomfortable with the extent of the passive investment revolution.

When you invest in a passive fund you are just buying exposure to an index. You are not compelled to understand how the underlying companies are run, what they actually do or why they are interesting. Most people probably only have rudimentary knowledge of how the index is constructed.

This bothers me because it feels like you’re investing blind with little appreciation of the underlying risks, unique to those businesses. Many indices are cap-weighted, which means they are overweight companies that have already grown and are underweight those that are yet to grow in the future.

There are of course more complex index constructions that aim to get around this, such as smart beta indices designed to capture certain risk-premia that traditional indices don’t. However, the issue of not really understanding what you are investing, still remains.

I want to know that I can believe in the companies I invest in. There has to be a certain degree of trust. This type of relationship goes way beyond risk metrics, generic financials statement analysis and theoretical valuation models.

I’m talking about really getting to know the companies you invest in, appreciate their business models and understand the environment they operate in. There is no room for being an armchair investor, so you have to visit these companies and meet the people who run them. I know some fund managers that go to extraordinary lengths to understand a stock they want to invest in, such as hiring private investigators to look into corporate management and posing as mystery clients to check out the quality of the service.

However, there is a lot more that we in the asset management industry can do. We have become so out of touch with our investors. We’ve made what we do sound so ridiculously complicated with over engineered investment philosophies and methodologies to impress, even for the most plain-vanilla long-only equity strategies.

We drone on about attribution analysis and sector rotation because we think that’s what our investors want to hear. We’ve made what we do sound so boring and technical, and made ourselves completely inaccessible to our investors. And, they are now leaving us in droves even if we have delivered decent returns because they don’t understand what we do.

Furthermore, many active managers have been accused of doing nothing more than closet-track their reference index. A recently studied by Better Finance, reported by the Financial Times, revealed the extent of this problem. It implicated Schroders, Fidelity International, JPMorgan, Henderson, Amundi and 80 other asset managers of doing this (The full list of funds can be found here).

Clearly, a new recipe for trust is needed. It could be as simple as lowering fees, creating a more human touch and eliminating the perception that we see investors as cash-cows.

What’s interesting about the horsemeat scandal is the way it was allowed to happen. Supermarkets go to great lengths to understand their complex supply chains. However, what they did prior to the scandal was focus too much on paperwork, cutting costs and maximising margins. What they should have done was conduct more sampling, made more on-site visits and got to know their suppliers better to build greater trust and cooperation.

Trust is very important in business. It’s something we in the active asset management industry need to work harder to earn from our investors.