In the 1990s, Colonial First State fund manager Greg Perry established himself as an industry doyen. Between 1990 and 2002, the manager’s flagship Imputation fund outperformed the All Ordinaries Index by 11.8% per annum. Together with CEO Chris Cuffe, the duo oversaw a highly successful period, with funds under management growing from $150 million to $100 billion, including $25 billion in Australian equities.

That period heralded an era when a number of fund managers established outstanding track records investing at the blue chip end of the ASX. Fund managers such as Perry, Peter Morgan and the late Robert Maple-Brown all significantly outperformed the All Ords for well over a decade. Long enough to suggest that it wasn’t by chance.

But the industry changed soon after the turn of the century. The pool of talented Australian fund managers seemingly dried up. The game transformed. Being a fund manager became less about outperformance. The new incentive – don’t underperform and you keep your funds.

At the large end of the market, the majority of active managers today are closet index huggers. Their portfolios look a lot like the index with small tilts towards their preferred index constituents. The table below shows the top five holdings for ten of Australia’s largest actively managed funds.

Source: Fund manager websites

It is difficult to tell them apart.

The average can’t be better than average

It is well documented that most active managers underperform the market. Investing is a zero sum game. Simplistically, for every winner there is a (relative) loser and the average investor (which includes fund managers) should perform in-line with the market. But because fund managers charge fees, the average fund manager might reasonably expect to underperform the market.

There have historically been exceptions to the rule. A few fund managers went out on a limb and ran a portfolio substantially different from the index. Either through luck or genuine skill, some would meaningfully outperform the index and perhaps justify their high fees.

But if you hug the index, like the 10 funds above, and charge a high fee, you guarantee underperformance. If you are invested in any of these funds via a platform charging the full retail rack rate, your investment would have underperformed the All Ords over both the past 5 and 10 years. For those with enough money to invest wholesale (which requires an initial investment of anywhere from $25,000 to $500,000), performance was still poor. Despite the lower wholesale fee, most of these funds still underperformed and none outperformed by more than 0.9% per annum.

How did it come to this? As importantly, how are they still getting away with it? How, given their underperformance, do they hang on to the billions of investor dollars they’re entrusted with managing? Surely that money would, or at least should, be out the door by now. And for that matter, how did they end up managing so much money in the first place?

I’m sure you have your own views on things. For my perspective we are going to take a look back over an extraordinary 13 years since I joined the Australian funds management industry.

1: Trapped in the Banks’ Cross-Sell Cross-Fire

Greg Perry’s performance attracted more than just investor attention. Soon after the turn of the century, the Commonwealth Bank acquired Colonial. This triggered a wave of consolidation. NAB soon acquired MLC from Lend Lease, Westpac acquired BT and ANZ acquired a 49% stake in ING Australia’s insurance and wealth management division.

But consolidation wasn’t just about acquiring fund managers and their strong track records. It soon became a battle to capture the entire value chain. Not just the fund managers but the platforms, the advisers and even the custodians. Colonial’s strong relationships with independent adviser networks, forged through its outstanding investment returns, disappeared as the Commonwealth Bank focused on becoming a major distributor itself.

A second wave of consolidation occurred. This time the banks gobbled up the adviser groups. The Commonwealth Bank acquired Count Financial, Financial Wisdom, Whitaker McNaught and BW Financial Advice. ANZ acquired the remaining 51% of ING Australia (and rebranded it OnePath), which included advisory brands RI Advice, millennium3 and Financial Services Partners. Westpac acquired Securitor and St George. NAB acquired JB Were, Apogee, Garvan, and Meritum.

AMP got in on the act, acquiring Godfrey Pembroke, Hillross and IPAC, while IOOF acquired Bridges, Consultum and Shadforths.

The industry changed as the banks and other large financial institutions used their own distribution networks to funnel investor dollars, via their own platforms, into owned fund managers.

Flicking the switch on incentives

A long time ago, Colonial’s business model was based on being a high returning fund manager. Performance was paramount and they had some of the most talented portfolio managers in the country under their roof. Investors certainly benefited. And they raised billions of dollars. A fund manager’s incentive was clear – outperform and you attract funds.

Over the last decade, Colonial’s flagship Imputation fund hasn’t come close to replicating the returns achieved under Greg Perry. It hasn’t even outperformed the All Ords once fees are taken into account. Yet Colonial now has close to $200 billion under management and made a $230 million profit for the 2016 financial year.

When you control the distribution network, the incentive changes. Once you needed to outperform. Now you need to not underperform. The easiest way to ensure that is to hug the index.

2: The 2003-2007 Bull Market. When Volatility Played Golf

Bloodletting was perhaps the most common medical practice from 1000 BC until the late 1800s. It involved the withdrawal of blood from a patient to cure disease. The theory was that bleeding maintained balance between blood and other bodily fluids with proper balance required to maintain health. In most cases, it was harmful to patients. Yet it was widely used for almost 2,000 years. Why? My guess is because no one came up with a better theory.

Less than a century after bloodletting became a thing of the past in medicine, a number of Nobel laureates created a financial form of bloodletting. It is known as Modern Portfolio Theory. This theory is the foundation of any Finance 101 course and is widely taught at universities throughout the world.

Without wanting to deliver a Finance 101 course in this blog post, my six favourite assumptions of Modern Portfolio Theory are:

– expected returns equal actual returns;

– investors are rational;

– a company’s share price reflects all information, including inside information;

– tax and brokerage don’t exist;

– investors can borrow as much money as they want and all pay the same low interest rate;

– share price volatility is the only form of risk.

Some of those assumptions need to be bent in the real world. Some don’t apply at all. But that hasn’t stopped modern portfolio theory becoming the mainstay of financial planning today. That, combined with a period where it actually worked, has pushed genuine investors to the fringe.

The great and efficient bull market

Occasionally a sick patient would recover, despite being bled. Similarly, for periods of time the market can behave in a way that makes it look like Modern Portfolio Theory actually works.

The period I’m referring to was the first bull market of the 21st century, in between the tech bubble and the Global Financial Crisis, or GFC. It produced four consecutive years of returns (2004-2007) that were greater than 15% per annum. In 130 years, this had only ever happened once, when the market recovered from the Great Depression in the early 1930s. The 2003-2007 bull market tortured absolute, benchmark unaware managers.

I happened to work at one such manager, MMC Asset Management, and can attest to the frustration of being a pure stock picker in this market. Owning a portfolio of the 20 largest stocks in the index and playing golf for four years was an extremely effective strategy.

Source: Capital IQ

The only market reversal greater than 10% occurred right at the end of the bull market. Arguably the GFC was already underway at this point. For the first four years there wasn’t one pullback over 10%.

What did this mean for active management?

The lack of volatility meant opportunities to find cheap contrarian ideas were few and far between. And strong index returns meant that profiting from these scarce opportunities didn’t result in standout performance, as it had during the 1990s or post GFC. In response to the absence of opportunities, MMC’s cash weighting increased. But the continued strong performance of the index meant that those who held cash were left behind in the performance tables.

It was a difficult time at MMC. We were led by Adelaide-based Erik Metanomski, in my view the best stock picker in the history of the Australian funds management industry. After establishing MMC in 1993, Erik returned 27% per annum for the next decade.

While MMC’s returns during the 2003-2007 bull market were strong in absolute terms, they paled in comparison to the All Ords. MMC achieved a 23% return on the shares it held, but a near 50% cash weighting diluted overall returns to 13% per annum. This was dwarfed by a market that returned close to 20% per annum.

Following the 2003-2007 bull market, some genuinely active managers disappeared, including MMC. Others were confined to the doghouse, with their funds under management being reduced to a fraction of their peak.

Those managers who thrived seemed to hold a lot of bank and resources shares, which pundits referred to as the barbell strategy. Many had much lower golf handicaps in 2007 than they did in 2004.

3: Gatekeepers Keep the Undesirables In

When I entered the industry, I naively assumed that the best performing fund managers would have the most money to manage. Sound logical enough? So why was this assumption so erroneous?

The answer partly lies with the gatekeepers of the industry. First thing’s first, who are these gatekeepers? They fall into two groups:

1. Asset consultants. Gatekeepers who advise large industry super funds and other big institutions.

2. Research houses. Gatekeepers who provide research to financial advisers, most of whom need said research to recommend a product to their clients.

Between them, they exert immense influence over the entire funds management industry. An aspiring fund manager had little hope of raising much money without the tick of approval from a gatekeeper.

While not suggesting gatekeepers abuse their power, there are inherent biases in how they conduct their research. They also use elements of Modern Portfolio Theory in their decision making process. These include the notion of diversification and measuring risk using volatility of returns when compared to the index.

How would a gatekeeper view Forager?

Let us use Forager as the test subject for a hypothetical review by a gatekeeper.

A gatekeeper would likely conclude that Forager:

A. Is too concentrated and needs to hold more stocks to diversify risk

B. Can and does hold too much cash (currently around 25%)

C. Should sell South32 and call itself a small cap manager

D. Has too small a team and should hire more staff (so long as they don’t lower average years’ experience of the team)

E. Should sell a 40% stake in itself to a big bank

F. Should hold more internal meetings, speak to company management more often and assign analysts to cover all sectors

G. Generates returns that are too risky compared to the All Ords

H. Is expensive

I. Has good performance, but given all of the above, how is this possible?

From the above exercise, it is clear that a gatekeeper would be unlikely to recommend Forager to its clients. (Without the emergence of self-managed superannuation funds (SMSFs), Forager probably wouldn’t exist.)

Their influence has led to many supposedly active fund managers running their businesses with one eye on the asset consultants. Hence more diversification, larger teams and consensus driven decision making, and portfolios that closely resemble the index.

Conclusion – Will the Industry Change for the Better?

In the early 2000s, the banks changed the funds management industry and the main incentive became to avoid underperforming. The 2003-07 bull market cemented the position of the lukewarm money manager. And the gatekeepers have defended them ever since.

Steve might think there is a Fuzzy Future for Fundies. Yes, industry funds are putting pressure on fees. The growing popularity of low fee index funds (particularly exchange traded funds) have created more options for investors. And gatekeepers are becoming less influential as SMSF growth creates a large pool of investors who don’t have to follow their recommendations.

It’s easy to sit in Steve’s chair at Forager and think that things are changing. But the industry is vast and the vested interests are well entrenched. This post has been about how we ended up in an unfortunate situation. My bet is we aren’t going anywhere soon.

Ready to invest? Visit this page for more information on how to invest with Forager. Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.