I prefer passive profit to active loss

Pension fund managers in growing numbers are opting for passive investment management — where the objective is purely to replicate an index.

The consultants think this is a mistake because "moving to passive management can give away a considerable amount of upside as excess net returns of 3% a year from active investing would compound over 10 years to deliver an additional 34.4% growth in assets".

What is odd about the statement is that while it is mathematically accurate, it flies in the face of experience.

Of course 3% a year delivers a 34% uplift over 10 years. The trouble is finding a fund manager who can deliver 3% above the index for one year, let alone 10 in a row. In fact, the opposite is more likely.

Surveys of pension fund performance over the last decade conducted by established analytical experts such as WM Group or Caps show consistently that more than half and, in many years, up to two-thirds of active managers have failed to do as well as the index even before they extract their fees. And the minority who are successful are normally about 1% above the benchmark. Outperformance of 3% over 10 years is very rare indeed.

The second fallacy is that consultants have any talent for picking skilled fund managers. If they had there would not be a problem.

In fact, as the biggest consultant Watson Wyatt once admitted, it takes at least 15 years to judge whether a fund manager's outperformance is skill rather than luck.

No one can wait that long, so what consultants do is focus on process and try to identify those attributes which successful managers tend to have. Thus they look at the track record to date and how it was achieved, on whether the firm is well-managed, and has a clearly defined investment process, and whether it is scalable — meaning would it be able to maintain performance if faced with a major influx of funds.

This scientific approach is worthy enough, and provides a legal shield against being sued by disappointed clients, but ultimately it is not enough. It provides no certainty.

Investment is as much an art as a science, and as such does not lend itself to this kind of measurement. It is the equivalent of trying to reduce Titian, Renoir or Van Gogh to painting
by numbers.

The evidence for this can be found at meetings currently taking place up and down the land between pension trustees and their active fund managers.

So lamentable has been the investment performance of so many that for the first time in living memory the fund managers are falling over themselves with offers to cut fees in an effort to avoid being sacked and replaced by index trackers. That is hardly the behaviour of an industry confident in its abilities.

At this point the consultants who probably recommended these less-than-successful fund managers in the first place usually maintain a discreet silence. Wisely so.

The growing risk in safe' bonds

Given how much time and effort is devoted to analysing the equity market, there is surprisingly little comment on the much more pressing issue of what is likely to happen to bond prices.

This is despite the fact the outlook for government securities, and by extension the future direction of interest rates, is every bit as important to the investment community.

There are exceptions, of course, and one who has courageously and characteristically ventured where others fear to tread is Jonathan Compton, managing director of Bedlam Asset Management, a small asset management firm that deserves to be much larger.

Writing in the company's recently published interim report and accounts, he said that "government bond markets and therefore many bond-related investments have entered a prolonged bear market... they are the new value-eating acid." Compton then pointed out that typically a bear market lasts between a third and a half as long as the bull run which preceded it.

Given that the government bond rally began way back in 1982 and only ended earlier this year, that is an up phase of 27 years, which implies at least nine years of falling prices. Without putting a number on it, Compton concludes that no one should put their money anywhere near government securities for a very long time.

After more that a quarter of a century of easy money in gilts, it may take people a long time to get used to the idea that government bonds can be every bit as "risky" as equities — and by the time the penny drops, they may well already be nursing big losses.

But in the current economic environment with more debt to be sold than has ever been attempted before against a background of a feeble economic recovery, currency weakness and the possibility of the return of inflation, bond investors really have no excuse if they are eventually caught out.