The ongoing search for fund manager skill

David Gallagher
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David Gallagher … ‘what we are doing has a lot of public benefit’

The Centre for International Finance and Regulation (CIFR), based in Sydney, was established as a result of a decision by the first Rudd Government, emanating from the Johnson report into Australia’s financial services industry and its interaction with the region. David Gallagher is the Centre’s energetic chief executive and Professor at the Australian School of Business at the University of NSW. He speaks to Greg Bright about some interesting current and recent research he has been engaged with that examines issues in the financial services industry.

David R. Gallagher, the academic and former asset consultant in charge of Australia’s new financial markets research body, has spent the past 12 or so years in collaborative efforts studying multifarious aspects of the system. In fact, he and his colleagues, have pumped out more than 50 research papers and other studies in that time. He has also jointly edited two books along the way: ‘Retirement Provision in Scary Markets’ and ‘A Review of the Australian Financial Services Industry’.

He is particularly interested in deficiencies in data and, in a departure from traditional academic research, often uses contacts and other means to tap into information which is not readily accessible to the public.

“In Australia we don’t always have ready access to high-quality publicly available data,” he says. In the US, for instance, pension fund holdings are publicly available, with a 60-day lag from the fiscal quarter-end, which is what he would like to see become a standard in Australia. The proposed ‘look-through’ regulations, to come into force next year, will require only annual publication and they are generating a fair amount of questioning by the industry.

“The data is available elsewhere,” Gallagher says, “so why not in Australia? We have one of the best capital markets in the world. We have a history of being innovative and competitive. We should be always seeking to improve the efficacy of our financial system.”

His main issue is that different measurement units are needed to get the full picture in, say, fund manager performance. For company analyses, for example, there are three critical financial statements that enable inferences about the performance of a firm; the profit and loss statement, the balance sheet showing changes in  assets and liabilities between periods, and the cashflow statement. Extrapolating this concept to the funds management industry, performance inferences are only really widely available through a ‘‘profit and loss statement’ – that is, a fund return figure. Without a balance sheet (portfolio holdings) and cashflow statement (trade activity) it is difficult to understand and appreciate exactly how the returns to investors have been generated, Gallagher says, and to unmask skill over luck (or incremental performance to general market returns).

“I feel that what we are doing has a lot of public benefit attached to it. I wanted to further develop a research area (with CIFR) and I hope the regulators see the opportunities which could flow from the work we are doing. The research results could be used for improved supervision, better benchmarking and overall improvements in efficiencies.”

CIFR has been well funded, with $41 million provided over four years, starting back in 2011. About $18 million of this has come from the Federal and NSW governments and the rest from six Australian universities and several industry supporters,. The universities are: UNSW, Sydney, UTS, Macquarie, Melbourne and ANU. Two US universities – New York University and University of California, Los Angeles – are also involved, along with two Australian research centres – Capital Markets CRC Ltd and SIRCA Ltd. As part of its funding agreement with the Australian Government, CIFR works closely with the regulators APRA, ASIC, RBA and Commonwealth Treasury. The organization has a staff of 10, some of whom undertake research themselves, and others externally from member academics. Gallagher is hopeful the organization will continue well into the future, having demonstrated a track record of high quality research that is relevant to public policy debate.

Some of Gallagher’s research encompasses both retail and institutional markets. For instance, forthcoming papers include: ‘Individual Investors and Broker Types’; ‘Does Portfolio Emulation Outperform Its Target Fund?’; Governance Through Trading: Institutional Swing Trades and Subsequent Firm Performance; and, ‘Dissecting Anomalies in the Australian Stock Market’.

Gallagher seems to have a knack for undertaking research which challenges the conventional wisdom, too. For instance, he suggests that there has been a fashion among investors seeking higher alpha by investing into concentrated portfolios. It is true from empirical evidence that such portfolios tend to outperform, but there is also an understandable reason why such portfolios should outperform relative to benchmark. Such portfolios typically look different to broad-market portfolios.

Similarly, with boutiques, there is also evidence of significant outperformance across the sector, but this may not be because of their typically smaller fund sizes. These funds have different incentive structures and benefit from smaller trading costs to larger funds.

Prior to completing his doctorate at The University of Sydney in 2001, Gallagher was a financial analyst at the former Towers Perrin (now Towers Watson). He did his Masters at the University of Wollongong and his bachelor’s degree at Macquarie University. He also worked as a visiting professor for a year at the University of Texas in Austin and served as a visiting scholar at the Investment Company Institute in Washington.

While in Austin he witnessed a political debate battle being played out between WalMart, the giant retailer, and others who were opposed to the company’s takeover of a rival because it would have lifted WalMart’s market share above 15 per cent.

“It made me think about our market with Coles and Woolies’ domination,” he says. “I came across a paper which showed firms in more concentrated industries performed worse than those in more competitive industries. The basic argument is they become lazy and underinvest in R&D. I wondered whether it was the same in Australia.”

His subsequent work on the subject, with others, showed the situation was the exact opposite in Australia. He believes that this is primarily due to geography – a small population spread thinly across a large land mass – and regulation. In order to allow for scale benefits, the government will encourage competition but only up to a point.

Of more pertinence to funds management, the study on market anomalies, which stretched over 1989 to 2010, demonstrates various styles which can show persistence in beating broad market equities, such as momentum and value, but that not all anomalies work in cycles.

Gallagher and his colleagues have found evidence that persistence of outperformance due to skill does exist in Australia, which provides more opportunity for managers to beat the index than, say, the US, but persistence tends to be only short lived. “After about six months it’s pretty much gone,” he says. And “herding”, most evident through the momentum style, which many managers incorporate into their process, can be beneficial because it can clarify a price signal which someone has identified. However, it may be only the next four or five investors who follow this who reap the rewards and this may only last about a week.

“The market is reasonably efficient in the long run. But it’s about how long it takes to achieve this,” he says.

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