"… when you reach for the stars, you may not quite get one, but you won't come up with a handful of mud either..."

Leo Burnett

Ten years after the FTSE 100 Index peaked at 6930 equities have become an unfashionable, under owned, asset class. In addition passive exposure is favoured by many who take the view that tracker funds are low risk and cheap.

The contrarian view is that this lack of enthusiasm for equities and disinterest in researching the prospects for individual companies has created exactly the right environment for active investment managers.

The influential Brinson, Hood and Beebower research paper published in 1986 was based on a study of the returns achieved by 91 US pension funds between 1974 and 1983. It concluded that 90% of the variability of the return could be explained by the allocations to cash, bonds and equities. In other words, stock selection skills hardly matter and tactical asset allocation should be a non-core activity.

Brinson was analysing investment returns when the market was dominated by active managers and index-tracker trades were a new development. Now the market is increasingly dominated by publicly passive investors and closet trackers who are so close to the index that it is hard to see the difference.

In these tough times when all potential sources of profit should be investigated our view at Cheviot is that it is important to actively manage both asset allocation and stock selection.

Reasons to be an active investor:

• Future annual economic activity is likely to be more volatile than in the recent past and economic cycles are likely to be shorter. More akin to conditions between 1960
  and 1980
• Annual inflation is also likely to be more volatile.
• There is an increased probability of policy error by governments as the high growth countries in Asia and Latin America interact with the larger slow growing indebted economies of North America and Europe.
• During periods of change investment markets reward investors that actively seek return from a wide range of asset classes and strategies. Diversification benefits are more tactical than strategic.
• Trend following strategies tend to be unrewarding in volatile markets.
• Identifying the correct entry price for each asset class will have an important effect on future returns. Higher volatility puts a premium on timing.
• Active investment can be lower risk than passive. The latter is susceptible to concentration risk, as was the case ten years ago at the height of the dot-com boom.
• Globalisation presents opportunities to identify attractive sectors and industries in any country. Active managers can then search for the strongest companies.
• On average company finances are in good shape although there is a wide divergence between the winners and the losers.
• Expect there to be a continuing stream of takeovers as strong companies seek to gain market share.
• The combined weighting in the FTSE All Share Index of the companies in the following table, pre bid, was only 1.2%. In contrast BP's weighting has declined from 7% to 5% year to date. Tracker funds will have suffered the full effect of BP's problems and whilst registering only minor gains from the appreciation of these mid-cap stocks. As Prudential discovered, mega-cap takeovers are hard to finance and so less likely to occur.

A combination of uncertain economic conditions, structural change and the trend towards passive strategies has created the right environment for those with the inclination and resources to implement active management.

Company Name	% of All-Share @ 31/12/09
Cadbury	0.7%
Tomkins	0.1%
SSL International	0.1%
Arriva	0.06%
Dana Petroleum	0.07%
VT Group	0.06%
Chloride Group	0.03%
Brit Insurance	0.04%
BSS Group	0.02%

David Miller
Partner, Cheviot Asset Managementt