The Active Management Challenge

A key issue facing the investment management business (and one largely ignored despite its gravity) relates to investment philosophy.  The vast majority of investment advice presumes (without supporting evidence) the validity of active management.  Most of the terrific market-related blogs I read regularly (such as those of Barry Ritholtz, Josh Brown and many others) make a similar presumption — they’re in the active management business after all — without defending it.  Can they? Will they? These blogs have strong opinions on most subjects in our business and articulate criticisms of those who, in their view, do things wrong.  But they are oddly silent (at least as far as I can tell) about the fundamental basis of what they do despite a great deal of evidence suggesting that they may well be wrong.

It seems to me that anyone in the active management business ought to be able to defend the process of active management with more than a sales pitch — y’know, with data and stuff.

As the vast majority of readers will obviously know, a passive investor most typically looks to hold every security from the market, with the most prevalent of such approaches looking to have each security represented in the same manner as in the market, in order to achieve market returns, usually via index funds. It is a buy-and-hold approach to money management. On the other hand, an active investor is one who is not passive and thus seeks to “beat the market” either in an absolute sense or on a “risk-adjusted” basis. It is the art of stock picking and market timing. Because active managers typically act on perceptions of mispricing, and because such misperceptions change relatively frequently, such managers tend to trade more frequently – hence the term “active.”

Passive investing (e.g., indexing) is predicated upon the efficient markets hypothesis.  To oversimplify, that hypothesis asserts that because asset prices reflect all relevant information and that investors act rationally on that information, it is impossible to “beat the market” over time except by being extremely lucky.  The evidence supporting this idea is surprisingly strong.

Most significantly, active managers generally fail to beat their benchmark indices.  Indeed, in 2010, only about 25% of active managers outperformed.  2011 was even worse.  Data from Morningstar shows that among 4,100 funds that invest in large-cap stocks, only 17% beat the S&P 500 for the year (strictly speaking, all index funds underperformed the market because of costs; however, for these purposes I will treat index funds as having matched the performance of “the market”). That is the smallest percentage since 1997.  Moreover, according to Bianco Research, 48% of equity mutual funds underperformed their benchmarks by more than 250 basis points. For example, the Fidelity Magellan Fund underperformed the S&P 500 by close to 14%. Even worse, those few active managers that do outperform in any given year have a very hard time (more here) keeping up the good work.

Hedge funds – despite (and in part because of) enormous fees – have also badly underperformed, and they are the most active of active managers.  Indeed, since 1998, the effective return to hedge-fund clients has only been 2.1% a year, half the return they could have achieved simply by investing in Treasury bills. Hedge funds are prone to the same inconsistencies as more traditional managers too. Legendary hedge fund investor John Paulson generated returns of up to 600% by betting against mortgages in 2008 as the market crashed, but got crushed by huge losses in 2011.  As the expression goes, legacies have been established with one great call in a row. 

More broadly, the Global Market Index (GMI) —a passive, unmanaged but well diversified mix of all the major asset classes weighted by market values — has outperformed nearly everything else over the past decade, providing a 6.0% annualized total return for the 10 years ending December 31, 2011. That puts GMI in the 89th percentile relative to the roughly 1,200 multi-asset class funds with at least 10 years of history (and thus makes it an even better performer overall than the 89^th percentile suggests once survivorship bias is factored in). GMI’s rebalanced and equal-weighted counterparts did even better. 

On the face of it at least, these facts seem to suggest that active management simply doesn’t make sense. Based upon the foregoing summary, is all the investment discussion, chatter and advice presuming the validity of active management really worth anything?

I think so and have laid out my reasons why in a series of posts available here. I challenge my colleagues — especially those engaged in active management — to answer the challenge and provide actual evidence (with data rather than ideology) for why active management makes sense. I would love for them to take me up on this challenge.  Our clients deserve as much.

 

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