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 89th 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.


39 thoughts on “The Active Management Challenge

  1. Robert,

    Nice article, yet I can’t help but notice you work for a company–Madison Avenue Securities–that promotes all sorts of expensive active management and market timing strategies. You specifically appear to have promoted a variety of active strategies in the past.


    • Dan —

      Thanks for reading and commenting.

      You raise three issues. With respect to active management, as I have written numerous times, I prefer a mix of passive and active strategies and support active management if judiciously used in areas with a reasonable, evidence-based opportunity for success (value, samll cap, ex-U.S., momentum, low volatility/low beta, concentrated) and in areas where a passive strategy is unavailable (as with some non-correlated investments). You can read The Value Project (linked above) for more.

      With respect to fees, they matter a lot (as I have written repeatedly). Since passive investing is cheater than active (and generally more tax efficient too), that is a significant point in its favor. However, I also think active strategies can offer value (as noted above). Joel Greenblatt’s value-weighted strategy is promising, for example. While low fees are important, they are not my only consideration.

      With respect to my firm, it is independent and its registered representatives and investment adviser representatives are all independent. We have no proprietary products and compel no particular strategies or investments.

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  3. If passive management is the answer for all individual investors all the time then we don’t need you, anybody else involved in personal portfolio management, or for that matter that part of the financial press that writes about personal investing. If you are so sold on passive management do you stick strictly to it? And if you are so sold on passive management have you advised your clients that with next to no effort they can select a Vanguard model portfolio that will do for them essentially everthing you do?

    Also, if and when the next severe crisis rolls around try counseling your clients to stay with passivity even as they watch their investments go up in smoke and even as they realize there is nothing their fund managers can do to bail-out of a sinking ship.

    • C. Vail —

      Thank you for reading and commenting, but you do not seem to have read the entire piece. I favor a mix of active and passive strategies today. I suggest you read The Value Project (linked above) for more. But what works today will not necessarily keep working (past performance is not indicative of future results). I will endeavor to change my views if and as events and the evidence warrant.

      In terms of advisors and the value they can offer, they can provide the best ideas and research and make portfolio and investment recommendations in accordance therewith. They can help clients set meaningful goals and develop plans to meet those goals. They can help clients manage their spending and evaluate their income needs now and in the future. They can point out ancillary needs (e.g., insurance, tax and estate planning) and help clients get those needs met. They can help clients ascertain, evaluate and re-evaluate the risks they are able to take, need to take and are willing to take and plan accordingly. They can provide immense practical support (e.g., saying “no” to adult children with a foolish financial request/demand when the parent(s) is/are unwilling or unable to). They can also help clients manage the behavioral biases and foibles that beset all of us. As Nobel laureate Dan Kahneman points out in his terrific book, Thinking Fast and Slow, a third party can be much more objective in this area and will likely see things that we miss in ourselves.

      In the words of the great Benjamin Graham, an “investor’s chief problem – and even his worst enemy – is likely to be himself.” A good advisor protects clients from themselves.

    • William —

      Thank you for reading and commenting.

      Successful active investors do not — in the least — indicate a problem with my thesis. Indeed, they support it.

    • Wow, 4 names out of what 50,000 active managers over the last century? Impressive evidence. William, if I put 50,000 people in a football stadium and then instructed them to engage each other in a coin flipping contest, someone will win and it will be 100% luck. flip 1 leaves 25K winners, flip 2 leaves 12.5, etc. The active outperformance stats in the real world are LESS than the random luck. How do you explain Bill Miller? What, he is a genius for 15 years then he is a moron? Did he just lose all his “skill” overnight? Nope, the coin finally came up tails for him. Of course, he still has his yacht.

      • Matt —

        Thank you for reading and commenting. Have you considered the possibility that Bill Miller’s well documented problems were caused by factors such as those Emmett sets forth in his comment rather than a lack of skill?

  4. Interesting piece. However, there are a couple of things that are misleading. Active managers (speaking to long only) build their strategies to outperform over longer time horizons. Measuring over and under performance by calendar year is short sighted in my opinion. Performance should be measures on a rolling 3 or 5 year basis (analysis should have at least 30 monthly data points). Further, those who create these studies rarely, if ever (I’ve never seen it),incorporate basic qualitative screen in their analysis that even the most junior of asset allocators would use to weed out weak funds. Things like over capacity (too large AUM), above average fees, inexperienced PMs or PMs departures, and weeding out closet indexers would certainly paint a brighter picture of active management.

    • Emmett —

      Thank you for reading and commenting.

      Your argument makes sense (if you read The Value Project — linked above — you will see that I support a mix of active and passive strategies). Lots of underperforming active managers do not invalidate active management. Moreover, proper benchmarking and evaluation are crucial. Using 2011 alone for evaluation may well be misleading (the results were particularly bad), but the performance numbers over rolling 3, 5 and 10 year periods are not a lot better.

      I also think your last sentence is worth repeating: “Things like over capacity (too large AUM), above average fees, inexperienced PMs or PMs departures, and weeding out closet indexers would certainly paint a brighter picture of active management.” I make much the same point in The Value Project.

      • Thanks for the response Robert. I haven’t done the analysis myself (yet) but am intrigued about the longer term performance being equally as bad. Perhaps I will write a white paper on the topic and then adjust for those qualitative factors and note the differences. Was unaware of your Value Project piece, thanks for sharing it. Best.

      • To be clear, Emmett, active performance is poor overall. But when screened as you suggest, I expect a significantly different result (even if it’s still far from what active managers would *like* to find). If you haven’t seen it, I suggest you take a look at the academic research referenced in The Value Project relating to this subject and “active share.” For example:

        Click to access Cremers.pdf


      • I think we are on the same page, my issue with a lot of the research that individuals like you or I put out there is the mis-specification of analysis periods (too short) and failure to dig into the data qualitatively, as mentioned above. I do agree that the majority of “active” managers will underwhelm in terms of performance. Also agree with the active and passive combo. Active share is a large component of how I personally select managers, nice to hear other credible investors are on the same page. Best.

  5. “y’know, with data and stuff”

    Right. I think the major problem is that people are looking in the wrong place for the data and stuff. To get significant results by comparing to a benchmark takes decades even for really good funds.

    But there is a better approach: compare the fund results to the results of a large number of random portfolios that have the same portfolio constraints as the fund. The random portfolios show us what luck looks like. Once we know that, we have a fighting chance of deciding if the fund has skill.

    • Pat —

      Thanks for reading and commenting.

      I like your approach but also think that there is more to it. Not enough people (including money managers, advisors and investors) are even looking for the “data and stuff.” Most active management claims are simply sales pitches. As such, they sell dreams, with supporting data often deemed unnecessary.

  6. “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.”

    An efficient market does not require that investors be rational. They aren’t. What is necessary is that they be unpredictable, so that you cannot reliably exploit their irrationality to make a profit. As Keynes put it, “The Market can stay irrational a lot longer than you can stay solvent.”

    • Jerome —

      Thanks for reading and commenting.

      I acknowledge your point (which was the primary reason I added the “[t]o oversimplify” qualifier. Indeed, few argue that the markets are truly efficient anymore. That view has morphed into a weaker claim — that market inefficiencies cannot be exploited with persistency. My view is set forth in The Value Project: the EMH is easy enough to invalidate, but people find that exploiting the market’s inefficiencies is, at minimum, extremely difficult.

  7. There are several mutual funds that, even after fees and loads, outperform their benchmarks consistently, over 3-, 5- and 10-yr periods. Not a ton, but enough for us to construct solid portfolios with them, if we have the tools to find them. Morningstar’s various databases (Principia, Advisor Workstation, Office, for example) make that possible. I am strongly in favor of active management, so long as I can find the funds that have beaten their benchmarks consistently AND are likely to continue to do so. Besides, the alternative is to throw-in the towel and guarantee ourselves sub-market performance. You said it yourself, index funds lose the battle because of fees. Absent the tools and knowledge, or the services of someone with the tools and knowledge, I reckon indexing/asset allocation/rebalancing is the best bet. But we need not be absent those tools and knowledge.

    • Icedogs —

      Thank you for reading and commenting.

      I generally agree with your outlook in that I believe active value can be found. I would simply like active management advocates routinely to justify their existence and process “with data and stuff.” I don’t think that unsupported claims and sales pitches are nearly good enough.

    • Icedogs & Bob,

      You are unable to find the overperformers in advance. The way the industry is set up is that the ones who do well then draw more funds. That is how an active manager makes money right? So you go through Morningstar, etc. and guess what? You pick Bill Miller because he outperformed pretty well for a few years when he had hardly any money under management. Then he outperformed by very little as his fund grew. Then he cratered and took all his client’s money with him. Only very few were with him from the beginning. The vast amount followed people like icedog into funds after they start to outperform. Then they lose usually. Miller’s real-world performance for his investors was much worse than just looking at how he compared to various benchmarks be cause he outperformed when he had 100mill AUM and cratered when he had 3bill AUM. (guessing at figures but the gist is correct)

      • In The Value Project, I note that size (AUM) is an important consideration and that smaller is better. Moreover, a history of outperformance can be indicative of skill but isn’t conclusive (I discuss this issue in some detail in TVP). I readily acknowledge that finding persistent outperformers in advance is difficult. But it may not be as difficult as it may seem when screened properly. For example, an “active” closet index isn’t likely to succeed and active managers in more relatively efficient markets (like domestic large caps) will have a very hard time.

        Some may decide that the risks of trying to outperform aren’t worth it. That can be a very rational decision (especially in a secular bull market). For these people, a fully indexed strategy can make great sense.

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  9. Reblogged this on Финсовет – Инвестиции без жадности и страха and commented:
    Ещё один профи задаёт “неудобный” вопрос своим коллегам по цеху (активных управляющих). Ну-ка: данные в студию!
    Мне близка такая честность.
    Что скажут наши местечковые — что есть у них в защиту своих высоких комиссий??

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