We Are All Active Managers

We have all heard the arguments about the flaws of active management and we all should have looked closely at the underlying data: active managers generally fail to beat their benchmark indices. Last year was the fourth-worst year for U.S. equity managers since 2001, as 69 percent of domestic equity funds lagged the S&P Composite 1500. Even more notably, as the period reviewed gets longer, overall performance gets worse. Over the fifteen-years through 2018, roughly 90 percent of all domestic and global equity and fixed income managers underperformed their respective benchmarks.

Institutional investors fare no better. On a risk-adjusted basis, 24 percent of funds fall significantly short of their chosen market benchmarks and have negative alpha, 75 percent of funds roughly match the market and have zero alpha, and well under one percent achieve superior results after costs — a number not significantly different from zero in a statistical sense.

Hedge funds – despite (and also because of) enormous fees – have badly underperformed too, and they are the most active of active managers. Indeed, if anything, their performance has been worst of all. Over the five years ended March 15, 2019, the HRFI Fund Weighted Composite has returned 2.81 percent, versus 11.03 percent for the S&P 500.

Meanwhile, and not surprisingly, assets are following performance. When it comes to mutual funds and exchange-traded funds that buy U.S. stocks, those that passively track indexes now hold 48 percent of assets. They’ll top 50 percent sometime this year if the current trend holds.

One seemingly obvious conclusion from all this data is that active management has lost, that it is like Nazi Germany after D-Day. The war wasn’t won (yet) and a lot of work remained to be done after Normandy, but the outcome was inevitable. That narrative is prevalent throughout the investment world.

However, there’s a lot more to it than that. For example, most descriptions of passive investing assume a cap-weighting strategy, but that is necessarily an active choice. Most ETFs use rules-based, non-discretionary approaches, but the rules are all determined by active choice. Moreover, the active/passive performance divide is more about fees than ideology, and fees are chosen. There is no way to get around substantial active management of some sort.

As an obvious starting point, investing successfully – investing at all – requires the active management of one’s life. The decisions to save, how much to save, and how consistently to save must all be actively made. Figuring out one’s hopes, dreams, and goals, developing a plan around them, and implementing that plan is decidedly active management. Evaluating risks and opportunities and acting on them is, by definition, an active endeavor. Determining a course, adjusting course as one’s situation changes and staying the course all require action. Staying smart when the markets are going wild takes active involvement and management, at least with respect to one’s emotions and biases. For all these crucial matters, passivity and inertia are the enemy. Active management is an absolute necessity.

I recognize that this argument may seem more than a bit disingenuous. It isn’t using “active management” in a consistent way or in the way it is most commonly used in our industry. Fair enough. Let’s dig a bit deeper.

As the vast majority of readers will already know, a passive investor typically looks to hold every security in the (or some) market, with the most prevalent of such approaches looking to have each security represented in the same manner and to the same extent as in the market, in order to achieve market returns, usually via index funds. It is a buy-and-hold approach to money management. It guarantees a heavy concentration in the largest, most overly hyped and inflated stocks while requiring that one buy high and sell low but, as the late, great John Bogle conceded, “that’s the market.” Even so, as noted above, indexing consistently beats that vast universe of active managers.

On the other hand, an active investor is one who seeks to “beat the market” either in an absolute sense or on a “risk-adjusted” basis. It is often the art of stock picking and market timing, but not always and less-and-less so as time goes on. Because active managers have typically acted on perceptions of mispricing and because these misperceptions change relatively frequently, such managers tend to trade more often – hence the use of the term “active.”

Even among those who accept as their goal to “own the market,” there are a variety of ways one might calculate a global market portfolio (see here, here, and here, for example) – the sum total of investable assets worldwide. For our purposes herein, we needn’t be very detailed. Suffice it to say that the allocation is, very roughly, 40-50 percent U.S. securities, 50-60 percent foreign securities, 45-50 percent stocks, 50-55 percent bonds, 18-25 percent U.S. stocks, and 25-30 percent foreign stocks, with some allocation to real estate and commodities.

Making the decision to use such a portfolio and to allocate sector weightings by market capitalization require active decisions. Yet, if your portfolio doesn’t fall within those parameters (and I’ll bet it doesn’t), you are taking a significant active bet. Adjusting this global portfolio for risk management, for other purposes, or for other reasons requires active management. For example, deciding to add real estate more accurately to reflect the extent of real estate ownership worldwide or reducing real estate exposure because of home ownership both require active management.

The more that investors seem to want passive management, the more the fund industry has reacted to that change (sometimes, but not necessarily, for the better). For example, increasing attention has been paid to alternative indexing approaches — so-called “smart beta” — that are built around specific factors (stock price/earnings ratios, company performance, share-price volatility, to name a few). Choosing any of them is activism, obviously, even if the investment vehicles are quasi-passive (i.e., rules-based), and the applicable rules must be selected actively.

Similarly, the sorts of investment approaches that have been shown to work persistently (such as value, size, momentum, and profitability) require activism if they are to be utilized (as part of a “smart beta” fund or otherwise). These approaches work generally, but aren’t market portfolios of any sort, even if and when the selection mechanisms are rules-based and/or the underlying vehicles are index funds. It’s active management of a different sort.

Unfortunately, most actively managed funds are actually highly diversified and thus cannot be expected to outperform. The more stocks a portfolio holds, the more closely it resembles an index, and you have to be different from an index if you want to beat it. The average number of stocks held in actively managed funds keeps increasing even as the total number of available stocks has gone down. Large numbers of positions coupled with average turnover frequently well in excess of 100 percent effectively undermines the idea that such funds could be anything but a “closest index.”

Numerous studies show that funds which are truly actively managed and more concentrated outperform indices and do so with persistence. See, e.g., Cremers & Petajisto, “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” (2007).  As summarized by Cremers and Petajisto:

“Funds with the highest Active Share [most active management] outperform their benchmarks both before and after expenses, while funds with the lowest Active Share underperform after expenses…. The best performers are concentrated stock pickers…. We also find strong evidence for performance persistence for the funds with the highest Active Share, even after controlling for momentum. From an investor’s point of view, funds with the highest Active Share, smallest assets, and best one-year performance seem very attractive, outperforming their benchmarks by 6.5 percent per year net of fees and expenses.”

Accordingly, it is possible to earn higher rates of return with less risk (particularly since risk and volatility are decidedly different things) via the judicious use of active management as traditionally defined. Nobody is managing the risk of an index. By combining a group of securities carefully selected for their limited downside (think “margin of safety”) and high potential return (think “low valuation” or, better yet, “cheap”), the skilled active manager has a real opportunity to stand out (think of investors such as Klarman, Buffett, and Abrams). This approach has practical benefits too in that the resources devoted to the analysis (original and ongoing) of each specific investment varies inversely with the number of positions in the portfolio. And it isn’t so different from the factor-tilts now used by so many.

On the face of it, at least, the realities of investing today seem to suggest that active management doesn’t make sense. However, the passive revolution doesn’t require the end of active management, merely an adjustment in focus. It makes certain well-supported demands, surely, such as lower costs, better diversification, a more careful consideration of rules-based mechanisms, and an approach that is comprehensively data-driven at every level. But active management’s death has been erroneously forecast and proclaimed.

The proper question isn’t whether to be an active manager, it’s what sort of active manager you’ll be. Active management is an absolute necessity. Indeed, the greatest need in the financial planning and investment management universes today is quality active management.

Because, after all, all of us are active managers.

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