Active Management Required

We have all heard the arguments about the flaws of active management and we all should have looked closely at the underlying data. Over any random 12-month period, about 60 percent of mutual fund managers underperform. Lengthen the time period examined to 10 years and the proportion of managers who underperform rises to about 70 percent. Even worse, equity managers who underperform do so by roughly twice as much as the outperforming funds beat their chosen benchmarks and the success of the outperformers doesn’t tend to persist. The SPIVA Scorecard from S&P demonstrates this phenomenon regularly and routinely.

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 1 percent achieve superior results after costs—a number not significantly different from zero in a statistical sense. Pension funds, hedge funds, endowments and private equity funds all provide similar outcomes in slightly different settings.

Meanwhile, and not surprisingly, assets are following performance. Just a decade or so ago, passive investing was a relatively small slice of the investment universe. On November 1, 2003, just 12 percent of all U.S. open-end mutual fund and ETF assets (not including fund-of-fund or money-market assets) were invested in passively managed products, according to Morningstar. Today that percentage stands at 27 percent and is growing fast. In the equity markets, fully 35 percent of all investments are now held in passive vehicles.

The obvious conclusion from all this data is that active management has lost. Sure, most money is still placed with active managers (at least for now), the story goes, but active management is like Nazi Germany after D-Day. The war wasn’t won (yet) and a lot of work remained to be done, but the outcome was inevitable. That narrative is prevalent throughout the investment world.

However, and to the contrary, I think active management is an absolute necessity.

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Confessions of an Institutional Investor

My friend Josh Brown (The Reformed Broker) just published an interesting piece, Confessions of an Institutional Investor. Here’s a taste.

“I’ve seen complexity fail over multiple investment cycles in these types of portfolios, but as Keynes told us, ‘Worldly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally.’  Somehow simplicity has become the exception while complexity is now the rule.

“I believe that meeting long-term spending needs for institutional portfolios and controlling risk can be accomplished through simplicity.  That’s not to say that it’s easy, just less complex.  A complicated portfolio relies on the hope of being smarter than your investing peers and the markets while taking on added risks.  We all know hope is not an investment strategy.”

Josh concludes by asking, “What do you think?” I’m glad he asked.  What I think is linked below.

• Is the Yale Model Past It?
• The Active Management Challenge

Voting with their Feet and their Dollars

I have regularly challenged advisors to justify their use of active management. 

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.

Examples of my challenges and related posts are listed below.

• The Active Management Challenge
• More on the Active Management Challenge
• The Charley Ellis Challenge
• Value is Elusive
• The Value Project
• The Best of Both Worlds: Active and Passive Investing

Sadly, the challenge remains largely unmet by the investment world as a whole. However, since I favor active management for a variety of investment types and styles, The Value Project — linked above — provides my response to this challenge.

It is therefore probably not coincidental that one of every three dollars invested in mutual funds and exchange-traded funds through the first four months of the 2012 has gone to Vanguard, according to Morningstar Inc. (and as reported by Investment News).  Investment in Vanguard so far this year is roughly $65 billion, nearly four times more than the next closest mutual fund company – PIMCO.  In ETFs, year-to-date through the end of April, Vanguard had gathered $21.6 billion, while BlackRock’s iShares collected $13.3 billion and State Street added $7.2 billion. As always, Vanguard focuses on passively managed index funds and ETFs. 

It seems clear to me that many advisors are simply not meeting the challenge to active management offered by the likes of Vanguard and, as a consequence, consumers are voting with their feet (and their investment dollars).  Moreover, low fees matter, especially in a low return, low yield world.

Consumers have pretty clearly thrown down the gauntlet.  How will the active management business respond?  Will it respond?

Here’s hoping, but only time will tell.

CFA Conference: The Puzzling Popularity of Active Management

The University of Chicago Booth School of Business offered this presentation examining the continuing popularity of active management. The moderator is David Barclay, COO of the Center for Research in Security Prices. The presenter is Lubos Pastor, Charles P. McQuaid Professor of Finance at the University of Chicago Booth School of Business. He is also a Research Associate at the National Bureau of Economic Research and a Research Fellow at the Centre for Economic Policy and Research. The focus of the presentation is why active management remains so popular. Note this article on this subject (more here).

My session notes follow.  As always, these are at-the-time notes.  I make no guaranty as to their accuracy or completeness.

• Are there too many active managers?
• Well-known stats — in 2011, 79% of large cap funds underperformed the S&P 500; the average equity fund lost 3% and the average hedge fund lost 5% v. S&P 500 being up 2%.
• Even Peter Lynch now recommends passive investment.
• Passive management now represents about 15% of the market.
• Why is the active market so large given performance (the assumption is that people are stupid).
• Pastor: It makes sense that the active market would be large even if investors are all smart.
• Alpha becomes more elusive as more money chases it (competition to find mispricings).
• Think of active managers as police officers and mispricings as crime.
• With disappointing returns, investors change expectations and reduce active investment (but the reduction is cushioned by decreasing returns to scale!).
• As passive management grows, active alpha will improve.
• Past underperformance doesn’t imply future underperformance (just that some money should be moved active to passive).
• Passive management should therefore only grow slowly (active should decrease slowly).
• Without active management, there would be a lot of mispricings; thus at least some active management is optimal.
• On an industry-wide basis, some active management makes sense; but does that apply on a personal/individual level?
• As index funds get bigger, it will be easier for active managers to outperform.
• Money to be made at the expense of index funds (e.g., buying ahead of an index reconstitution).
• Burk & Green (2004): as funds get larger, it will be harder to outperform; Pastor agrees.
• Passive management may need to grow substantially before we begin to see significant impact of the sort Pastor predicts.
• CRSP has and will have some new index possibilities combining academic research and industry practice with objective and transparent measures (see here).
• These indexes focus on investability.
• Fewer U.S. securities since 2000 (down about 1/3); thus breakpoints (e.g., small to mid-cap) defined by cumulative market cap.
• Bands around the breakpoints to decrease trading costs for passive managers.
• Mega-Cap (top 70%; 284 stocks today)); Large (top 70%; 646 stocks today); Mid-Cap (70-85%); Small Cap (85-98%); Micro Cap (98-100%).
• CRSP indexes and migration — considered many approaches; weighed trade-off between turnover and style-purity.
• CRSP introduced the concept of “packeting,” which cushions movement between adjacent indexes (to reduce transaction costs).
• Multi-dimensional approach to value and growth.
• CRSP — Re-engineered market-cap-based indexes, emphasizing cost efficiency.