The active management industry has done a poor job of making the case for its own existence. In an era of generally poor relative returns and high fees, it is easy to see why investors have been drawn to passive approaches. However, long-term and highly active investment strategies work. They are increasingly important as rapid technology-driven change is likely to create a clear divide between stock market winners and losers. Asset owners ought to strive for more than the sub-market return offered by passive funds. There is academic evidence that patient, high-conviction investment strategies can beat the index. However, it is essential to separate some of the truths from the myths in what has become a contentious debate.
The average active manager will underperform the market. Unfortunately this statement is mathematically inevitable1. The market return is made up of the return on passive portfolios (broadly the same as the market by definition) and the return on active portfolios. Therefore the return on the average actively and passively managed dollar will be the same as the market. Passive strategies underperform as they mimic the market but incur trading costs and charge fees. Active managers generally charge higher fees and so their average after-fee performance is worse.
Whilst the headlines often declare that “Active managers underperform in US equities over the past X years”, it is actually more interesting that the average active manager in US equities ever outperforms passive peers. Before-fee performance ought to be the same and the higher fees reduce returns. So what is going on? Some have suggested this is a cyclical phenomenon, perhaps reflecting whether it has been ‘a stock-picker’s market’. However, we think the explanation is much more straightforward.
First, passive fees can be higher than you might expect2 and in some instances higher than the fees charged for active management. Second, the group of active managers considered by studies is never complete. A study may focus on active mutual fund managers whose performance will differ from pension funds or hedge funds. Third, the collective performance of active often reflects an allocation to assets outside the comparator market. This is particularly true at the moment as mutual funds have a cash balance and this has hindered performance through eight years of rising US equity markets. Similarly, most US funds have an allocation to international equities and this has been an impediment in a period of dollar strength.
Some of the reasons put forward for the travails of active US equity managers are more dubious. We do not believe that the US market exhibits a higher level of efficiency than any other major market. The logic of this argument is that US companies are more intensively analysed than those elsewhere. There is no academic support for such an argument and there is empirical evidence against it. The average large US company has its earnings estimated by 15 Wall Street analysts, which compares to 14 analysts for emerging markets companies and 16 analysts for international developed market companies3.
More importantly, the fact that there are lots of analysts looking at a stock doesn’t make the market more efficient. The shortcoming that seems clearest to us is that many market participants are trying to do the same thing – predict short-term trends in earnings and share prices and predict how others will react to them. This is evidenced by the continuing decline in average holding periods for stocks listed on the New York Stock Exchange. For those trying to invest for the long-term in the best growth companies in the US, this creates opportunities.
The large and seemingly random perturbations in the stock prices of some of America’s most innovative, capital light, technology-driven internet companies when they report earnings suggest that thoughtful evaluation of the opportunities is not the dominant driver of trading in the shares. The idea that estimates of the long-run value creation from these companies could shift by such a magnitude every three months is risible.
1. Sharpe, W.F. (1991) The Arithmetic of Active Management.
3. Cohen T, DeSantis J, Nielson D, Leite B. (2014) Active Investing: The Cyclicality of Performance in the U.S. Large-cap Equity Market.
The charts below demonstrate this. On the left we see the frequency with which retailers Walmart and Amazon met analysts quarterly earning expectations over 2005–2015. The chart on the right shows their respective market cap change over the same period. Quarterly performance is not necessarily the best indicator of long-term value creation.
Data to end December 2015.
Source: Bloomberg, Thomson Reuters.
Many funds that describe themselves as ‘active’ are closet index funds. They overcharge their investors as they do little to earn active management fees. Their holdings overlap so much with the index that their performance is unable to differ materially from it. This leads to a high degree of certainty that they will underperform on an after-fee basis. Such funds have a marked impact on the averages of mutual fund performance.
Active share is a measure of how different a portfolio is from its benchmark. The seminal paper on the topic ‘How Active is Your Fund Manager?4’ highlighted a remarkable result: true active management as measured by high active share predicts relative fund performance in US equity mutual funds. On average, funds with the highest active share outperform after fees, while funds with the lowest active share underperform. At first pass it seems astonishing that such a blunt tool could be a predictor of performance. Is it really true that you only need to know that your fund manager is taking bets, not whether those bets are good or bad?
The explanation may lie in the reason that closet index funds with low active share exist in the first place. As outlined eloquently by former Vanguard CEO, Jack Bogle, it is the constant pressure to post good short-term relative results that can push managers to move close to an index. More cynically, tracking a benchmark closely ensures that a manager never underperforms by a wide margin in any one period which can be a trigger event for the termination of a relationship by fund investors. This is known as ‘herding’.
When a fund manager trades frequently, the one guaranteed outcome is that there will be trading costs. As market short-termism has increased, studies have looked at the impact of the holding period on delivered returns. This work5 shows a clear positive relationship between time horizon and performance. i.e. the longer the average holding period for stocks in a portfolio, the better the relative performance of the portfolio. When this information was combined with the data on active share, an important result emerged: the best results were obtained by those US equity funds that combined both high active share and patience. Funds with a low turnover but low active share did not outperform nor did the funds that combined high active share with high turnover.
Source: Cremers and Pareek, 2015, Patient Capital Outperformance.
4. Cremers M, Petajisto A. (2009) How Active Is Your Fund Manager? A New Measure That Predicts Performance.
5. Cremers M, Pareek A. (2015) Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently.
The views expressed in this article are those of Tom Slater and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
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