SWIMMING AGAINST THE TIDE

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.

Active manager under-performance has nothing to do with market efficiency

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 Amazon or Netflix 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.
2. http://www.thisismoney.co.uk/money/diyinvesting/article-3078576/The-best-worst-tracker-funds-following-markets.html
3. Cohen T, DeSantis J, Nielson D, Leite B. (2014) Active Investing: The Cyclicality of Performance in the U.S. Large-cap Equity Market.