What Happened to Active Management?
There is a long running argument between proponents of active management and those who favor a no-frills, low cost indexed approach. The case for indexing is, in part, that the average manager does not beat the benchmark. The somewhat obvious reply is that there are thousands of active managers and you should be able to identify at least the top half and hopefully the top quarter. The indexers continue that there are countless academic studies that prove that active managers cannot consistently beat the benchmark. The active team then rolls out a list of managers who have beaten the benchmark over multiple trailing periods. The indexers boast of low fees. The actives chortle about their net of fee performance and point out that indexers will never beat the benchmark due to expenses. And on and on it goes.
The truth is that indices do better in some environments than in others. In very strong markets, it can be difficult to beat the indices, especially with the proliferation of ETF index funds which make it easy to “buy the market” rather than labor over the relative merits of individual companies.
It is helpful to note how some of the indices are constructed in order to gain some perspective. Most of the major indices are referred to as “cap-weighted” indices because the composition of the index reflects the relative market capitalizations of the components. The value of Apple’s stock was approximately 8% of the total value of the Russell 1000 Growth at one point and currently is a little below 5% of the index. So when you buy the ishares Russell 1000 Growth, you end up with a 5% investment in Apple. In fact, you end buying more of the stocks that have recently done well, which can seem to categorize index investing as a momentum strategy. This is in contrast to the old value adage of buy low and sell high. Given this momentum play, it is easier to understand why index funds might do better in strong markets. On the other hand, when the market turns down and some of the high-flyers are returning to less lofty levels, an investor’s starting point will be an overweight to yesterday’s winners. The other obvious insight favoring active types in a bad market is that an active manager may move to defensive positions, including cash, in an effort to protect capital. This will not occur in an index fund, which is pretty much on auto-pilot.
Given this quick analysis, it would seem that over time an active manager’s ability to stay close to the benchmark in upswings and significantly outperform in down markets would prove to be a winning scenario. The question is how much time do we give managers? Generally investment policies target an investment horizon that matches a market cycle, loosely characterized by a 3-5 year timeframe. In theory, managers should be able to prove their worth over this timeframe.
However, a recent look at mutual fund statistics measuring managers included in Morningstar and Lipper’s databases vs. respective benchmarks shows dramatic underperformance in the large cap and mid cap categories over the past 3 years. For example, in the 3 years ending March 31, 2013, the Russell 1000 Growth index had an annualized total return of 13.06% while the Lipper category average was 10.36% and the Morningstar category average was 10.82%. This is a fairly big miss over a 3 year period. The results for Large Cap Value are similar as the Russell 1000 Value returned 12.74% while the Morningstar category was 10.97% and the Lipper category was 10.46%.
So what happened? Can we just chalk it up to the wonders of index investing in an up market? Perhaps, but there’s always another side to the story. Active managers have offered numerous explanations over the past year or 2 for the underperformance.
- High Correlation between stock returns. Managers have argued that in the recent “risk-on, risk-off” environment, all stocks have gone down at the same rate when there is fear of a crisis such as Europe breaking up etc. The problem with this argument is that these risk-off periods have been followed by risk-on periods where correlations have subsided, and over time a reversion to risk-on should provide the stock picker an opportunity to erase the performance deficit.
- High Dispersion between stock returns. Managers further argued that certain stocks such as Apple or other large index components such as Exxon or IBM have had stock performances that were far in excess of the average stock in the index, thereby punishing any manager who didn’t own these stocks. This seems to contradict the first argument and seems like more of an observation than an explanation. This argument is valid, however, when high performing stocks conflict with the investment style or process of a particular manager. If the style is to look for companies with accelerating growth, then that manager might not be investing in a company like Exxon, which is a big part of the index.
- Low quality companies outperform in the beginning of a recovery and few active managers profess to target low quality companies as long term investments. While this was true early in the market’s rebound, that argument is getting a little old 4 years in.
The Increased use of index ETFs at the expense of actively managed mutual funds may very well have had an impact on the relative performance of active managers. Intuitively this has merit in that if everyone sold their actively managed mutual fund and invested the proceeds in an indexed ETF, the net losers would be the overweight positions (active share) in the actively managed portfolios. But is this actually happening? And perhaps more importantly, why would it happen?
Perhaps, the reason active managers are underperforming is due to the seeming dichotomy between stock price performance and the economy. We have accepted that we are in a New Normal slow growth economy, with employment rates that are too low and capital spending that is too weak. Yet stock prices continue to do very well. Why? Because seemingly there is no place else to invest. The Fed’s zero interest rate policy has pushed investors into the market, but not necessarily into individual companies. This is clearly a rationale in the near term for index investing. How long will this last? Until it doesn’t. When will that be? Ah, the $64,000 question.
Chances are that this particular 3 year period is not long enough to evaluate active managers. Their ability to protect capital (i.e. outperform in a down market) will be tested soon enough and the debate between active and passive will continue. In the meantime investing in the stock market just because there are no alternatives is a strategy that warrants a healthy dose of caution.