John "Jack" Bogle, the retired founder of The Vanguard Group, wrote in his Princeton University thesis in 1951 that mutual funds "may make no claim to superiority over the market averages" (1). While he expected "mutual funds to live up to this responsibility and become much more active in the future", it seems nothing much has changed.
It is claimed that nearly 30 per cent of so-called active UK equity funds are not actively managed at all (2) and recent data shows that only one in twenty US domestic equity funds and less than twenty percent of euro denominated European equity funds beat their benchmarks for the five year period ending June 2016 - it was a similar story over ten years as well (3). Such statistics feed a frenzy of financial headlines that highlight the investor disillusionment over the mediocre performance of active investment managers on a regular basis.
With passively managed assets growing 18% to US$6.7 trillion in 2016 to one-quarter the size of actively managed assets that grew only 4% last year (4), this article explains why you should not give up on genuine active managers so long as you apply some sensible manager selection criteria.
Passive and Active Investing
Passive investing is no doubt appealing due to generally much lower fees, good transparency and strong liquidity. Devotees point to the reality that market indices are merely derivations of the aggregated actions of all investors and, since you can only beat the market by exploiting someone else's mistakes, the average investor will underperform once fees and other costs are taken into account. Some also believe it is becoming more challenging for active investors to sustain a competitive advantage and reliably outperform with new information and tools due to technological progress and more industrious investment research (5).
Yet, as the scale of passive investing grows the defence of active investing becomes more apparent. After all, active investors are vital for the market to function efficiently. As they trade stocks perceived to be under- or over-valued, they provide market liquidity and the best valuation of a company's share price given all currently available information. If passive investing grew disproportionately large the market would become less efficient and improve the prospects for active investors to return until equilibrium is restored.
Surely successful investing is as much about avoiding over-priced and/or inferior businesses as it is about finding good quality ones that offer better value. Why would a prudent investor invest in every company, good or bad, simply on the authority of an index committee? Investment management is very much a people business and, despite all the technology, the decision to invest in a company requires human judgement. A passive investor is not incentivised to undertake any analytical endeavours and sidesteps the human factor that is crucial to determine the merits of each investment.
As a result, the passive investor is likely to own relatively more over-priced companies (and less of those that are under-valued) and also be predominantly invested in a relatively small number of the market's largest companies (6). Further concentration issues may prevail in terms of industry and/or country exposures that can also deliver undesired risks.
We believe portfolio holdings should be chosen deliberately for their potential to add value in line with their price, fundamental and other stock specific characteristics. They should be scaled according to the investor's conviction and risk appetite, and continually monitored for their ongoing inclusion. But, above all, a long term perspective and patience is key.
Debunking the Negative-Sum Game
Much of the active/passive debate is focused on the inescapable truth that active investment management is this negative-sum game. However, the real argument is against those 'active' managers who are intent on retaining assets by taking a safer, short-term, index-clasping approach while still charging high fees. If the estimated £58 billion of UK equity funds hugging the index was instead invested in the least expensive UK tracker fund, investors could save themselves upwards of £756 million a year in fees alone (7). It is these closet-indexers who sail too close to the benchmark who inevitably drag down the performance of the average active portfolio after fees, giving active investing a bad name and driving investors into passive alternatives. Much of the blame lies at the door of these mediocre active funds and, as a result, they are coming increasingly under the spotlight from the regulators.
With the current trend in favour of passive investing, the additional scrutiny may perhaps create a window for change. "Smart beta" approaches in the form of exchange traded funds, for example, are raising the bar for active managers. Those who respond positively by providing an honest review of their strategies will better serve their investors who may otherwise seek better value elsewhere. Active investing is certainly not a lost cause, far from it. As Ellis noted (8), unconventional active managers are the most likely to outperform and those already with clearly differentiated capabilities or longer fundamental time horizons will be under less pressure to compete.
To remain faithful to active investing we believe you need a disciplined investment approach with the necessary talent, conviction and patience to win at this negative-sum game. Let us look at these attributes in more detail.
Active Attributes
As in many human endeavours, to be successful on a persistent basis you need a certain degree of talent or skill that is distinguishable from luck. As luck tends to mean revert (or run out) over time, rather than relying on past performance to offer only limited information, a forensic assessment must be made of the decision making process. A clearly articulated and transparent investment approach is really important. A solid qualitative understanding of how it has been implemented, including the good (and bad) decisions, is crucial to acquire any confidence that historical results may (or may not) happen again. A manager trying to sell a performance track record predominantly hinged on luck will be quickly caught out when having to explain how the underpinning investment decisions were arrived at.
An essential feature at the heart of the investment decision making process is fundamental analysis. Selecting an investment on a thorough examination of a company's business has a better chance of success and adding value over and over again compared to other less reliable strategies such as technical analysis, macroeconomic forecasting or market timing.
The active manager must also demonstrate conviction in its ability to make investment decisions. This is the vital ingredient that binds everything together and is particularly important when the manager acts contrary to its peers. While other factors need to be considered, a concentrated number of holdings representing only the best ideas and a high Active Share (9) can indicate a strong level of conviction. On a related point, high conviction managers are more likely to offer a closer alignment of interest through performance-related fee structures rewarding active return rather than just the ability to gather assets.
Finally, a patient active manager should aim to invest over the long-term. Many of our favoured managers expect to hold investments for three to five years, although some will go out even further. As already mentioned, it is becoming more challenging to consistently beat the market over the shorter-term because any competitive advantage is unlikely to be sustained. The longer the time horizon the less likely that short-term factors or luck can overwhelm a good investment decision, and the more likely that the manager's skill will shine through. Cremers (10) suggests that only those highly active portfolios with patient investment strategies (longer than two years) out-perform their benchmarks on average, whereas those that trade frequently generally under-perform regardless of how active they are. Consistent with our views, he found that long-term managers largely focus on stocks that others find less attractive, buying relatively illiquid or deep-value stocks on the cheap and holding them with conviction over relatively long periods until their prices reach or exceed their perceived fair value.
Once an ideal active manager has been found, the investor may of course have to be patient and ride out any waves of under-performance if they are to reap the rewards of their manager's investment capabilities over the long-term. As actively managed strategies are inevitably in or out of favour from time to time, imposing a rebalancing mechanism can mitigate any bad luck and take advantage of any good luck that comes with market 'noise' over the shorter-term. Frictional costs must not be ignored but the redistribution of out-performing assets to under-performing ones can profit from this short term cyclicality.
Post appointment, a manager monitoring discipline is critical to continue to explore investment views and re-affirm confidence in the stewardship of the assets. This is also in the best interests of the manager as the investor's understanding of the investment proposition over time will help keep them patient for the long haul.
No-One Said It Was Easy
Investors should not despair and surrender to the convenience of an indexed fund. Neither should they have to make do with paying additional fees for a mediocre active manager.
However, the market is far more complex than most people realise and talented active managers are a rare bunch and hard to find, not least because of the difficulty in discerning whether their success is down to skill or luck. It takes time and a lot of dedicated hard work to understand the manager, their approach and the environment in which they operate – our behavioural psychologist, for instance, plays an important role in our qualitative assessment by providing insights which go beyond the traditional financial and investment analysis.
It has to be worth it. The plain fact of the matter is that if markets were simpler and active management was easier, the rewards would be commensurately smaller as many more investors would find they have the skills to be successful. It is the very complexity of the market that offers the opportunity to outperform for those in the minority that have the wherewithal to do so. We have been involved in the investment management industry for almost as long as Bogle's first index fund and remain committed to seeking out true active managers that live up to their responsibilities.
Stamford Associates Limited
February 2017
Author: Andrew Downes, CFA, is a Senior Investment Consultant at Stamford Associates Limited.
The information and opinions contained in this article are intended for general discussion and do not constitute a personal recommendation. Past performance is no guide to future performance and you should seek independent advice before entering into any financial transaction. For professional investors only.
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(1) Regan, M. (2016, November 23). Jack Bogle Q&A: "We're in the Middle of a Revolution". Bloomberg Markets, 25(6)
[2] Evan-Cook, S. (2014). Kill the Filler - the Costs of Closet Tracking. Premier Asset Management. The study looked at funds in the IMA's UK All Companies and the UK Equity Income sectors
(3) S&P Global. (2016). SPIVA® U.S. Scorecard, SPIVA® Europe Scorecard. S&P Dow Jones Indices. Retrieved from https://us.spindices.com/documents/spiva/spiva-us-mid-year-2016.pdf, https://us.spindices.com/documents/spiva/spiva-europe-scorecard-mid-year-2016.pdf
(4) FTfm. (2017, February 12). Passive funds grew 4.5 times faster than active in 2016. The Financial Times
(5) Ellis, C. D. (2017, January 20). The end of active investing? The Financial Times
(6) For instance, the largest fifty companies in the UK equity market account for 70% of the FTSE-All Share Index
(7) See 2 above
(8) See 5 above
(9) Active Share is a measure of the percentage of stock holdings in a portfolio that differ from its benchmark index
(10) Cremers, M., & Pareek, A. (2016). Patient capital outperformance: The investment skill of high active share managers who trade infrequently. Journal of Financial Economics, 122(2), 288-306
