Some years ago, I was talking to a money manager about a major bond issue that was about to hit the market. The client didn’t like the bonds, but he was going to buy them anyway. Since the deal would be a significant component to the index by which he was benchmarked, he wasn’t prepared to risk being wrong on its relative value. I was happy to do the trade, of course, but his reason for buying the bonds was flawed. He wasn’t prepared to be brave, a requirement for successful active management.
Paul Samuelson issued his famous “Challenge to Judgment” in 1974, urging money managers to show whether they could consistently beat market averages. Those who couldn’t, Samuelson argued, should simply go out of business. In his view, investors were better off purchasing a highly diversified, passively managed portfolio that mimicked an index. Indeed, the idea behind indexing is to effect broad diversification within and across asset classes so as to achieve market-like returns. That is seen as good because—it is said—one simply can’t beat the market.
Unable (or unwilling) generally to meet Samuelson’s challenge, active managers have steadily ceded market share to passive-style investment vehicles ever since. Although the idea took root slowly, passively managed funds now control in excess of 25% of all domestic equity fund assets.
This trend makes sense. Even the strongest advocate of active management must concede that, as a matter of simple arithmetic, the universe of active managers will underperform the universe of passive managers because costs matter and passive management is a much cheaper endeavor. As Morningstar discovered, low-cost funds beat high-cost funds across the board. Factor in the added tax efficiency of passive investing and it is clear that active management bears a difficult burden. Indeed, only about 25% of active managers outperformed in 2010. Moreover, those few who do have a very hard time keeping up the good work.
Passive investing is predicated upon the efficient markets hypothesis. To oversimplify, that hypothesis asserts that because asset prices reflect all relevant information and because investors act rationally upon that information, it is impossible to “beat the market” over time except by being lucky. In reality, however, there is an abundance of evidence that markets are less than perfectly efficient.
There is no such thing as perfect information. Information can be and routinely is biased, erroneous, flawed and incomplete. More significantly, the idea that we can somehow rationally interpret all that information is—frankly—ludicrous. Behavioral economics teaches us at least that much.
For example, Dalbar’s Quantitative Analysis of Investor Behavior annually demonstrates just how irrational investors are. Over the past 20 years, the S&P 500 has returned 9.14% annually while the average equity investor has earned only 3.83% per annum, demonstrating how unsuccessful we are at controlling our emotions. We are plainly and predictably irrational—individually and in the aggregate. However, exploiting the market’s inefficiencies is extremely difficult, partially due to those very same emotional factors. We simply tend to follow the herd. Thus the efficient market hypothesis is easy enough to falsify, yet indexing remains excruciatingly difficult to beat.
Active management outperformance can only be predicated upon two things—market timing and security selection. Since there is little evidence that market timing works (nobody can foresee the future), we’re left with security selection.
Unfortunately, most “actively managed” funds are actually highly diversified and thus cannot be expected to outperform. The more stocks a portfolio holds, the more closely it resembles an index. The average number of stocks held in actively managed funds is up roughly 100% since 1980, according to the Center for Research in Security Prices. Large numbers of positions coupled with average turnover in excess of 100%, according to Morningstar, effectively undermine the idea that such funds could be anything but “closest indices.”
Properly used, diversification is a means to smooth returns and to mitigate risk. Excessive diversification, on the other hand, is merely (in Warren Buffett’s words) “protection against ignorance.”
Numerous studies show funds that are truly actively managed, and thus more concentrated, outperform indexes and do so with persistence. As summarized in a paper, “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” by Martijn Cremers and Antti Petajisto of the International Center for Finance, Yale School of Management:
“Funds with the highest Active Share [most active management] outperform their benchmarks both before and after expenses, while funds with the lowest Active Share underperform after expenses […]. The best performers are concentrated stock pickers. […] We also find strong evidence for performance persistence for the funds with the highest Active Share, even after controlling for momentum. From an investor’s point of view, funds with the highest Active Share, smallest assets and best one-year performance seem very attractive, outperforming their benchmarks by 6.5% per year net of fees and expenses.”
Accordingly, it is possible to earn higher rates of return with less risk (particularly since risk and volatility are decidedly different things) via active management. By combining a group of securities carefully selected for their limited downside (think Benjamin Graham’s “margin of safety”) and high potential return (think “low valuation” or, better yet, “cheap”), the skilled active manager has a real opportunity to outperform passive strategies. This approach has practical benefits, too, in that the resources devoted to the analysis of each specific investment varies inversely with the number of investments in the portfolio.
However, such success is extremely hard to achieve. That’s why I prefer an approach that mixes active and passive strategies and sets up a variety of quantitative and structural safeguards designed to protect against our inherent irrationality. I want to focus on those areas where I am most likely to succeed.
In the large-cap space, markets are relatively efficient and thus alpha-constrained. The mid- and small-cap sectors provide more opportunities, even though liquidity constraints can create difficulties. International equities tend to provide the best opportunities due to the wide dispersion of returns across sectors, currencies and countries. Indeed, the SPIVA Scorecard from S&P demonstrates that a large percentage of international small-cap funds continues to outperform benchmarks, “suggesting that active management opportunities are still present in this space.” Moreover, value strategies outperform and do so persistently in multiple sectors, especially over longer time periods.
Active management is not merely predicated upon outperformance. It can also provide risk mitigation. Yet defining risk can be quite difficult. Traditional quantitative finance equates risk with volatility. By that definition, broad diversification lowers risk because it lowers volatility. I look at risk more practically, however. For me, risk relates more to my chances of losing money over time than to the volatility of my portfolio.
For a deep value investor, purchasing a stock that has been beaten up and trades at low multiples to its fundamental value may have high volatility, but not be all that risky due to a significant “margin of safety.” Grouping such stocks together in a carefully concentrated fashion provides the best opportunity to outperform while mitigating risk. As Warren Buffett put it, “a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it.”
Even so, the best and most successful investors make mistakes and have down periods that can last a significant period of time. That’s why the client I referenced above was so willing simply to mimic the index. He knew performance that was close to his benchmark would allow him to retain assets while significant underperformance could cause investors to head for the hills (just ask Bruce Berkowitz). Being willing to stand out is perhaps as hard as achieving the actual outperformance. That’s why so many investment advisors remain willing to act like index investors and hope for roughly index-like returns. It’s a matter of survival.
Surviving in this business can be a major challenge. Actually to succeed by providing clients with real value is even more difficult. It demands the bravery to incur much greater risks—career and reputation risk rather than just investment risk. Successful active management demands bravery. How brave are you?