More than 20 years ago, when I was still directly involved in the institutional sales and trading world, I was talking to a money manager client about a big global bond deal, managed by my then firm, that was about to hit the market. The manager didn't like the deal very much, but he was going to buy it anyway and in noteworthy size. His view was that 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 value.
It was a classic trade by a closet indexer — a manager who claimed to be seeking active alpha but who was, instead, afraid to move too far from his benchmark. The last thing that manager wanted was to stand out, because the career risk to him of becoming a negative outlier was far greater than was the potential benefit of being right.
About 20 years before that, back in 1974, Paul Samuelson issued his famous “Challenge to Judgment.” In it, Samuelson challenged money managers to show whether they could consistently beat the market averages. Absent such evidence, Samuelson argued that portfolio managers should “go out of business — take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives.”
In his view, investors were better off investing in a highly diversified, passively managed portfolio that mimicked an index than using judgment to pick stocks. Indeed, the idea behind indexing is to effect broad diversification within asset classes and broad diversification across asset classes so as to achieve market-like returns.
Unable or unwilling generally to meet Samuelson's challenge, “active” managers like my client have increasingly acted like indexers and, not coincidentally, have steadily ceded market share to passive or quasi-passive investment vehicles. In 1975, John Bogle launched the First Index Investment Trust (later renamed Vanguard 500), the first stock index fund for individual investors, which is now one of the largest mutual funds in the world, and with it launched a seminal market trend toward passive investment generally and indexing in particular. Although the idea took root slowly, passively managed funds now control roughly 40% of all domestic equity fund assets, according to Morningstar.
Moreover, most “actively managed” funds are actually highly diversified and thus cannot be expected to outperform. Even so-called “smart beta” portfolios are designed only to try to outperform marginally. That's because 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 data from the Center for Research in Security Prices. (See Pollet & Wilson, “How Does Size Affect Mutual Fund Behavior?” Journal of Finance, Dec. 2008). Large numbers of positions coupled with average turnover in excess of 100% (per William Harding of Morningstar) effectively undermine the idea that such funds could be anything but a closet index.
As Patrick O’Shaughnessy of O’Shaughnessy Asset Management has recently and convincingly argued, managers today are much more interested in seeking assets than seeking alpha. A quality concentrated portfolio offers the opportunity for substantial outperformance. But such portfolios can significantly underperform for long periods and, even worse, a lesser quality portfolio might fall apart entirely. In either situation, the career risk to a manager is extreme. That explains the move to closet indexing pretty well, I think.
Since even before Samuelson's famous challenge, the Sequoia Fund has seemed to be exactly what a quality mutual fund should be. It is one of the last old-style funds with “conviction” — concentrated positions in stocks the fund managers believe in strongly. Since its inception in 1969, Sequoia has remarkably outperformed the S&P 500 by over 3% per year and has returned an average of over 14% annually to its investors. But recently the $5.5 billion fund was wrestling with heavy withdrawals as clients asked to pull more than $500 million in the first quarter of this year, largely due to a huge stake — roughly 30% of its holdings — in Valeant Pharmaceuticals International. The drug company's shares are down roughly 65% this year amid questions about its business and accounting practices.
Arguably, Sequoia is the only fund clearly to have met the Samuelson challenge. But as I write this, concentration and conviction aren't working so well for Sequoia as investors are aggressively questioning the judgment of Sequoia's managers and are taking their money elsewhere.
Accordingly, it seems beyond clear that the money management business today is dominated by indexers and closet indexers. Even the strongest advocates of active management must concede that, as a matter of simple arithmetic, the universe of active managers will underperform the universe of passive managers. Costs matter and passive management is a much cheaper endeavor. As Morningstar keeps demonstrating, in every single time period and data point tested, low-cost funds beat high-cost funds. Factor in the added tax efficiency of passive investing (much longer holding periods and far fewer transactions in general) and it is clear that active management bears a difficult burden in the contest to earn the trust and business of investors.
Perhaps even more tellingly, the performance of active managers and alleged active managers — in the aggregate — is astonishingly poor. A recent Bank of America Merrill Lynch analysis of mutual fund performance found that less than one in five large-cap mutual funds outperformed the S&P 500 in the first quarter in 2016, which represented “the lowest quarterly hit rate in our data history spanning 1998 to today.”
“The average fund lagged by 1.9 [percentage points], marking a record spread of underperformance,” explained equity and quantitative strategist Savita Subramanian and colleagues at Merrill. “And growth funds, for which our data extends further back, saw a 6% hit rate, the worst since at least 1991, with the average fund lagging by the widest margin we have recorded in our quarterly data: –3.5 [percentage points].”
As Bloomberg's Oliver Renick trenchantly pointed out, “It was a stock picker's market in the first quarter. Too bad about the stock picks.” Active managers got what they say they want so far this year: much lower correlations and much more breadth. However, the 50 stocks in which mutual fund managers are the least invested gained 5.3% in the first quarter compared with a 3.1% decline in a gauge tracking the most popular ones.
These findings are consistent with the regular SPIVA scorecards provided by S&P, which measure the performance of actively managed funds against their relevant S&P index benchmarks. During 2015, 66.11% of large-cap managers, 56.81% of mid-cap managers, and 72.2% of small-cap managers underperformed their respective benchmarks. Over the most recent five years, 84.15% of large-cap managers, 76.69% of mid-cap managers and 90.13% of small-cap managers lagged their respective benchmarks. Similarly, over the 10-year investment horizon, 82.14% of large-cap managers, 87.61% of mid-cap managers, and 88.42% of small-cap managers failed to outperform on a relative basis.
S&P's SPIVA Persistence Scorecard is even more depressing. Out of 678 domestic equity funds that were in the top quartile as of September 2013, only 4.28% managed to stay in the top quartile by the end of September 2015. Furthermore, only 1.19% of the large-cap funds, 6.32% of the mid-cap funds, and 5.41% of the small-cap funds remained in the top quartile.
Indeed, an inverse relationship generally exists between the measurement time horizon and the ability of top-performing funds to maintain their status. No large-cap or mid-cap funds managed to remain in the top quartile at the end of the five-year measurement period while only 7.48% of large-cap funds, 3.06% of mid-cap funds and 7.43% of small-cap funds maintained top-half performance over five consecutive 12-month periods.
Hitting the Wall
A key insight of Michael Mauboussin's excellent book “The Success Equation” is what he calls “the paradox of skill,” simply defined as follows: “As skill improves, performance becomes more consistent, and therefore luck becomes more important.” In 1941, Ted Williams had a batting average of .406, making him the last player in Major League Baseball to hit over .400 for a full season. Yet at least one batter hit .400 or better in nine of the 30 seasons between 1901 and 1930. Why is this, when overall skill has improved since then, in light of much broader access to talented players as well as superior coaching and conditioning?
As legendary scientist Stephen J. Gould has explained, as skill increases and moves toward human limits (the “right wall” of human achievement), the disparity between the average and the great narrows. As a consequence, although the mean batting average in the majors has remained roughly .260 since the 1940s, there are now fewer players at the extremes. In other words, “variation in batting averages must decrease as improving play eliminates the rough edges that great players could exploit, and as average performance moves towards the limits of human possibility and compresses great players into an ever decreasing space between average play and the immovable right wall.”
In the same way, money managers can lose sight of the fact that while they may be improving their products or skills, others are too, thus reducing the opportunity for excess returns. The great Peter Bernstein made the right connection between baseball and money management: “Competition is too tough for somebody to hit .400. I watch baseball figures like a hawk, and it seems that's how the world has become. The market is full of smart, eager, highly motivated, highly informed people. It's hard to be a winner by enough to matter, or to stay a winner by enough to matter. There's also the whole benchmark problem, namely that there's tremendous pressure on managers to keep their tracking error down. There's no incentive to make the big bets that are necessary to hit .400. You can't beat the market by a lot unless you make big bets.” See also: Peter L. Bernstein, “Where, Oh Where Are the .400 Hitters of Yesteryear?,” Financial Analysts Journal, March/April 1999.
The hurdles that money managers must overcome to meet Samuelson's challenge and beat the market are extremely high. The vast majority of managers who try to do so will fail, even though many of them are extremely talented and dedicated. Casual investors have no need or reason to beat the market, no matter what active manager marketing may suggest. Owners of an S&P 500 index fund generally own shares in 500 excellent companies. There is nothing inherently wrong with that. Nor is there anything wrong with utilizing market “factors” to try to improve investment performance. But investors in “smart beta” or similar strategies shouldn't expect outsized performance.
Investors who want or need substantial outperformance need to look for and at smaller funds with concentrated portfolios of quality assets that are held a long time to have a plausible chance of success. But these investors ought to understand that most such attempts fail and that the desired success is getting harder to achieve each and every passing day.