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.”