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Why Active Managers Fail (and Why You Shouldn’t Fire Them)

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The active managers at fund Grantham Mayo van Otterloo (GMO) are advising investors not to hastily fire active managers who have performed abysmally vis-à-vis their benchmarks in 2014.

No, they are not saying that GMO, best known as the hedge fund home of Jeremy Grantham, has underperformed. This is not personal.

Rather, two of GMO’s investment management executives, Neil Constable and Matt Kadnar, offer a novel explanation as to why active managers underperform — when they do underperform.

An understanding as to that reason may help suppress the desire to fire managers who may well outperform in the coming years, they say in a new GMO white paper called “Is Skill Dead?

The timing of their paper stems from fresh data on 2014 suggesting that between 80% and 90% of U.S. active managers underperformed their benchmarks last year.

That large proportion, which is typical of manager performance on the up or downside, troubles Constable and Kadner, who contend that the results should be somewhere around 50-50 net of fees if active managers were pursuing independent strategies.

The pattern of herdlike performance suggests a specific cause influencing manager success or failure that goes beyond standard portfolio decisions in terms of sector biases or investment style since, they write, “for every active manager that is overweight a sector, there is another who is underweight.”

The systemic cause they propose lies in the propensity for U.S. managers to allocate a generally small portion of their portfolios to non-U.S. stocks, small-cap stocks and cash. “Underperformance in any of these will act as a drag on the performance of the overall portfolio,” they write, as in fact all three did vis-à-vis the S&P 500 in the 12 months ending last Sept. 30.

“If a manager were to have had 5% of his portfolio in non-U.S. stocks, 5% in small-/mid-cap U.S. stocks, and carried 1% in cash, then he will have effectively started with a deficit of 120 bps versus the benchmark. That is a lot of ground to make up from stock picking within the S&P 500 alone,” Constable and Kadner write.

The GMO duo test this simple three-factor model by regressing U.S. large cap manager performance against rolling 12-month returns of each factor, overlaying the predicted data against actual results.

The result is a visibly very close relationship between the performance of their three “out-of-benchmark allocations” and active managers’ ability to add alpha.

In other words 2014 (as with other periods of extreme active manager underperformance such as 2011 and 1995-’99) was a year in which forces were aligned in such a way as to make it extremely difficult for active managers to beat their benchmarks.

“U.S. equities trounced non-U.S. equities, large-cap stocks trounced small-cap stocks, and equities trounced cash. That was a lot of trouncing going on. And, sure enough, active management was trounced,” Constable and Kadner write.

Those conditions could, but are not likely to, recur next year, they say, so investors who value the active managers they have selected would do well to hold tight; reacting to short-term losses by extrapolating future subpar performance can end up compounding investor losses.

Rather, the GMO team reminds investors that there is a fundamental difference between active and passive management:

“Active management allows for the continuous assessment of the state of the market and to make intentional choices about how best to take advantage of opportunities and mitigate risk. Passive management precludes the ability to add value in this way.”

Or, as they humorously caution investors:

“Winning stock pickers are deemed to have exhibited superior foresight and brilliance while the losers have suddenly become idiots and are often shown the door.”

Constable and Kadner suggest that investor pain stems mainly from the normal ebb and flow of style coursing through the market and that, as ever, successful investing requires patience.

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