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.”