The average active equity mutual fund underperforms its benchmark, an assertion that sparks little controversy. This appears to be the case for active equity hedge funds as well. The story gets even worse when the results are AUM weighted. Collectively, active equity delivers no value to its investors and in fact extracts value from them.
In our highly competitive markets, no industry can long survive if it fails to deliver value to its customers. The consequences of these competitive forces are on full display in the current environment, as money flows out of active funds and into passive equity funds. Passive investing is being touted as a superior alternative to active equity and who can argue with this given the overwhelming evidence in support of this assertion.
As an active equity industry, we have to ask ourselves how we descended into such a sorry state. The conventional explanation is that portfolio managers and their investment teams lack stock-picking skill, but as is often the case, the answer is not quite so simple.
A careful analysis of the situation reveals that investment teams, buy-side analysts in particular, are not the problem; instead it is the system that sprang up for distributing funds. So rather than loudly denounce the lack of stock-picking skill, those in the distribution system have soul searching to do. As comics character Pogo was fond of saying, “We have met the enemy and they are us!”
Buy-Side Analysts Are Superior Stock Pickers
There is considerable research showing that buy-side analysts are superior stock pickers. (See, for example, Wermers (2000); Berk and Green (2004); Cohen, Polk, and Silli (2008); Pomorski (2009); Wermers (2012); Wermers, Yao, and Zhao (2013); and Frey and Herbst (2014).) The table below presents the results along this line from a study I conducted.
Active Equity Fund Best Ideas: Top 20 Relative Weight Stocks
Based on single variable, subsequent gross fund alpha regressions estimated using a data set of 44 million stock-month US active equity mutual fund holdings from Jan 2001- Sep 2014. Source: Lipper and Morningstar
These results reveal that the top 20 relative weight holdings generate fund alpha while the lowest ranked holdings destroy alpha. So any restriction imposed on a fund that leads to holdings other than best-idea stocks will negatively impact a fund’s alpha. If enough holdings are added, a potential positive alpha is transformed into an actual negative alpha, the sad situation on display today.
Conventional wisdom in the fund distribution system is full of such restrictions. Just to name a few: hold many stocks for diversification purposes, manage to low volatility and drawdown, avoid tracking error and style drift, grow large, and impose sector weighting constraints. In essence, the distribution system is a closet indexer manufacturing juggernaut.
To be clear, I and my co-author Jason Voss of the CFA Institute are talking about those who run the distribution system, both inside and outside the fund itself. The internal sales and marketing teams work hand-in-glove with the external platforms, BDs, RIAs and institutional investors, imposing value destroying restrictions on investment teams.
The “pot of gold” generated by analysts’ best ideas, somewhere around a 4% average alpha based on several studies, is eaten up by fund fees (less important) and external restrictions placed on the fund (most important). In the end, the fund itself captures the entire potential alpha and then some by growing too large, ultimately turning itself into a closet indexer. So none of the alpha is delivered outside the fund and, what is worse, additional value is extracted from investors.
Fixing a Broken Investment Management Model
A system that encourages closet indexing while delivering negative value to investors is clearly broken. So what is to be done?
The investment teams, particularly buy-side analysts, need to be elevated to a starring role as they are the ones who can deliver the most value to investors. In this regard, funds need to be incented to consistently pursue a narrowly defined strategy and take only high-conviction positions.
Participants in the distribution system need to avoid imposing restrictions that get in the way of successfully pursuing an equity strategy. More specifically, asset bloat, benchmark tracking and overdiversifying need to be discouraged, for these are the precursors of closet indexing.
In trying to resurrect the industry, an important first step is to move away from the discredited 1970s Modern Portfolio Theory. Not only is the evidence overwhelmingly against the pillars supporting this model, but it provides a theoretical justification for many of the value-destroying restrictions foisted upon funds.
As is the case in every transition, one must declare an end before one can advance to a new beginning. Declaring an end to MPT is an important first step in this reclamation project.
The new market paradigm will most likely arise from behavioral finance, a set of ideas sweeping across the financial landscape. The advisory business is already being transformed by these concepts, with major players, Merrill Lynch and Morningstar to name just two, establishing behavioral finance units and disseminating the resulting research throughout the advisor community.
Many advisors see this as an important value added path for competing with robo-advisors, which provide little help to investors for avoiding value-destroying emotional errors. Studies reveal that focusing on the avoidance of emotional investing errors can enhance investment returns by 2% – 4%.
Thus, some financial professionals are thinking of themselves as Behavioral advisors rather than as simply numbers-driven financial advisors. A recent signpost in this industry transformation is Kaplan Financial Education establishing a BFA (Behavioral Financial Advisor) certification and designation.
Can a Behavioral Financial Analyst designation be far behind? Behaviorally based objective measures will begin replacing what is currently used for analyzing investments. Several of these were mentioned above: asset bloat, benchmark tracking and overdiversification being predictive of fund underperformance. That is, objective behavioral measures are predictive while the traditional measure of past performance is not.
A behavioral market model will become the new, much improved paradigm. An early version will be introduced in one of our last posts. It will provide a stable framework for understanding and analyzing markets as behavior, particularly group behavior, changes little over time.
A Robust Debate
My and Jason’s posts to follow will provide suggestions on how the system might be fixed. Our goal is not to present final solutions but to spark a robust debate around the many challenges facing a broken industry.
Imagine a world in which only the lowest cost index funds along with truly active, alpha generating funds exist, with nary a closet indexer in sight.
Together let’s launch the active equity renaissance!