“The reports of my death have been greatly exaggerated.”
Broadly speaking, there are two schools of thought for investment managers: active management and passive management. In this article, we look at the new pressures building up on active management and what it means for institutions trying to design a prudent investment portfolio.
Passive Management Review
As a reminder, passive management is when an investment manager no longer tries to “beat” an index (like the S&P 500) and instead tries to match the performance results of the index. Usually a computer program can do much of the, albeit minimal, trading to keep the portfolio matching the index. The lack of thoughtful decision making and minimal trading requirements means passive investments are intended to be less expensive to operate. Relative to active management, passive management with indices generally has the following advantages:
- It’s cheaper for investors
- It’s more transparent, with easily defined expectations
- Long term performance is usually above the median peer group of active managers.
- It’s easier to defend from a fiduciary stance, with a lower due-diligence burden.
- Some retail investors can benefit from tax-efficiency, given reduced trading
Active Management Review
In contrast to the rules driven predictability of passive management, investors can hire active managers to do almost anything. Active managers benefit from human intelligence, foresight, and innovation. Active managers can make specific investments with the goal of beating their target index or they may simply try to equal the index return, with lower risk. They can ignore traditional investments completely and try out alternative strategies to lower the volatility of a portfolio. Relative to passive management, active management has the following advantages:
- Active managers have the potential to outperform the index; passive funds don’t
- Active managers have a greater variety of strategies to meet investor goals
- Some institutional investors benefit from useful revenue sharing agreements
The options – and combinations - for passive and active strategies are limitless. Please read our February 2012 Article on “The Basics of Portfolio Construction” on our website for greater detail and insights.
Active Management Pressure
Up until now, the advantages for passive or active management, enumerated above, have been well known. So, why has there been increased argument for the end – the death - of active management during the past year? There are three reasons: absolute performance, relative performance, and capital flows.
Since the market bottom of the financial crisis in early 2009, major US equity indices have more than doubled since the market low, and some have tripled in value, without a substantial correction in the meantime. Given this high level of absolute performance, some investors have become complacent about the benefits of low-risk options available through active investment. As noted, active managers also tend to underperform the index and their passive investment counterparts, but the relative performance difference has increased lately. (We will explain some of the reasons why in a moment.) Plenty of institutional and retail investors have noticed these trends and started voting with their pocketbooks. In other words, the capital flows away from active management towards passive investment options have been a significant trend over the past decade.
We mentioned the relative performance for active managers versus their indices has been particularly weak this year. We know, in the long term, indices tend to outperform active manager category averages, but usually the outperformance is by a percentage point or so. However, in 2014, the differences between active managers and the index were starker for many asset classes.
Let’s look at an example: the mid cap category. Here, we are looking at the investment returns for US companies which are worth between $2 billion dollars and $15 billion dollars. In 2014, the Russell Mid Cap index earned 13.2% in investment returns. In contrast, the average active manager in the mid cap category earned only 7.8% in investment returns. That is more than 5 percentage point of difference between the index and the peer group. Why did the active managers, on average, underperform so poorly?
The primary reason for underperformance of mid cap managers stems from market capitalization. Most indices are asset weighted. In plain English, asset weighting and index means the largest companies in the stock market are the largest part of the index. However, active managers can allocate their stock selections however they like. In fact, active manager bets are generally equally weighted. For instance, if an active manager thinks that two companies - the very large “IBM” and very small “Bluth’s Banana Stand” - are both going to do well this year, the manager may buy equal dollar amounts of both stocks; the active manager doesn’t need to calculate which company is bigger and weight the bets accordingly.
So why does this matter? In 2014, there was a huge disparity between bigger companies and smaller companies. The largest companies (the IBMs) earned 13.24% in 2014 while the small cap companies (the Banana Stand) earned only 4.89%. Consider the weighted average of the (asset-weighted) index is around $11 billion while the median weight (equal-weighted) of the index is around $5.5 billion. So, an asset weighted index is going to be more influenced by the largest companies’ performance. Meanwhile, active managers have their bets spread more evenly between all of their best picks, large and small. In fact, the active managers’ weighted average capitalization is around $7 billion, so they are more influenced by the performance of the smaller companies. In other words, active managers have split their bets more equally than the index, which gravitates towards the biggest companies.
So, we can explain one reason why the average active manager is underperforming. Is that an excuse? No. At least, it isn’t a sufficient excuse in the long-term. We do not subscribe to the notion where active managers get a pass because of their purchasing tendencies as a group. After all, active managers can do whatever they want to outperform and are paid, handsomely, to win. This idea is expanded our “Circular Reasoning in Due Diligence” blog post from February 2014.
We have heard many excuses for continued active manager underperformance, including a market preference for low quality over high quality positions, which active managers tend to favor. (Never mind the actual quality metrics, measured by debt / equity ratios, are nearly identical between indices and active manager averages.) Another excuse, albeit a smaller one, is the petty cash requirements means active managers will always lag behind in strong market rallies. It doesn’t matter if the excuse is true. Simply identifying the forces as an excuse for underperformance is no excuse, it is simply an explanation.
If we could demonstrate the forces which support passive management over active management are dominant forces in the long term, then we are obliged to use passive managers. Consider this logic: what if the reason for underperformance is simply the higher fees for active management. What if, other than fees, long term performance was identical for passive and active options? The problem is perfectly attributed and explained, but it’s not an excuse. To be a valid excuse, active managers need to make the case why the factors influencing their biases are, in the long term, going to provide additional value to their clients.
Given our previous example, where mid cap indices beat their peer groups, there is a valid defense for active management. Smaller companies, which tend to rely on US customers, do better in US-centric rallies since large caps rely on international revenue. However, the large caps did better in 2014 because the valuations were already stretched for small and midsized companies. In the short term, the mid cap space may continue to favor indices over active management, since valuations are still historically high for smaller companies. However, over the long term, the relative strength of various asset classes – growth & value, large & small - move up and down in cycles.
Is Active Management Dead?
Active management is likely to become less popular over the next decade since fiduciary prudence is well served by low-cost options which tend to outperform peers. The comparisons to cheap and easy indexing isn’t going away. 2014 was a culmination of many strong near-term trends which worked against active managers, but the long term trends aren’t going to provide much relief. However, active management is certainly not dead.
If active managers want to demonstrate their worth, they need to work harder at making the case for their business rather than relying on a presumption of good value they had enjoyed in previous decades. In particular, they need to focus on what they deliver which is unique among their peers and, over the long term, better than their passive index fund competitor.