“The archer missed the bull’s-eye because he didn’t hit the target.”
This sentence, while true, doesn’t explain anything substantive about the situation’s cause and effect.
An improved sentence would be, “the archer missed the bulls-eye because his broken arm was impeding his aim.” The improved sentence supplies a clear cause to the effect.
Why are we discussing logical arguments in a blog about finance and investing? The reason is because we have been disappointed with active managers using circular reasoning to defend their poor performance relative to their indices. When we conduct due diligence on our mangers, we try very hard to understand the causes of relative performance, both positive and negative. This understanding is blocked when active managers frequently explain underperformance with this excuse, “the market hasn’t favored active management.”
Let’s consider that defense for a moment. As long as individual security returns vary at all, there will be positions which outperform the index and positions which underperform the index. Naturally, active managers try to pick the winners—those securities which outperform the index. Conversely, an active manager will underperform their index, if their selections—in aggregate—underperform their index. Active managers are not required to buy or sell any particular type of position. Now, the opportunity set for mangers might be different depending on the strength of the market’s direction and the variance of returns among different securities. But there is no market that inherently favors or disfavors active management.
It is entirely fair to say a particular style of management was not favored. For example, in the 3rd quarter of 2011, most active fixed income managers made the same bet. Specifically, most active managers bet that long duration treasuries and government bonds were overvalued relative to credit bonds. Thus, most active managers overweighted credit bonds and many of them underperformed the index when government bonds rallied. In other words, there was a common bet that many active managers made which ended up underperforming the index; most active managers underperformed. On the other hand, there was nothing to force active managers to make that bet. It simply is untrue to suggest that the market somehow disfavored active management.
Instead of bonds, let us consider stock managers. It is completely fair to notice that active managers, in general, tend to pick higher quality names than the index. It would also be completely fair to notice that high quality names underperformed low quality stocks over the past few years and so, as a result, active managers tended to underperform. Again, it is not fair to infer that active management didn’t work or was somehow out-of-favor because of a similar bet made by active managers.
When active-managers try to excuse their underperformance by claiming the market didn’t favor active management, what they are actually saying is that do not understand the causes for their relative underperformance. In our July 2012 Article on Portfolio Construction, Westminster Consulting asserted a healthy skepticism over the superiority of either approach – passive or active. We detailed advantages and disadvantages of both active and passive management, and we suggested there is room for both types within a portfolio. We are not against active management. However, active managers are not allowed to defend poor performance on circular reasoning.