In many previous articles (e.g. “The Death of Active Management
” from Feb 2015) and blog posts (e.g. “Filing down the FANGs
” from February 2016), we’ve looked into the various advantages and disadvantages of using active managers, those trying to beat the benchmarks, versus passive managers, those trying to match the results of benchmarks as inexpensively as possible. Here is one criteria we haven’t looked at yet: opportunity set. In other words, how diverse is the investible universe? How correlated are the asset market prices) to select from? Think about it: if there are 1000 stocks to choose from, but if every stock goes up and down in perfect lockstep, there aren’t any opportunities to have a relative advantage for an active manager. Furthermore, how much in fees does active management incur and how important of a drag on relative performance is that fee level?
Consider traditional US Equities. Just looking at fees alone, Large Cap active managers tend to be less expensive than Small Cap active managers. So, you might think that Large Cap managers have a lower bar to overcome, a smaller hurdle, if you’re making the decision to use active management in the Large cap space. However, the number of large and megacap stocks tend to move in higher correlation to one another (because they often move with tides of macroeconomics) compared with smaller companies, which may cater to specific niches and distinct sub-markets. Not to mention, there are simply more small and mid-sized companies than large ones; we could make a reasonable argument for delineating 2500 small and mid-sized companies compared to about 500 large and megacap companies in the US. So, practically and numerically, the opportunity set is more diverse and higher for small and mid cap stocks. So, the advantage for passive vs. active management is arguably a tie for US equities. There isn’t necessarily a better choice between small and large caps in the debate of passive and active management given the fees and opportunity set.
On the other hand, consider US Real Estate as an asset class. Assuming most investors aren’t going to be making private real estate deals and are instead considering Real Estate Investment Trusts and Real Estate Operating Companies (REIT, REOCs), let’s look at the options. The median US Real Estate investment fund charges 1.28% in fees. So, as a simplification, the typical US Real Estate fund should be generating an additional 1.28% in returns (or risk-adjusted returns) over its index to be worth owning instead of a passive index fund. That’s a pretty high bar. Furthermore, we see that the number of holdings within real estate indices is fairly low. The S&P US REIT Total Return is a thin investible universe, with only 150 holdings. The correlations between the index and media real estate funds are well over 99%. Why? First, the holdings of the largest REIT players (Simon Property, American Tower, etc.) overlap heavily in the index and popular active real estate managers. Second, a lot of real estate investments correlate incredibly strongly with each other. So, it’s pretty hard for an expensive active manager in this limited universe to generate enough excess return to be worth the fees.
Photo by Olu Eletu