Circular Reasoning In Due Diligence By: Gabriel PotterMBA, AIFA®

“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 an article 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 justify their underperformance with this excuse, “the market hasn’t favored active management.”

Let us 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. Therefore, there is no market that inherently favors or disfavors active management. 

It is true that the opportunity set for managers might be different depending on the strength of the market’s direction and the variance of returns among different securities. For example, Manager XYZ is a contrarian large cap value stock manager. A contrarian investor generally picks positions that have fallen in price, and they won’t pick stocks that have rallied recently. The underlying investment philosophy for contrarians suggests that stocks, once they’ve appreciated in price, are less likely to appreciate in the future. On the other hand, there are “momentum” market environments where they previous winners continue to win. In a momentum environment, a contrarian investor will likely underperform.

So, 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.

It is also true that, collectively, active managers tend to make similar bets. For example, we 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 have generally tended to underperform. However, it is not fair to infer that active management did not work or was somehow out-of-favor because of the similar bet made by active managers generally. 

There are investment styles that move and out of favor in the marketplace. These style biases can be explained. There are individual reasons for any specific manager to underperform. These reasons can be supported with attribution analysis. However, 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 even 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.

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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