Why Is Active Management So Difficult?
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You have to feel sorry for active managers.
The first actively managed mutual fund was introduced in 1924. More than 50 years later, in 1976, John Bogle introduced the first publicly available index fund. Despite their huge head start, actively managed U.S. equity funds now manage less in assets than passively managed funds. They were overtaken by the passive funds in 2018, according to Bloomberg.
In 2021, passively managed U.S. equity funds added $346 billion in new assets, while actively managed funds had $195 billion in outflows, according to Morningstar.1 In fact, since 2006 actively managed U.S. equity funds have lost assets every year (except for a slight gain 2013), while passively managed funds have experienced significant positive inflows.
This trend may be due, in part, to another problem active managers have. They have a hard time beating relevant benchmarks. Most can’t beat them for even a single year and, of those that do, few continue their winning ways for long.
According to the year-end 2021 SPIVA Scorecard research from S&P Dow Jones, here is the percentage of actively managed U.S. equity funds that underperformed the S&P 1500 Index over various time periods ending December 31, 2021. It paints a grim picture.
- 72% for the three-year period (80% on a risk-adjusted basis)
- 75% for the five-year period (81% on a risk-adjusted basis)
- 86% for the ten-year period (93% on a risk-adjusted basis)
- 90% for the twenty-year period (95% on a risk-adjusted basis)
S&P Dow Jones research has made similar findings for every type of actively managed fund compared to its relevant benchmark, year in and year out.
Not only is their performance lackluster, but the survival rate for active managers is woeful. S&P Dow Jones found that over the past 20 years, nearly 70% of domestic equity funds have been merged or liquidated out of existence.
Why Is active management so hard?
Active U.S. equity fund managers have clearly taken a beating relative to their passive counterparts and relevant benchmarks. But the problem is not limited to active U.S. equity fund managers. Institutional managers, fixed income fund managers, tactical allocators, and market timers have similar problems. See one of my previous articles, Don’t Believe the Rules in Investing.
With so many brilliant people devoting their careers to active management, why are their results so disappointing? Here are 10 reasons:
- Active management Is not a science. Water freezes at 32 degrees Fahrenheit. Light travels at 186,000 miles per second. The Earth travels around the Sun once every 365 days, 5 hours, 59 minutes, and 16 seconds.
There are no equivalents in investing.
We can measure how markets have behaved in the past, but there are no rules of the universe dictating that they will repeat their behavior. The past can serve as a guide and help us set the boundaries of our expectations, but we cannot rely on it to repeat itself.
- Markets are complex adaptive systems. Financial markets are comprised of millions of heterogeneous participants who may apply different decision rules to their activities. The market’s behavior is the sum of their activities.
The goal of each participant is, ultimately, to extract economic value from the market at the expense of other participants. To do this, they must learn and adapt. Thus, the size and shape of the playing field, and even the rules of the game, are always changing.
- Value Is in the eye of the beholder. It is common to hear an active manager talk about whether markets or stocks are over- or under-valued. This implies that there is a “normal” or “correct” value, and that the manager knows what it is.
Active managers investing based on this frame of reference will be sorry. For the last 50 years (1972-2021) the average trailing 12-month P/E ratio of the S&P 500 Index was 19.66. On average, investors were willing to pay $19.66 per share for $1 of earnings.
During that period, the S&P’s P/E ranged from 7.39 in 1980 to 70.91 in 2009. Obviously, the market’s perception of value changes over time. There is no rigid, mechanical way to determine the “normal” or “correct” value. This makes active management difficult. How do you anticipate how millions of market participants will perceive future value?
- There are many well-armed competitors. Despite the move toward passive investing in recent years, there are still many talented professionals trying to extract value from the financial markets. As Charles Ellis observed: “They have more advanced training than their predecessors, better analytical tools, and faster access to more information.”
These well-armed competitors make the markets even more efficient and make it even harder for an active manager to gain an advantage.
- Not every good idea turns out to be a good investment. Active managers make bets. The bets may be company specific or more macro, like a bet on a sector, a factor, or an investment style. The bets are usually driven by research, experience, and judgement.
There are always forces at work that turn even the most well thought through bet into an empty intellectual exercise. They might be company specific, like a new competitor or an emerging technology. They might be more global, like a war, a pandemic, or a housing bubble. The most powerful of all is systemic market risk. Even the best ideas may struggle to take root during a market downdraft.
There are always more variables than can be reasonably considered. The future is unknowable. Active managers are always playing the odds. Not every bet pays off.
- Fees and expenses. Some headwinds are more subtle. The fees and expenses associated with active management are generally higher than those associated with passive investing. Those fees and expenses are paid no matter what the market does.
This means the performance bar is set higher for active managers. To shine, an active manager must beat both the passive manager, who charges lower fees, and their relevant benchmark, which contains no fees.
An active manager may beat their relevant benchmark before fees but fall short after fees are paid. This would put them in the “loser” category on the SPIVA Scorecard.
- Compared to what? All research on the merits of active management uses some form of measuring stick. Often that measuring stick is an index. The SPIVA Scorecard research cited above is an example. Sometimes it’s a peer group of other managers.
What if the manager was not trying to beat the benchmark or does not fit into the peer group? When we lump disparate managers together into arbitrary categories and determine their success using a common measuring stick, we need to be careful about the conclusions we draw.
It’s possible for a manager to achieve their stated objective without beating a “relevant” benchmark or standing out among their “peers.” If they do, are they winners or losers?
- Timing Is everything. How patient should we be in deciding whether an active manager is a winner or a loser? Asking an active manager to beat their benchmark or stand out among their peers every year is a tough standard. Some ideas take time to pay off.
What if a manager regularly underperforms for three or four years in a row and then has an amazing year that makes up for all the underperformance and then some? If a manger sees where the world is going, but it takes a long time for others to catch up to the manager’s vision, is the manager good or bad?
Most measuring sticks (including the SPIVA scorecard) use a rigid calendar year or calendar quarter approach that doesn’t take the manager’s unique pattern of performance into account. This makes sense from the perspective of the measurer. But does it unduly penalize active managers? Are we failing to capture the full picture because our tools are crude?
- A few good days. We’ve all seen the charts that show what happens to performance if you miss just a handful of the best days in the stock market. As a refresher, the S&P 500 Index returned 10.66% annualized for the 15 years from 2007 through 2021. If you missed the ten best days, your return would have been cut in half--5.05%. If you missed the thirty best days, you would have experienced a negative return of -1.18%. Less than 1% of the trading days made the difference between excellent performance and a loss.
This fact can make it difficult for active managers, particularly for those who practice some form of market timing or tactical asset allocation. This is also why perma-bears, who are constantly predicting doom and hoarding cash, are usually better at generating headlines than putting money in their clients’ pockets.
- A few good stocks. A paper by Professor Hendrik Bessembinder documented that the best-performing 4% of stocks explained the entire net gain for the stock market between 1926 and 2016. The other 96% of stocks collectively matched the performance of one-month Treasury bills and most of those lost money. Just five stocks – Exxon Mobil, Apple, General Electric, Microsoft, and IBM – accounted for 10% of the market’s return.
Heaton, Polson, Witte (2017) studied 14,455 US stocks from 1989-2015 and found a similar pattern. Forty percent of the stocks generated no positive return, while the S&P 500 Index was up almost 1,200%. More than 50% of the stocks generated less than cash. Less than 20% of the stocks produced a disproportionate amount of the gain.
In 2021, the S&P 500 Index returned 28.71%. Just five stocks accounted for 31% of those returns. They were Apple, Microsoft, Google, Tesla, and Nvidia.
However you slice it, the returns of the stock market are determined by a relatively few stocks. This level of concentration makes active management challenging. Active managers are shooting at a relatively small target.
Many obstacles to overcome
The point of this article is not to discourage advisors from using active managers. In fact, they can play an important role in helping clients reach their financial goals.
Rather, advisors should understand and appreciate the many headwinds that active managers must overcome in their efforts to add value relative to passive managers. Hopefully, this will help advisors better discern when active managers might be appropriate for a client’s portfolio and when a passive alternative might be a better choice.
In addition, some of the standard tools we use to measure the merits of active managers may not fully capture the value they add. Using better tools will not make active management any easier, but it may give us a clearer picture of the value it might add.
Scott MacKillop is CEO of First Ascent Asset Management, the first TAMP to provide investment management services to financial advisors and their clients on a flat-fee basis. He is an ambassador for the Institute for the Fiduciary Standard and a 45-year veteran of the financial services industry. He can be reached at [email protected].
1According to Morningstar, a passively managed fund is a fund whose investment securities are not chosen by a portfolio manager, but are automatically selected to match an index or part of the market. By contrast, active strategies do not track an index. Instead, active fund managers make specific security selection decisions based on their own ongoing research, analysis and expertise.