The Death of Active Management Has Been Greatly Exaggerated
For the year ending December 31, 2021, passive mutual funds and ETFs reported estimated net inflows totaling $958.43 billion, compared to estimated net inflows totaling $249.91 billion for actively managed funds.
This disparity has caused some to wonder about the viability of active management, with speculation about “the end of active management as we know it.” As active managers, we clearly have an interest in the outcome of this discussion. We believe reports of the death of active management are – to quote Mark Twain – “greatly exaggerated.”
It’s actually quite easy to “beat the market” over the long term (which we define as approximately three to five years), once you understand some basic rules.
In this blog post, we discuss our process and the basis for our view that our disciplined, rules-based, low-cost and tax-efficient approach will likely beat the benchmark index over the long run. In future posts, we will address another myth: That the markets are so efficient it’s almost impossible to find mispricings and explain how to use pricing errors to outperform the index over the long term.
Our investment philosophy is anchored in behavioral finance, defined by quantitative data and refined by fundamental analysis.
We use both fundamental and quantitative factors with long track records of identifying stocks that are trading below and above their long-term intrinsic value. We understand the quantitative and qualitative merits of the companies we own and why they are mispriced.
By adhering to our highly prescribed processes, we avoid the behavioral errors often committed by investors. We would also note that our process mitigates the behavioral errors that are unintentionally committed and exacerbated by blind followers of indexing. As our next piece on Advisor’s Perspectives will explain, adherents to indexing are accidentally engaging in performance chasing or herding. This is a common, easy-to-understand and costly behavioral error.
One of many examples
We are admirers of Vanguard, and especially of its late founder, Jack Bogle. The commitment of both Vanguard and Bogle to the interest of shareholders is admirable. The firm is a leader in providing broadly diversified index funds and ETFs to its clients at a very low cost.
Our write-up of Vanguard’s Small-Cap Index Fund (VSMAX) was for illustrative purposes only. In no way is it meant to be critical of their Fund or its services. Our point is simply that it’s easy increase the expected return of this index by adopting the simple rule recommended below.
The underlying premise of this fund (and other funds that track an index) is that investors will achieve higher expected returns by purchasing all the stocks in the index, rather than attempting to separate the “winners” from the “losers”.
We believe this premise is flawed. VSMAX fund tracks an index that is nearly identical to the Russell 2500.
In the chart below we show the compound returns to three different groups of stocks for the period from December 31, 1978-April 30, 2022. The red bar shows the returns of $1.00 invested in stocks of companies that lose money or have negative earnings compounded to $17. The second navy blue bar shows that $1 invested in the Russell 2500 Index compounded to $161. The final, light blue bar, shows that investing in only the stocks of firms with positive earnings within the Russell 2500 (those with net profits), compounded to $227. By simply eliminating the stocks of companies with negative earnings you compound wealth at a much higher rate than the benchmark.
Proponents of passive management accept the inevitability of buying stocks of money losing companies because they believe (as the efficient market hypotheses holds) the impossibility of separating the winners from the losers.
The benefit of eliminating the negative earners is indisputable: A single factor strategy of not buying money losing stocks soundly beats the index over time.
Lessons for today
The percentage of money losing firms in the Russell 2500 is near all-time highs (approximately 35%).
Why would you buy an index filled with these negative earners, when the history of these stocks demonstrates they will likely underperform the positive earners? The record weight of loss-making stocks in the Index today could prove a more formidable headwind going forward.
More recent data supports our view.
The chart below shows that from December 31, 2016 to April 30, 2022, there was a speculative bubble in negative earners, causing them to outperform positive earning firms for most of that period. The stock price of those negative earners started to decline from their peak in June, 2021. As explained on pages 2 and 3 of our post which analyzed the only other precedent like this (the Dot.com mania), history provides powerful evidence that this trend lower for loss making stocks will likely continue.
While simply separating positive and negative earners is likely to beat the index in the future, there’s another very simple yet no-less powerful factor that supports our view.
We looked at data as of April 30, 2022 and found that negative earning stocks have a total yield (dividends + buybacks of stock - issuance of stock) / market cap) of -6.4% vs. 2.8% for positive earners.
Why would investors simply buy an index which includes a record number of negative earners at very high valuations?
We offer Small Cap and Small Cap Growth model portfolios at low fees that don’t include negative earners.
We agree with the research that shows that funds with low fees tend to generate higher expected returns, which is why our fees are low.
We don’t agree that blind adherence to a passive strategy is “low cost.”
For every dollar invested in the Russell 2500 index from December 31, 1978-April 30, 2022, investors earned $161 (compounded). By simply separating negative from positive earners, they would have earned $227 (compounded). Following a passive strategy cost those investors $66 for every dollar they invested.
The dogma around indexing serves to obfuscate another goal: Avoiding regulatory risk. Are investors well-served by being herded into passive funds that include significant exposure to stocks with weak fundamental characteristics and elevated valuations?
We acknowledge the valuable role of index funds: Beta should be inexpensive. But the arguments indicating they are difficult to “beat” are seriously misleading, as we have demonstrated.
Dr. Sanjeev Bhojraj is a portfolio manager and co-founder of L2 Asset Management. He is widely published in journals in finance and accounting and specializes in behavioral finance. Dr. Bhojraj is a Chaired Professor in Asset Management and the co-director of the Parker Center for Investment Research at Cornell University’s Business School. He has a Ph.D, ACA, ACMA and B.Com.
Matt Malgari is a portfolio manager, the Managing Member and co-founder of L2 Asset Management. Matt spent 14 years at Fidelity Investments as an Assistant Portfolio Manager on its $70 billion Diversified International Fund, sector analyst, diversified analyst and trader. In 2010, Matt became the Managing director of Equity Research for Knight Capital Group. He received his MBA from Cornell University and a BA from Middlebury College.