Why Some Money Managers Succeed by Losing
Every year, according to the New York Times, Americans pay about $600 billion in fees to so-called active money managers -- managers who try to earn market-beating returns by trading actively. Those fees are about equal to the gross domestic product of Switzerland.
Of course, defining “active” asset management is difficult. For example, many people think of exchange-traded funds as passive investments, because they’re diversified. But if a money manager trades ETFs as if they were stocks, trying to time the market, that seems pretty active. Another gray area is so-called smart beta strategies, which try to beat the market without trading very much. However you slice it, we Americans pay a huge amount of money to third parties -- hedge funds, actively traded mutual funds, asset-management companies and family offices -- that promise to earn us superior returns. Much of this is a transfer from rich Americans outside of the finance industry to rich Americans within the finance industry. But a hefty chunk comes out of the pockets of middle-class Americans, much of whose savings are in pension funds and retirement plans that contract out to active money managers.
As financial pundits love to point out, the majority of these active managers will fail to beat the market. This isn't a statement about market efficiency (for that, you would need to look at the persistence of performance over time). It’s simply a statement that the average dollar of investment money can't earn an above-average return, before fees. So after fees, the average investor will underperform the average. Naturally, the numbers bear this out -- index funds routinely outperform actively managed mutual funds. Hedge funds, as a class, have been on a severe losing streak for many years.
Does this mean that our pension funds and retirement funds are wasting our money by giving it to active managers? Most pundits would tell you “yes” -- if retirement funds can get the market average return by simply buying the market average itself with a low-cost passive strategy, they should do that instead of squandering Americans’ hard-earned nest eggs to line the pockets of money managers.
A finance professor, on the other hand, would hedge and tell you “maybe.” It’s possible that active managers actually raise the market average return when they trade. If active managers uncover new information -- if they realize that a company’s prospects are better than anyone realizes, or that the market is in a bubble, etc. -- then by trading on that knowledge they can send capital where it needs to go, lowering the cost of capital for healthy companies with good prospects, and diverting money away from doomed enterprises. In the famous Grossman-Stiglitz theory, for example, this is exactly what happens.
If you think this sounds preposterous or far-fetched, just imagine a world where everyone took the advice of financial pundits, buying a little piece of every stock and bond on the market and holding it until retirement. In that world, stock and bond prices would have absolutely nothing to do with the true value of companies, and capital would be allocated randomly. One single active manager would have a huge opportunity to profit and, in the process, create lots of real value for the economy.
So in theory, there is a possibility that active managers are earning their keep. But there’s one big problem with this story. How do you, the investor -- or your retirement plan or pension-fund manager -- have any idea which active manager is finding real information, and which is simply executing a bad strategy that will lose money? Looking at past performance can tell you a little, but not a lot, since most managers have only been in business a short time, and there is lots of randomness in the system. Also, conditions change -- a strategy that worked for the last five years may not work next year, especially since the wider world is likely to have cottoned on to that strategy by the time it has produced a run of good returns.
Therefore, active management suffers from a huge asymmetric information problem. There’s just no way for a hedge-fund manager or mutual-fund manager to prove to investors, ahead of time, that she has alpha that produces above-market returns. Even if she knows she can beat the market, she usually can’t prove it. This problem is well-known in the hedge-fund industry, but has gotten only a moderate amount of attention from academics. It may be possible for active management to collectively earn its keep, but in practice what probably happens is that a lot of money gets handed out to active managers at random.
So there is probably a lot of waste in the system. But it isn’t just because the average manager can’t beat the average. It’s because the average investor can’t reliably identify managers who have the ability to beat a passive strategy. It’s highly likely that every year, retirement and pension-fund managers take billions of dollars out of the nest eggs of hard-working middle-class Americans and squander that money betting on losing horses.
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