Yes, the World Is Out to Get Active Managers
The world is out to get active money managers. As Bloomberg’s Charles Stein reports, they’ve been having a tough economic recovery, with only 21 percent of stock-picking mutual funds beating their benchmarks during the past five years. They (at least, several that Stein talked to) have also identified a culprit on Constitution Avenue:
Managers say they haven’t changed, the market has. The easy money climate of near-zero interest rates engineered by the Federal Reserve has artificially inflated prices of lower-quality U.S. stocks, they say, punishing those who focus on businesses with the best fundamentals.
This Fed thing is temporary. There will surely be multiyear stretches in the near future when the stock pickers as a group beat the indexes. Plus, it always struck me as unseemly of value investors to complain about the times when markets don’t reward “businesses with the best fundamentals,” since it is precisely those times that winnow out the ranks of value investors enough to give the best of them a chance to beat the market over time. If the shares of businesses with the best fundamentals outperformed other stocks every year, then everybody would buy them, and they’d become so expensive relative to those fundamentals that they would be really bad investments.
But I digress. Even if the Fed probably won’t be making stock pickers’ lives miserable for much longer, there are other tormentors lined up and waiting. Some of them are just a few blocks away at the White House, which issued a fact sheet Monday on “Strengthening Retirement Security by Cracking Down on Backdoor Payments and Hidden Fees” that my Bloomberg View colleague Matt Levine says could maybe also have been titled "Strengthening Retirement Security by Cracking Down on Active Investing." And a few Metro stops away, the U.S. Supreme Court is hearing oral arguments today in a case that could put added pressure on corporations to throw expensive actively managed funds out of 401(k) retirement plans and replace them with passive index funds.
The issue is that running an actively managed mutual fund invariably costs more than just buying the stocks in an index and holding onto them. Some active managers will outsmart that index and some won’t, but it’s hard to tell ahead of time who’s who. When you factor in the cost difference, then, active funds will reliably generate lower returns for non-clairvoyant investors than index funds do. These are what Vanguard founder Jack Bogle once called “The Relentless Rules of Humble Arithmetic,” and they are increasingly becoming the rules that government regulators and judges apply in determining whether assets are being managed prudently. The model is the government’s Thrift Savings Plan, which offers four index funds and a Treasury bond fund, plus a series of life-cycle funds that move money around among the first five funds.
So while it is possible to imagine that the current disdain for actively managed mutual funds among individual investors will eventually subside and possibly even be replaced by enthusiasm, there are all sorts of institutional forces that will keep pushing money out of active funds and toward cheaper passive ones. And while it was once believed that the rise of index investing would make markets less efficient and thus create new opportunities for active money managers, the new thinking is that perhaps the opposite is true. Here’s financial adviser and pundit Josh Brown, summing up an argument from Larry Swedroe and Andrew Berkin’s new book “The Incredible Shrinking Alpha”:
[W]ith all the unskilled investors departing, pros will be left to square off against only other pros. The lack of retail punters and their harvestable mistakes cuts off one of the most reliable historical sources of alpha for sharp-eyed managers.
The result is an arms race, in which active managers put more and more resources into beating their peers but find that their relative position hasn’t improved at all. Some strategies will work for a while -- such as, for the past few years, activist investing, which is like active investing only much, much more active. But only for a while.
That’s the theory, at least. It probably isn't quite as dire as all that. Professional money managers surely make a few “harvestable mistakes” of their own. But on the whole, yes, active money managers: the world IS out to get you.
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