Active-Investment Management Never Went Away
For the record, active management never went away. The claim that it has returned, after a run of fairly horrific performance, is likely little more than some mean reversion. This all comes in the midst of a shakeup in the investment industry, as low-cost indexing has dominated growth in the business for the past half-decade.
It hasn’t helped active managers that the investing public has become much more reluctant to pay high fees for mediocre performance. Or that investors have learned to resist chasing past performance on the misplaced expectation that it will persist in the future. On top of it, there are signs that investors are starting to avoid the self-destructive mistake of selling during market declines and buying near tops.
I have nothing against active-investment management. But the issues with active management -- poor performance, high costs and behavioral problems -- are why for most people, a passive strategy makes a lot of sense.
Vanguard Group Inc. has dominated the debate about active versus passive investing. With good reason: As noted by Morningstar’s John Rekenthaler, “Vanguard enjoyed the largest sales ever by a fund company in 2014, outdid that record in 2015, and beat it again in 2016.” Other companies that manage passive funds, such as BlackRock Inc., State Street Corp. and Dimensional Fund Advisors LP, are attracting assets as well. But remember, Vanguard also manages more than $1 trillion in active funds.
Wading into the active-versus-passive debate requires some context. Let’s consider some details:
Performance: No investor should ever complain about a bad quarter or even a bad year if the underlying process is sound. That is simply the nature of any portfolio. There are going to be times and specific market conditions when a particular style will be out of favor.
The real problem with any given performance period is whether the methodology actually can generate alpha -- market-beating returns -- and is repeatable. All too often, poor performance is itself a manifestation of a questionable underlying strategy, and not the end problem itself.
Hence, my beef with much of the world of active management is usually about the structural challenges. Alpha is a rare commodity, and the odds against outperformance are high. There are many reasons why -- costs, turnover, management by committee -- but as Michael Mauboussin explains, it isn't that professional investors lack the skills. Indeed, the paradox of skill is that there are too many sophisticated, talented investors. As the variation in skill narrows, it becomes harder to stand out from the crowd.
The simple fact is that in any given year, outperformance is rare. Repeated outperformance year after year is so challenging that only a handful of outliers manage it net of costs over any appreciable period of time.
Fees: Mediocre performance is bad enough, but paying up for it adds insult to injury. If you have been a regular reader of this column, you have seen my criticisms of overpriced, underperforming hedge funds (see this, this, this, this and this); there is no need to relitigate any of that here. But I am not even referring to the typical hedge-fund compensation structure of a 2 percent annual fee and 20 percent of any profits, but rather to high-fee mutual funds whose expense ratios tend to fall somewhere between 1 percent and 2 percent a year.
And as the legendary stock picker Bill Miller reminded us, many of these managers are “closet indexers” -- meaning they construct a portfolio that mimics an index fund, but charge fees that are in keeping with active management. Paying a premium for active management is one thing, but paying a premium for what is essentially an index fund is unacceptable.
Factor Investing: I want to try and distinguish between factor investing and smart beta. Although some lump these together, they are, in my opinion, different approaches to an alternative to traditional index investing. The former has a rich academic literature. Investing based on factors such a small capitalization, value, quality and momentum has lots of evidence in support of it ability to outperform a benchmark index.
Smart beta, on the other hand, has been described as both an alternative to capitalization-weighted indexes as well as a clever marketing slogan. Research Affiliates LLC has shown some alpha generation (or above market returns) from some types of so-called fundamental indexing.
Investors who want to participate in alternatives to passive indexing have a variety of good options to consider. But selectivity is the watchword: be aware of the drag of increased costs and consider if a methodology has an actual (not theoretical) potential to beat benchmark indexes. Lastly, investors must police their own behavior, especially the tendency to chase whatever is hot at the moment or get scared out of markets amid volatility, flawed narratives and pundits predicting doom.
There is a place in portfolios for active investing, but it is fraught with pitfalls. Proceed with caution.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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