The average active equity mutual fund underperforms its benchmark.
This statement sparks little controversy and can be applied to active equity hedge funds as well.
The story gets worse when the results are AUM-weighted. Collectively, active equity delivers no value to its investors and, in fact, extracts value from them.
In our highly competitive markets, what industry can survive if it fails to deliver value to its customers? The consequences of these competitive forces are clear as money flows out of active and into passive equity funds. Passive investing is being touted as the superior alternative, and who can argue?
As an active equity industry, we have to ask ourselves how we descended into such a sorry state. The conventional explanation is that portfolio managers and their investment teams lack stock-picking skill. But as is often the case, the answer is not so simple.
A more careful analysis indicates that investment teams, buy-side analysts in particular, are not the problem. Instead, the fund distribution system is what's at fault.
So rather than loudly denouncing the lack of stock-picking skills, those in the distribution system have some soul searching to do. As Pogo used to say: "We have met the enemy and he is us."
Buy-side analysts are superior stock pickers.
There is considerable research showing that buy-side analysts are superior stock pickers. I conducted a study that supports this conclusion.
Active Equity Fund Best Ideas: Top 20 Relative-Weight Stocks*
* Based on single variable, subsequent gross fund alpha regressions estimated using a data set of 44 million stock-month US active equity mutual fund holdings from January 2001 to September 2014. Source: Lipper and Morningstar
The top 20 relative-weight holdings generate fund alpha, while the low-ranked holdings destroy it. So any restriction imposed on a fund that mandates holding anything other than the best idea stocks negatively affects a fund’s alpha. If enough mandates are added, a potential positive alpha is transformed into an actual negative alpha.
The fund distribution system is full of such restrictions: Fund managers are required to hold many stocks for diversification purposes, manage to low volatility and drawdown, avoid tracking error and style drift, grow large, and impose sector-weighting constraints.
In essence, the distribution system is a closet indexer manufacturing juggernaut.
To be clear, we are talking about those who run the distribution system, both inside and outside the fund. The internal sales and marketing teams work hand in glove with the external platforms — broker-dealers, registered investment advisers (RIAs), and institutional investors — imposing value-destroying restrictions on investment teams.
The “pot of gold” generated by an analyst’s investment decisions — somewhere around a 4% average alpha based on several studies — is eaten up by fund fees and the external restrictions placed on the fund.
In the end, the fund itself captures the entire potential alpha and then some by growing too large, ultimately turning itself into a closet indexer. None of the alpha is delivered outside the fund, and worse, additional value is extracted from investors.
Fixing a Broken Investment Management Model
A system that encourages closet indexing while delivering negative value to investors is clearly broken. So what is to be done?
Investment teams, particularly buy-side analysts, need to be elevated to a starring role since they deliver the most value to investors. Funds need to be rewarded for consistently pursuing a narrowly defined strategy, taking only high-conviction positions.
Participants in the distribution system need to avoid imposing restrictions that impede the successful pursuit of an equity strategy. More specifically, asset bloat, benchmark tracking, and over-diversification need to be discouraged. Why? Because these are the precursors to closet indexing.
To resurrect the industry, an important first step is to move away from the discredited 1970s modern portfolio theory (MPT). Not only is the evidence overwhelmingly against this model, but MPT provides the theoretical justification for many of the value-destroying restrictions foisted upon funds.
The new market paradigm will most likely arise from behavioral finance. The discipline is already transforming the advisory business. Major players — Merrill Lynch and Morningstar, among others — have established behavioral finance units and are disseminating the resulting research throughout the adviser community.
This is an important value add in the competition with robo-advisers. The mechanical solution offers little help in steering investors away from value-destroying emotional errors. Studies reveal that focusing on minimizing emotional investing can enhance returns by 2%–4%.
Some financial advisers now think of themselves as behavioral advisers. A recent sign of this industry trend: the Behavioral Financial Advisor certification and designation.
Can a "Behavioral Financial Analyst" be far behind? Behaviorally based objective measures will begin to replace the metrics currently used to analyze investments. Several of these measures — asset bloat, benchmark tracking, and over-diversification — are more predictive of fund underperformance. That is, objective behavioral measures are predictive, while the traditional measures targeting past performance are not.
A Robust Debate
Future posts in this series will provide suggestions on how the system might be fixed. The goal is not to present final solutions, but to spark a robust debate around the many challenges facing a broken industry.
Imagine a world in which only the lowest-cost index funds along with truly active, alpha-generating funds exist, without a closet indexer in sight.
Together let’s launch the active equity renaissance!
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38 Comments
The rise of the machines. Robots love closet indexing...and ETFs.
Hello Mike,
Thank you for your comment. Would you care to elaborate more on your point?
Yours, in service,
Jason
Mr. Howard mentions that: "Collectively, active equity delivers no value to its investors and, in fact, extracts value from them."
Of course *taken collectively* this must be the case, by simple arithmetic, since active managers can make profits only at the expense of other active managers, right? I guess that I had presumed that this was widely accepted in accordance with Sharpe's work on the subject ("The Arithmetic of Active Management," 1991 and "The Arithmetic of Investment Expenses," 2013).
Pedersen ("Sharpening the Arithmetic of Active Management," 2016) adds a small glimmer of hope that *taken collectively* active management can add value, but he doesn't propose that this will be much help to investors, as identification of outperforming managers in advance is next to impossible.
Hello John,
Actually, this is an oft repeated fiction. Tom addressed this very well in my interview with him last year. Here is the link: https://blogs.stage.cfainstitute.org/investor/2016/07/26/is-active-mana…
I reproduce my question and his answer below for convenience:
"CFA Institute: Talk to me about the additional fiction that active management is a zero-sum game.
"A strongly held belief within the investment industry is that stock picking across active equity funds must be a zero-sum game. Such an assertion is true for the stock market as a whole, as stock picking must have as many losers as winners. But this does not have to be the case in every market segment.
"The US stock market has a current total market value exceeding $38 trillion. Active US equity mutual funds hold $3.6 trillion, about 9% of all equities. So it is entirely possible for the average stock held by funds to outperform at the expense of the other 91% of the equity universe.
"Arguing that stock picking among equity funds must be a zero-sum game is akin to arguing it is impossible to drown in a lake of average depth of three feet. That lake may have pockets 20 feet or more deep. Both represent indefensible statements.
"In particular, this study estimates that the average stock held by active equity mutual funds earns an alpha of 1.3%, confirming that mutual funds do earn superior returns. Indeed, this must be the case in order for equity funds to cover their fees and, in turn, earn a near-zero collective alpha."
Yours, in service,
Jason
Hi, Jason:
Thanks for your reply.
No offense, but we'll have to agree to disagree on this one. :-)
Let's look at your example. In your example (as I understand it), 91% of invested funds are passively managed. 9% of invested funds are in active management. Is that correct?
If it is, then one might write an equation giving the total return of the market portfolio as a weighted sum of the passive and active segments:
Market Return = ( 0.91 * Passive Return ) + ( 0.09 * Active Return )
Okay so far?
But now, if we can presume that passive investors hold the market portfolio, we realize that the Passive Return must be equal to the Market Return. So our equation becomes:
Market Return - ( 0.91 * Market Return ) = 0.09 * Active Return
or
0.09 * Market Return = 0.09 * Active Return
thus,
Active Return = Market Return
But this is before costs.
After costs of active management, the Active Return must be less than the Market Return.
Hope this helps to explain Dr. Sharpe's math.
John
Hi John,
If I agreed with your assumptions then your math would hold. Those assumptions: a) People can buy the 'Market' portfolio, and b) that every active manager holds a subset of the Market portfolio as their portfolios.
Regarding your first assumption, how can an investor invest in a single passive product that includes claims on the performance of, yes, the S&P 500, but also silver, molybdenum, lumber, art, every option, a 2020 maturity bond from Slovenia, et. al.? Not only that, but the 'Market' portfolio is not just the public assets. For if it is to lay claim to 'Market' (with your capital 'M,' not small 'm') then it must include every private asset, too. So my collection of mid-century modern furniture needs to be in there, too. How does an individual investor get to buy a claim on my coffee table in a single product?
Regarding your second assumption, since I am guessing your answer to the first question is that there is no such investible Market, then all an active manager has to do is to hold assets not in your proxy for the Market. That is, she just needs to have assets different than the market, little 'm.' One way of doing this, that is quite obvious is to hold the S&P 500 plus one other asset.
Yours, in service,
Jason
The primary problem with asset management - both active and passive - is that most 'asset managers' are actually asset gatherers. It is abundantly clear, not least from the track record and shareholders letters from and interviews with Warren Buffett, that size of assets under management and subsequent investment returns are in most cases negatively correlated. Very few investment strategies scale, notably 'value' - and as Research Affiliates recently pointed out, despite being the best performing long-only equity investing strategy over the long term, 'value' is also the strategy most likely to get an adviser fired by his client for short term underperformance. When investors come to appreciate that size is the enemy of performance, the active industry will shrink back to a more appropriate level of AUM. I say when, but I really mean "If". Many funds are aggressively sold more than they are voluntarily bought.
Hello Tim,
To me you have hit the nail on the head! I raise this very point in my article last year entitled, "Alpha Wounds: Benchmark Tail Wags the Portfolio Management Dog." In particular, my words under the heading, "A Brief History of the Benchmark." Few take the road less traveled to gain AUM: earning them through performance. Most take the road very well traveled: convincing through marketing.
Yours, in service,
Jason