Active investing – what’s the point?October 9, 2014
As I took up the July/August 2014 edition of Financial Analyst Journal, the last thing on my mind was finding fodder for a blog post. I was not looking to be impelled into writing a response to one of the articles published there, but found that thought crossing my mind more than once as I read the well-written article titled The Rise and Fall of Performance Investing by Charles Ellis, CFA.
Mr. Ellis provides excellent insight in the history of active management. He notes the genesis of the market for active investing, from 50 years ago when most trades were done by individuals and only 10% of total NYSE trading was being done by institutions, who were mostly rebalancing index-like investment portfolios, to the reverse today, where nearly all security transactions are done by institutional investors seeking outperformance of some benchmark. As the author suggests, increasing numbers of young professionals have entered the investment management industry in the employ of these institutions, seeking an engaging, challenging and rewarding career, with ever-improving analytical tools and training backing each subsequent group of entrants. Couple this with the “global commoditization of insight and information,” and the result is the ever-increasing efficiency of modern markets. As we all know from Finance 101, perfect form market efficiency implies no opportunity for outperformance from active management, and even semi-efficient markets have a limited opportunity set to achieve outperformance. Mr. Ellis goes on to make the case that, given this ever-increasing market efficiency and the coincident difficulty outperforming with active management, investors should be taking advantage of the overwhelming abundance of low cost passive vehicles available to virtually anyone. This is the heart of the active versus passive debate – why pay for active management when it may very well lead to underperformance of the passive alternative net of fees?
Mr. Ellis portends that a shift to passive investing will be stonewalled by those of us that benefit from active management. He points out that, despite much data suggesting ineffectiveness of active management, the “rational change” to low-cost indexing has been exceedingly slow to develop. As professionals in this industry, he claims, we will not accept this shift, and will in fact “imaginatively and often quite stubbornly” resist the change, because we have much to lose professionally and because most new hypotheses do not prove out when rigorously tested. But, let me be the first to say (well, perhaps the second, as I read an opinion article on FundFire recently by John Chisholm getting at this same theme, and perhaps I will discover I am much further down the list once I get through that stack of research papers on my desk,) I could not agree more with Mr. Ellis. The industry is due for a shift to more passive investing.
Finding a skilled active manager is difficult. From among the scholarly articles I have read, I have seen a range quoted of 5% up to 15%, at the high end, of active managers in the universe that have outperformed net of fees. I agree that the group of skilled active managers is only a fraction of the entire universe. Obviously, most authors will say as they cite these statistics, the theory of active management has not proven worthwhile in practice. However, as I see it, the problem is not with the theory of active investing. The problem is with the degree of active investing we have in in the current market. The depth and breadth of data and information available to the average investor today is mind-boggling, as Mr. Ellis points out, and it is human nature for many investors to believe they can better interpret and capitalize on that data than any other investor group. Thus the wealth of data has combined with the behavioral belief of superiority to create an abundance of active management. The question is, if that investor or money manager is in fact able to use this overwhelming supply of data better than anyone else, is it because he was lucky, was he the blind squirrel finding the nut, or because he is skilled? Those investors that have skill and those that have luck together perform the price discovery function in our current environment.
I believe an industry-wide movement toward passive management makes sense, to some degree, particularly for those investors that do not have access to, interest in or aptitude for deciphering all the available data, nor the asset base or associations to actively invest at a smaller fee, a critical component to long-term investment success. In theory, this shift would reduce the demand for active management, and the supply of active management would adjust downward as a result, hopefully because those that do not show skill as active managers would leave the industry or seek employment at an index fund. This reduction would leave those managers with true skill performing the price discovery function of the market with a greater opportunity set for outperformance available to them due to less competition from active investors who were really just lucky at the end of the day. This skill is what the active investor pays for, and what should yield net of fees outperformance.
The critical component to this theoretical exercise is the discovery of those active managers that can add value, increasing the demand for their skills and eliminating demand for those managers that have just been lucky. Capacity constraints are an obvious next question – if we are focusing only on those managers with skill, what happens when they reach capacity and close? Remember all those investment professionals entering the industry with better and faster analytical skills that have made our markets increasingly efficient? The hope is they would put their skills to use with active management, and those without that skill will realize it and choose another facet of investment management, perhaps “value discovery,” helping clients invest to meet their life goals, as Mr. Ellis describes.
I will not count myself among the numbers that are “imaginatively and stubbornly” resisting the shifts suggested by Mr. Ellis. I take his point, and the point of countless other articles and studies on the topic, to heart. But I do not feel that active management is as useless as they would have us believe. What happens in a world of only passive investments, if the only investable vehicle is one big index fund? Who vets the prices set by that index provider in that scheme? I believe there is a yet-to-be-defined happy medium between the worlds of passive and active management. Active management has come a long way, and perhaps has reached an asset gathering peak that has led to diminution of the opportunity set, but I do not believe the opportunity set has been eliminated. There are limitations in our system whereby markets will never be fully efficient; there will always be pricing anomalies and arbitrage opportunities. It behooves us as an industry to reward those that can capitalize on those opportunities, and send the rest on their way.
This publication does not represent investment advice. All opinions and results included in this Publication constitute FDx Advisors or FolioDynamix’s judgment as of the date of this Publication and are subject to change without notice.