Active Investing, Passive Investing — Let’s Call the Whole Thing Off

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The paradox is that you do need active management to make the market efficient
Professor Burton Malkiel, Princeton: via WSJ

Passive investing turned forty on August 31st, and it’s not even showing its age. Investors are allocating to passive investments at a seemingly accelerating rate. Just recently, the Chairman of the Illinois State Board of Investment, Marc Levine, announced a shift of two-thirds of its assets to passive management to reduce fees. The reallocation took $1 billion away from hedge funds. It would seem that active management is dead, but what about Professor Malkiel’s claim? The market needs active management to make the market efficient.

The Trend – Allocation to Passive Investments

Assets continue to pour into passively managed mutual funds and exchange traded funds (ETFs). The 2016 Investment Company Institute Fact Book shows a decisive trend toward passive investments. Institutions are replacing actively managed assets with broad index-driven, passive exposures, and retail investors have wisened up, as well. Moreover, recent rule-making at the US Department of Labor extended a fiduciary obligation to financial advisors. Defining financial advisors as fiduciaries was hailed by the DOL as the solution for “Conflicts of Interest in Retirement Advice,” which would “[Save] Middle Class Families Billions of Dollars Every Year.”

Share of Active and Passive Investment Management

Source: ICI 2016 Factbook

Active Investment Management – Three Challenges

If active management is to survive, it must do so on its merits. It must deliver superior risk and cost adjusted returns to the alternative — passive investments. It’s a simple prospect, but it’s beset by three challenges: fees, incentives, and the limits of arbitrage. To approach these, perhaps it first makes sense to review the basic prospect of active management.

Active Management Overview – Discretionary & Systematic Approaches to Active Management

Active management is predicated on making deliberate decisions to allocate capital to securities that will outperform a corresponding benchmark. These decisions can be based on a variety of factors, but they largely fall into two buckets: discretionary and systematic. Discretionary investors make active decisions at the discretion of the manager.  These managers typically fall into the view on investment management. A thoughtful portfolio manager, perhaps supported by a group of analysts, evaluates companies and sectors, one by one, gets to know them intimately, and arrives at a thesis that one or more of them have not been properly valued by the market. Perhaps it’s their growth opportunity or maybe it’s that the company has fallen out of favor and the market is not realizing the value of its future cash flows. In the case of an activist, they may believe a company needs to change to unlock its value.

Systematic investors attempt to externalize their decision-making model into a repeatable system. Whereas a discretionary investor will ultimately leave the decision to the portfolio manager, alone.  The systematic investor uses a decision-making model to allocate capital to securities. These may be simple heuristics or complicated, mathematical, computer-driven models. In each of these cases, however, the systematic investor seeks to take the element of human discretion out of the portfolio construction process and replace it with a consistent, rules-based approach.

Active Management’s First Challenge – Fees

Both systematic and discretionary investors charge fees for their service. It’s no surprise to anyone, but it does put a meaningful drag on performance right out of the gate. A 1-2% management fee means the manager must outperform their index by at least 1-2% just to stay in line with the index-performance. Outperforming the index is a difficult prospect in itself, but management fees make it even harder. Moreover, trading costs may be netted from the fund separately, which layers an additional cost to the fund. Hedge fund fees can be even steeper. Hedge fund managers often take a two percent management fee and twenty percent of the profits.

Active Management’s Second Challenge – Incentives

Because active managers are judged by a benchmark, active managers actually have a powerful incentive to manage to the benchmark. What does that mean? They become so-called “closet indexers.”

If an active manager is judged on whether they outperform the S&P 500, they will eagerly watch the S&P 500’s every move, down to each individual stock’s contribution. Naturally, they will want to pick only the stocks that go up and avoid those that go down, but managers don’t have perfect information, and sometimes the market surprises you. There’s a saying, the market can remain irrational, more than you can remain solvent.  So what happens when some of those winners start to become losers? The manager’s performance starts to diverge from the benchmark, and they start to get worried.

The psychology is plain. It’s loss aversion. If a manager has gone through the hard work of gathering assets, their biggest fear is that they’ll lose them. What’s the most likely way to lose assets? Underperform the benchmark. So you manage to the benchmark. You watch your tracking error, which is the degree to which your performance varies from the benchmark. You stay away from big, high conviction bets. The manager doesn’t manage the portfolio to in an effort to pick winners. Instead, they manage the portfolio in an effort not to lose. If the index is down for the year, that’s ok. That means everyone lost money. These portfolios, though active in name, hew very closely to the composition of their corresponding benchmark index. If you’re lucky, they’ll perform at least as well.

Active Management’s Third Challenge – Performance

Let’s face it, the industry’s got too many mutual funds
Joseph Sullivan, CEO, Legg Mason: via WSJ

It’s hard. It’s rare. And in some sense, it’s lucky. Strong investment performance in the public equity market is a difficult prospect. Fees provide a drag, and the incentives discussed above introduce a tendency toward herd behavior in the form of closet indexing. Worst of all, the efficient market hypothesis argues that a manager’s decisions are no better than monkeys throwing darts at a dartboard crammed with stock-tickers.

The efficient market hypothesis assumes that markets are efficient. What does that mean? The price of any individual security reflects all of the available information about it and its prospects. Moreover, as new information comes to light, the market adjusts quickly to reprice the related securities. These events have an immediate impact on the market. In its strongest form, the EMH claims that the market not only incorporates public information, it incorporates private information. Therefore, no investor should be able to profit above and beyond the average investor.

The proverbial deck is stacked against the active manager’s performance.

Active Management is Dead – Long Live Active Management

Here’s the conundrum, though. Active managers are the only investors making decisions based on the companies themselves. They look at valuation. They look at company management. They review products and services and put them in the context of a competitive environment. Active managers make active decisions based on their interpretation of the facts. Passive managers provide exposures regardless of the facts.

Janus Mutual Funds aggressively branded their funds as the ones that made the extra effort to suss out and understand the little things that could make or break a company. This 2007 commercial promoting Janus Mutual Funds profiles a possible investment considered by a portfolio manager. The story line illustrates the lengths and depth the manager goes to in order to better understand the risks associated with the datacenter business. The portfolio manager ultimately comes to understand that some datacenters used water sprinklers, and found that the company in question does not. She seizes on the differentiation and invests, and Janus presents it as a real world example of what separates their portfolio managers from the crowd.

The Janus commercial is intended to separate them from other active managers — managers who presumably don’t do their homework. But the same applies to the difference between what an active manager does compared to a passive manager. A passive manager doesn’t do the fundamental research that Janus describes. A passive manager will typically allocate capital to an index that consists of a basket of securities. Those securities have not been qualified based on the quality of the management through interviews and discussions. The passive investor doesn’t qualify the soundness of the business operation or ask probing questions about the viability and timing of the next product cycle for a company. Passive exposures provide no protection from the kinds of risks identified by an active manager in this story line. A passive investor is seemingly just as likely to invest in the company with water sprinklers as the one without.

Active Investment Management Provides a Public Good
Which brings us back to the beginning. As Professor Malkiel asserts, you need active management to make the market efficient. Economists have a word for this. Active investment management is similar to a public good.
Economists use the term, public good, to describe a good that benefits everyone in the market. Everyone receives the benefit of active management — most of all, passive investors. Because public goods benefit everyone in the market, they are considered non-exclusive. No one can stop you from availing yourself of its benefits. An efficient market is an efficient market for all.
Public goods are also considered non-rivalrous. Non-rivalrous means that its use does not reduce its availability to others. Hal Varian, the noted economist, famously describes information goods as public goods, and a news story provides a clear example of a non-rivalrous good. A news story can be reprinted and recirculated again and again at nearly zero marginal cost, so your consumption of the news will not rival my ability to consume the news. And so, courtesy of the active manager, anyone can avail themselves of the market and its efficiency.
Active management provides market efficiency, and market efficiency is a public good. The public good of efficient markets provides the opportunity to be an effective passive investor.
But is there such a thing as too much Passive Investing?
What if market efficiency is not always non-rivalrous? What if too much passive investing crowds our or drowns out the effect active managers have on the market. What if too much passive investing makes the markets inefficient?
How would too much passive investing look to the market? Active stockpickers would discover bargains and then find that the market doesn’t react. Their stocks stay cheap. Swift market moves and high correlations would move stocks move as groups. High-quality positions would move in tandem with low-quality positions. Positions would seem to move more in line with their corresponding index than the underlying fundamentals of the business. Indeed, positions may seem more likely to follow the performance of a passive ETF of which it happens to be a member than anything else.
These conditions don’t sound too dissimilar those that have persisted since the crisis and created an environment in which active managers have persistently underperformed. Indeed, clients have punished them for this: with more than $335bn flowing out of US active funds in the past 12 months (FT).
Could this be the function of the growing influence of passive investing? Perhaps. The early research would suggest this may be the case for many stocks, already. If so, it would change how active managers build their portfolios and require a rethinking of how they understand individual stock and market risk.