Given the debate of the past 50 years, we conclude that what might have started off as an ironclad theoretical case for passive management has been worn down by the real-life insights of the behavioral economists. Today a fair observer could say that with all the possible sources of inefficiencies in stocks arising from investor behavior, active managers should be able to add value over a passive strategy—or at least that they have they the raw materials available to them. But what happens in the real world?

A large and diverse investment industry works hard to outperform the broad markets, but the historical record of returns achieved by active managers is mixed. Many times, the average manager falls short, depending on the asset categories, time periods, and market environments considered.

This underperformance is not just a recent phenomenon. At about the same time Robert Shiller was finding exceptions to the Capital Asset Pricing Model (CAPM) and the notion of efficient markets, real-world results were also challenging old beliefs that astute managers could beat the market. In mid-1975 Charles D. Ellis, the founder of Greenwich Associates, a pioneering firm of consultants in investment management, authored an article on the failure of active management, titled “The Loser’s Game.”¹ For the three market cycles running from September 1962 to December 1974, he pointed out that:

Not only are the nation’s leading portfolio managers failing to produce positive absolute rates of return (after all, it’s been a long bear market) but they are also failing to produce positive relative rates of return. Contrary to their oft articulated goal of outperforming the market averages, investment managers are not beating the market: The market is beating them.²

Forty years later, not much has changed, and investment managers are still being beaten. Table 6.1 details the 1-, 3-, 5-, and 10-year performance of managers of institutional active strategies investing in U.S. large-cap core equities, all as of December 2015. For the year then ended, as well as 3 and 5 years, between 40 percent and 50 percent outperformed the S&P 500 (before the deduction of management fees). For 10 years, however, the proportion is far higher, at 69 percent (also before fees).

Shouldn’t skillful managers always be able to outperform the market? It’s not very likely. This chapter covers the various forces that come into play in determining whether a manager outperforms or underperforms in a given year. In many cases, such market pressures can more than offset any value the manager adds from skill.

Market Regimes

Professional investment managers’ task of generating excess returns for clients has never been easy, but the data suggest that the job has become more difficult in recent years. One important factor has been the nature of the market environment. There is a financial phenomenon known as a stock pickers’ market—periods where markets reward those companies that manage their businesses well with higher share prices (and punish the opposite).³

That is, at certain times, there are big differences among the performance of individual stocks related to the financial performance of individual companies. Those active managers who can anticipate the likely winners and avoid the less distinguished can thus outperform the market as a whole. But there are more challenging market regimes—where companies’ fundamentals seem a secondary factor, and stocks tend to move as a pack, rendering managers’ processes for picking stocks on their fundamentals less effective. Markets of the past few years have worked against stock pickers, and this can be shown by a number of measures.

Correlation and Dispersion

The two best statistical measures of how widely the returns of individual stocks vary from one another are correlation and dispersion. Correlation primarily measures to what extent stocks move in the same direction, while dispersion measures how much the magnitude of returns varies across stocks.

During periods that stock prices are heavily influenced by broad macroeconomic factors—as opposed to the financial health of their individual businesses—investment managers have less to work from in generating differential performance. That is, if all stocks are moving more or less together, managers face fewer opportunities to create a return that meaningfully outperforms the market as a whole (at least in the short run).

That has certainly been the case since the 2008 global financial crisis, a period during which the world’s financial markets have been propelled higher by sustained near-zero interest rates and excessive liquidity. Looking at the stocks in the Russell 1000,⁴ correlations measured over rolling periods of 63 trading days averaged 0.26 in the 10 years preceding the financial crisis (1998 through 2007) but rose to 0.39 between September 2008 and December 2015.⁵ During the thick of the crisis, September 2008 through December 2010, correlations averaged 0.46. Figure 6.1 plots the average correlation of every possible pairing of stocks within the Russell 1000 from 1980 through 2015, illustrating the rising trend of the past several years and the extremes in correlation reached in 2009, 2010, 2011, and late in 2015.

This is not to say that managers are necessarily more likely to outperform in periods of high dispersion or low correlation. For the years 2003 through 2012, researchers at S&P Dow Jones Indices found that high dispersion of stocks in the S&P 500 did not increase the likelihood of outperformance for active managers.⁶ This conclusion is not surprising: market characteristics alone do not make managers any more or less skillful. However, all managers, whether skilled or not, are likely to be more challenged in periods of low dispersion and higher correlation.

Company Quality

Another view of the recent unusual market conditions, and the challenge to active managers, can be seen in the behavior of stock market indices based on the quality of the underlying stocks. The USA Quality Index published by MSCI Inc. ranks U.S. companies on factors of business quality—defined by MSCI as showing high return on equity, stability in earnings growth, and low financial leverage—and includes just the top 20 percent (125 large and mid-cap companies, from a universe of about 625 U.S. companies). Over the long run, higher-quality companies have outperformed: for the 40 years ended December 2015, the MSCI USA Quality index compounded at an 11.5 percent rate, while the overall MSCI USA index returned 10.1 percent annually. For the three calendar years ended 2014, however, quality companies lagged the broad market, earning an annualized return of 19.4 percent, versus 20.4 percent for the broader U.S. market—leaving higher-quality companies at a counterintuitive annual return disadvantage of 1.0 percent.

Why did higher-quality companies fall short in those years? That is a puzzle: we assume that most active managers—although perhaps not all—follow investment methods that seek higher quality companies (as shown by those companies’ tendency to earn superior returns over the very long term). Paradoxically, however, the recent winners were companies of lower quality.

Lower-quality companies may have been well rewarded in those years for several reasons. Perhaps investors assumed lower-quality names would see sharper recoveries in profits than the more resilient high-quality companies, and purchased those stocks more eagerly. Alternatively, because low-quality shares saw greater falls in prices, they may have made sharper percentage recoveries in returning to normal levels (an advantage which may be biased by the time period selected for measurement).

In our view, however, the prime mover for lower-quality stocks—and higher quality companies as well—was the overpowering force of quantitative easing (QE) undertaken by the Federal Reserve starting in November 2008. When interest rates decrease, the current value of cash flows to be received in the future rises—and all the more so when rates approach zero, as they did in the Federal Reserve’s three programs of QE.^7,8 (For a general discussion of the math of valuation for financial assets, and how changes in interest rates can change asset prices, please see Appendix B.)

With lower-quality stocks, all these factors probably played some role in their strong returns, with the illogical result that managers sticking to their strategies based on quality were bound to underperform.

The Weight of Cash

Another drag on the recent performance of active managers arose from holdings of cash in active strategies. Index funds are fully invested in their markets at all times, or nearly so. Active portfolios, on the other hand, typically hold 2 percent to 3 percent of assets in cash, in order to be able to initiate new positions as opportunities present themselves without necessitating the sale of an existing position to do so. In the case of mutual funds, managers also have to be able to meet redemptions immediately, which is facilitated by having cash on hand.

While necessary for the smooth functioning of the portfolios, holding cash creates a drag on performance, because cash typically has a lower yield than the return on stocks.⁹

Over the long run, going back to 1928, stocks have returned about 10 percent annually, while three-month Treasury bills have earned about 3.5 percent. On that gap of 6.5 percent, a 3 percent cash holding would have cost an average of about 0.2 percent per year in portfolio return, or a cumulative 0.6 percent over a three-year span.

Since the global financial crisis, however, the drag of cash has been especially acute, as returns on stocks have been strong, and those on cash unusually low—essentially zero—raising the cost of not being fully invested. In the four years ended December 2015, the Standard & Poor’s (S&P) 500 gained about 77.0 percent, while three-month Treasury bills earned 0.2 percent (that’s not per year, but the cumulative total). Thus, the typical 3 percent cash holding of a mutual fund would have cost active managers about 2.3 percent, or about 0.6 percent per year.

Luck versus Skill

Investment managers face many challenges—complex forces in the markets and economy, which are constantly changing—so that even in favorable environments, outperforming the broad market is not a sure thing. To generate superior performance, a manager needs a capable investment process, and to be able to execute it with skill.

But beyond skill, investment management also involves luck (both good and bad), in the eyes of investment strategist and prolific author Michael Mauboussin. In his book The Success Equation: Untangling Skill and Luck in Business, Sports and Investing, he subjects all three human endeavors to statistical scrutiny, and rates investing as one involving a high share of luck.¹⁰ The financial markets are highly random in their operation, particularly over short periods, and while Mauboussin ranks investing as less dependent on luck than, say, slot machines or roulette, he believes it is nevertheless a field where skill has less of an impact than, in his own ranking, professional hockey, football, baseball, soccer, basketball, or chess.

Mauboussin recognizes that attributing so much to luck is not psychologically satisfying—considering the importance of successful investment management, and all the effort that it entails:

One of the main reasons we are poor at untangling luck and skill is that we have a natural tendency to assume that success and failure are caused by skill on the one hand and a lack of skill on the other. But in activities where luck plays a role, such thinking is deeply misguided and leads to faulty conclusions.¹¹

It’s not that investment management is easy, or that managers don’t possess skill. He describes a concept known as the paradox of skill, which holds that over time, as participants in sports, investing, or whatever become more skillful, their performance becomes more consistent, making luck increasingly important to any one person’s results. In professional baseball, for instance, it’s been nearly 75 years since Ted Williams achieved the last .400 batting average.¹² But it’s not for lack of skill: since then, training methods have advanced, teams are drawing from a wider pool of talent, and both pitchers and hitters have raised their skill levels. “[I]n statistical terms,” Mauboussin writes, “. . . the variance of batting averages has shrunk over time, even as the skill of the hitters has improved.”¹³

Like baseball, investment management exhibits a paradox of skill. Earlier, we cited the influential 1975 article by investment consultant Charles Ellis, “The Loser’s Game.” During the 30 years prior to the article’s publication, wrote Ellis, the investment management business had drawn large numbers of intelligent professionals, and accordingly become more competitive. The publication of Ellis’s article coincided with the beginning of the Employee Retirement Income Security Act (ERISA) for corporate pension funds, which greatly expanded the scope and size not only of pension plans but also the managers needed to handle them, and prompted a second evolution of the industry’s intellectual horsepower.¹⁴ “As the population of skilled investors increased,” Mauboussin observes, “the variation in skill narrowed, and luck became more important.”¹⁵

In the field of investment management, sorting out skill and luck calls for looking at the persistence of managers’ performance through time. This has been a popular topic for financial economists to examine, and with 50 years’ worth of study the results are mixed. Assessing the persistence of skill in investing is complicated by measurement problems: the market environments and periods of time under study; the market segments and investment styles included; and the techniques of measurement—how performance is decomposed, and the adjustments made for the risks managers take in active portfolios.

One comprehensive study from 2010, “Performance and Persistence in Institutional Investment Management,” authored by academics Jeffrey Busse, Amit Goyal, and Sunil Wahal, examined 4,617 U.S. equity portfolios from 1991 through 2008 holding $2.5 trillion in assets, and from examining past returns found little to no evidence of persistence of performance among investment managers. Like Mauboussin, they also addressed the skill-luck continuum: “We find very weak evidence of skill in gross returns, and net-of-fee excess returns are statistically indistinguishable from their simulated counterparts.” Comparing their own results with the many competent studies conducted prior, they concede that some persistence can be detected over short periods, such as one year, but conclude: “To us, on balance, it is difficult to make the case for persistence.”¹⁶

Other researchers find more constructive conclusions on distinguishing between luck and investment skill. In a 2014 report on equity investing, Willis Towers Watson, the global investment consulting firm, pointed to studies showing that going strictly by the numbers does not suffice in proving skill. Relative returns, or alpha, of investment managers are highly random, they point out, and it’s often difficult to draw statistically significant conclusions on track records shorter than 15 years. Although a few firms can produce such long histories, they seldom have been truly “intact” for that long—that is, without turnover of the investment staff, or a significant increase in managed assets that might have required changes to portfolio construction.¹⁷

Willis Towers Watson makes the important observation that over short periods, say, three years—a time frame often relied upon by institutional asset owners—managers can apparently outperform their benchmarks, even when they don’t show much skill over the long run. In their judgment, across the universe of investment managers only 10 percent can be considered truly skilled over the long term, while 70 percent show mediocre performance, and 20 percent are truly inferior. And while skilled managers are far more likely to outperform the rest, Willis Towers Watson asserts that “[even] if you only ever hire managers with good past performance, only 21 percent of your candidate managers will be skilled.”

Given that historical performance alone is an unreliable guide, Willis Towers Watson advises that asset owners also consider the economic reasoning behind principles in firms’ investment philosophies, as well as the details of their investment processes, including reviews of portfolio positions to see that philosophies are logically carried out.

J. P. Morgan Asset Management studied the question of manager consistency for the 10 years ended June 2013. Comparing results of the two five-year intervals within that period, they found that from 35 percent to 45 percent of active equity managers repeated their outperformance, depending on which market segment they worked in. However, in earlier 10-year periods—those ending in 2009 and 2011—consistency of outperformance was significantly greater, at 50 percent to 60 percent. Researchers did not offer an explanation for the slippage in the later years, but concluded that “these levels indicate modest consistency at an industry level, and do not point to either high, reliable levels of consistent outperformance by successful managers, or the opposite, the notion that manager outperformance is a constantly mean-reverting trend.”¹⁸

An insightful analysis into the causes of active managers’ over- and underperformance was made by researchers at GMO LLC, the Boston-based investment firm, in a February 2015 white paper titled “Is Skill Dead?”¹⁹ They start with the supposition that if active managers were applying independent investment strategies, for any given period roughly half would beat their benchmark, and the other half would fall short. Instead, they find that the ratio of outperformance or underperformance is consistently one-third to two-thirds, or as they say: “Almost everyone wins, or almost everyone loses. This strongly suggests that there are some common factors that drive the performance of the typical manager and that these factors ultimately heavily influence their success or failure.”

They posit that missing the mark is the result of managers’ holding investments outside their benchmarks, citing managers of large cap U.S. stocks as an example. Many take active stakes in off-benchmark securities such as non-U.S. stocks, small cap U.S. stocks, or cash. These other asset classes can result in performance very different from the U.S. large-cap S&P 500, depending on the time period.

To measure the difference to an active strategy, GMO built a model that assumed investment of 5 percent in non-U.S. stocks, 5 percent in small and midcap U.S. stocks and 1 percent in cash. They found that the pervasive underperformance of 2014 coincided with all three factors lagging the S&P 500, as did underperformance in 2011 and 2012, as well as in 1995 through 1999. “The conclusion to be drawn,” say GMO researchers Neil Constable and Matt Kadnar, “is that a very large proportion of the historical variability of large cap managers’ ability to add alpha is explained by our simple three-factor out-of-benchmark model.” (The model’s r-squared, that is, the proportion of variance it explains, is an admirable 70 percent.) GMO concludes that often what appears to be skill, or lack of skill, can in fact be attributed to the forces of market regimes.

Investors Voting with Their Dollars

Many forces can combine to cause investment managers to lag their benchmarks. Perhaps it is not surprising, then, that investors have migrated away from active strategies. As of March 2015, 62 percent of U.S. equities owned by U.S. institutional investors was held in active strategies, down from 74 percent in March 2010, and 79 percent in March 2005 (Figure 6.2).

Some observers have predicted that the active managers’ share of institutional assets would fall to below half, but investor attitudes have not slipped quite that much.²⁰ Among individual investors, index funds have gained a smaller, but still substantial share. In 2000, index funds made up about 6 percent of total U.S. mutual fund assets, but by 2014 had increased to about $2.1 trillion, or 13 percent of the $15.9 trillion in mutual fund assets.²¹ Exchange-traded funds accounted for about as much—another $2.0 trillion in assets. As a group, active managers have their work cut out for them in convincing investors to stay the course for the prospect of above-market returns.