Chapter 7
The Case for Active Management
In striving for returns that beat the market averages, investment managers face many challenges—ranging from adverse economic and market climates, to a competitive battle among active managers, to a flood of low-cost passive investment products that match the returns of the market. Asset owners face their own set of demands, in having to identify managers able to carry forward their skill into future markets. This chapter starts with a front-row seat in the active-passive debate, and then details our reasoning on the merits of investing with active managers, and thoughts on manager selection.
April 2015: Investment Giants Square Off in New York City
Promoters of the active-passive struggle sponsored a championship bout in April 2015, at New York’s Plaza Hotel. Two of today’s more thoughtful financial minds—Jack Bogle, founder of the mutual fund giant Vanguard Group, and innovator of the S&P 500 index mutual fund, and Jim Grant, renowned financial author and editor of Grant’s Interest Rate Observer—mounted the Plaza podium.1 The occasion was one of the popular conferences on professional investment sponsored by Grant’s, and the aim was to further the decades-long discussion central to the investment management business. An excerpt of their comments:
Jack Bogle: “The low-cost proposition is elemental and simple: the gross market returns shared by investors, as a group, is a zero-sum game. The cost of investing, shared by active [mutual fund] managers at a high cost, is 2 percent a year, roughly. The cost shared by index fund investors is about five basis points (or 0.05 percent). Therefore low-cost investors—collectively—must earn higher returns. . . . That’s why indexing is so dominant.”
“The question Mr. Grant poses is: ‘Is [indexing] a fad?’ No, it is not a fad. It is a new way of owning America at low cost.”
Jim Grant: “I disagree that the cost of investing is the determining factor in success. For the average lay public investor it may generally be true, and for the run-of-the-mill index-tracking professional it may also generally be true. But the argument I wish to make is that for the accomplished professional investor it ought not to be true. For not a few of the people in this room, it certainly isn’t true. [But] Jack counsels not to try—it’s almost as if one should not bother to open the paper, but instead go with the S&P 500 flow.”
“[In] the market that you buy today,” Grant continued, “you have 99 stocks with a short interest over 5 percent, 149 with a P/E ratio over 25 times, or no P/E ratio, and [when you invest in passive index funds] you get it all. Mr. Bogle wants you to get it all, and . . . not discriminate or make judgments.”
While the two opponents made strong cases in April 2015, no winner emerged, and the debate goes on. There’s no clear solution: it’s a complex issue, and there are many ways to pose the question, and just as many analytical routes to an answer.
Jack Bogle’s rationale starts with a crucial foundation in the arithmetic of returns. For all those investing in a market such as U.S. equities, the aggregate return (before fees) has to be the return of the market. Some managers and investors might earn more than the market for a given year, but that has to be offset by others earning less. Everyone can’t be above average.
This is a central point in the debate: it must be true that all managers can’t beat the market at the same time. But some do, and Jack Bogle acknowledged that idea in his presentation: “Of course, some managers can win. A winner could be a value-seeking, footnote-reading, neurologically and emotionally qualified manager.”
An Active-Passive Equilibrium
Could a stock market where all investors pursue active management, or all are passive, stay in equilibrium? Probably not: If all investors were active, their combined efforts would make prices highly efficient, and some investors would realize they could earn better returns than the average active manager by avoiding the costs of research and simply holding a passive index fund. Indeed, this is a good description of the conditions that prevailed when index funds got started. At the other extreme, if all investors were passive and no managers were researching company fundamentals, mispricings would abound and astute managers would realize they could earn better returns than the market by incurring the costs of research and engaging in active strategies to capitalize on those mispricings.
A more likely equilibrium would see a mix of active and passive investors that changes with market regimes—such as the current arrangement. At times when the research efforts of too many active investors make the market too efficient to beat, astute investors would move to passive at the margin. But if too many investors swing to passive management, so that the reduction in research activity led to a less efficient market—and better results from active managers—then some investors would migrate back toward active management.
Modern Portfolio Theory (MPT) encouraged the development of passive portfolios as a viable option for investors, and led to measuring active managers’ returns against passive market benchmarks. But in a variation on what physics calls the “observer effect”—where a scientist cannot measure a phenomenon without altering it somehow—evaluating managers against passive indexes has brought unintended consequences to active portfolio management, in two ways.
First, many managers have come to emphasize performance relative to benchmarks over the absolute returns of their strategies, and frame their stock selection and portfolio composition relative to the indexes they are compared to. A manager may find a particular company to be highly overvalued, but if it constitutes 3 percent of the benchmark index, he likely would feel pressure to hold at least a nominal position, even against his better judgment: if he is wrong, and the overvalued stock performs well nonetheless, the decision to exclude it would hurt the strategy’s relative return. (By definition, however, not holding it would not change the portfolio’s absolute return, other than representing an opportunity lost.)
Second, the drumbeat of quarterly and annual returns on indexes has also caused many managers to shorten their investment horizons. A manager might believe that a company is undervalued, and that at some point over the next few years, the market would recognize and correct the disparity. But if his clients are unwilling to tolerate performance below the benchmark for more than a year, he may not be willing to chance a position in its shares, for fear that the mispricing will not be resolved soon enough. Such a focus on short-term relative performance may be steering managers away from what they believe are the best long-term investments.
In this context, the ideas of Deb Clarke, global head of research at Mercer, are again relevant. She holds that evaluating managers against a passive benchmark over short to medium time periods may induce decisions by portfolio managers that place more importance on short-term results, and wind up harming the long-term interests of investors.2
The Case for Active Management3
At this point, we have reviewed the theoretical arguments that MPT makes against active management, and we have discussed some of the empirical data that indicates that the average manager does, in fact, struggle to beat the market in most time periods. So why do we still believe that active management can add value?
MPT is an impressive achievement, and it has reshaped for the better the way that people think about investing by focusing on the relationship between risk and return. But like any body of theory, it is based on certain simplifying assumptions. When it comes to defining risk, we believe the assumptions that MPT makes are too simple. The work of behavioral economists has demonstrated conclusively that investors do not perceive risk in the way that MPT defines it, and more importantly that each investor perceives risk differently. As a result, we think MPT’s conclusion that there is one portfolio of stocks—the market portfolio—that is optimal for all investors is unfounded. Each investor needs to understand his or her own perception of risk to determine which investment strategy suits them best.
That leaves the door open to pursue actively managed strategies. The empirical evidence does indicate that most active managers have failed to outperform the broad market, but we take the view that this is an indication that many of those managers are not following a sufficiently disciplined investment process. To the extent that behavioral biases create market inefficiencies, managers need to understand how and why those inefficiencies arise. Most importantly, managers need to understand that they too are subject to these same behavioral biases, and must learn to recognize and overcome them in their own thinking. Generally, the best way to achieve that is to create a process that will guide the manager toward (or away from) stocks with certain characteristics (or sets of characteristics), despite what the manager’s “better judgment” might be saying, and to stick to that process rigorously.
Capturing the impact of stock-specific inefficiencies requires a disciplined process that (1) understands the forces that create an inefficiency, (2) captures it by “casting a wide net” across stocks that are likely to be affected, and (3) properly structures the portfolio so as to filter out the impact of any factors (e.g., size or industry effects) for which the manager currently has no forecast, and which might otherwise swamp the excess return generated by the inefficiency that the manager is trying to capture. We would argue that most active managers fall down at one or more of these steps. If that is true, then the fact that active managers have not generated excess returns as a group does not constitute proof that generating excess return is impossible; rather, it demonstrates that it is simply very difficult, and that most managers have not been following an approach that is likely to work.
It is important to understand, though, that even the most skillful active managers will sometimes underperform. Indeed, just as getting a hit three times for every 10 at-bats makes for a great baseball hitter, one could argue that outperforming 60 percent of the time makes for a great active manager. But that means even the best managers will underperform 40 percent of the time. And in some market environments, most active managers can be expected to underperform. The market conditions of recent years, in which unorthodox monetary policy sent a flood of liquidity into the capital markets, pushing up low-quality stocks faster than high-quality stocks and magnifying the drag from holding cash, created just such an environment.
Successful active management is difficult, and the need to identify skillful managers in advance adds to the complexity for investors. To conclude, we offer the closing passage from “Active Management in Mostly Efficient Markets,” written by Robert Jones and Russ Wermers, which appeared in the Financial Analysts Journal in 2011. The authors—one an investment practitioner and one an academic—surveyed a wide array of academic literature on whether active management can add value and on whether investors can identify skillful managers ex ante. They end their article with these conclusions:
[S]tudies suggest that investors may be able to identify [superior active managers, or SAMs] ex ante by considering (1) past performance (properly adjusted), (2) macroeconomic correlations, (3) fund/manager characteristics, and (4) analyses of fund holdings. We suspect that using a combination of these approaches will produce better results than following any one approach exclusively.
Active management will always have a place in “mostly efficient” markets. Hence, investors who can identify SAMs should always expect to earn a relative return advantage. Further, this alpha can have a substantial impact on returns with only a modest impact on total portfolio risk. Finding such managers is not easy or simple — it requires going well beyond assessing past returns — but academic studies indicate that it can be done.4
The next two chapters consider the details of fundamental analysis and security selection, and look at some of the analytical errors many active managers commit—in focusing on accounting earnings as a measure of profit (Chapter 8), and the application of valuation metrics based on earnings (Chapter 9). Chapter 10 then considers the investment process of Epoch Investment Partners, based on companies’ ability to generate free cash flow, and how it is allocated to growing their businesses and rewarding owners.