June 6, 2018
Written by Nathan Erickson, CFA®, CAIA, Managing Partner and Chief Investment Officer
“Even God would get fired as an active investor.” – Wes Gray, Ph.D.
One of the most commonly debated topics in the finance world is active management versus passive management of equity portfolios. Active management is typically characterized as “stock picking”, where a manager or managers select individual stocks for a portfolio based on their own analysis or opinion. Passive management is typically characterized as owning an index, or building a portfolio absent of individual stock evaluation or analysis. Historically, actively managed mutual funds have had higher costs, represented by their expense ratios, and have underperformed indexes or passively managed mutual funds. The explanation of underperformance is usually that active managers cannot outperform with any consistency (they may do well one year but poorly the next) and certainly not enough to overcome the cost of investing with them. When investors see this evidence, they typically conclude that active management doesn’t work, is too expensive, and that they would be better off buying index funds.
We are not going to argue with the conclusion that most investors are better off in passive funds as opposed to active funds. However, we do think it is worth considering other factors that may contribute to active manager underperformance. In his book, The Big Secret, Joel Greenblatt of Gotham Asset Management discusses interesting results from his analysis of mutual funds and institutional asset managers from 2000-2010. Over the time period, the S&P 500 was basically flat and, at the same time, the best mutual fund for that decade had an annualized return of 18%. While the fund returned 18%, the average investor in the fund lost 11% per year on a dollar-weighted basis. This is similar to the famous annual Dalbar study which shows that most investors underperform the mutual funds they invest in due to decisions they make to buy and sell the fund in the interim. When the fund does well, investors buy, and when it does poorly, they sell (this is effectively buying high and selling low, the opposite of what investors are supposed to do).
For an active manager to outperform an index, they must do something different. They cannot invest identical to the index and expect to outperform. If the active manager is going to be different enough to outperform, it is fair to assume that at times they are going to underperform, potentially by a similar amount. For example, in another study, Mr. Greenblatt looked at the top quartile of institutional asset managers over the same time period, 2000-2010. He found that 97% of managers in the top quartile spent at least three of those ten years in the bottom 50% of performance. Furthermore, 79% spent three of the ten years in the bottom 25% of performance, and 47% with the best 10-year record spent at least three of ten years in the bottom 10% of performance. While the 10-year returns are among the best, there were many times throughout the decade where their short-term performance would have prompted doubt in their abilities.
Warren Buffett, who many view as one of the greatest investors of all time, has also had challenging short-term relative performance:
While Berkshire Hathaway stock has outperformed the S&P 500 by nearly 5% annually over the last 27 years, in eight of those years he underperformed. In fact, the largest difference in return was in 1999, when Berkshire Hathaway underperformed the S&P 500 by 41%. Tracking error, which measures the distance between returns, was an astronomical 18.6%. This means that, in any given year, investors in Berkshire Hathaway can expect their returns to be plus or minus 18.6% of the returns of the S&P 500.
If Berkshire Hathaway were an average mutual fund, it would see money flow in and out at breakneck speed, and investors would be judging Mr. Buffett’s skill with each passing year’s returns. Perhaps Mr. Buffett’s greatest skill is not his investment selection, but his ability to counsel his investors to have a long-term perspective. His annual letters to investors are repeatedly filled with down-to-earth statements that encourage patience and commitment.
Unfortunately for most other active managers, they must deal with emotional decision making by their investors on a regular basis. What investors don’t realize is that their behavior can have meaningful influence on an asset manager’s investment process. For example, most active managers who pick stocks have an entry point and an exit point. Each manager has a thesis for why they want to buy a stock, and a thesis for when they will sell. When investors respond emotionally to market movement or performance, they force decision making by the manager that is inconsistent with their thesis. Investors who pile into a fund because it is doing well force the manager to invest excess cash in stocks they may like, but at prices that are higher than they want to pay. Investors who sell out of a fund because the market is volatile, or because the fund is underperforming, force the manager to sell stocks at prices below their targets to generate liquidity and redeem shares. Some managers may intentionally hold higher amounts of cash to pay redemptions to impatient investors, which further dilutes performance over time.
Even institutions are not immune from this behavior. We recently heard a story from a very successful hedge fund manager who raised billions of dollars for a fund in the mid-2000s, mostly from large pension plans and endowments with long time horizons and low requirements for liquidity. The manager forewarned its investors that the investments they make take at least three to four years to develop, and the fund may underperform before it outperforms. At the time, many of these investors stated they were likely to add to the fund during times of underperformance, taking advantage of an opportunity to buy low. Instead, as the financial crisis approached in 2008, many of the investors demanded their capital back, insisting they needed the liquidity despite the fact that many of them did not. This was an emotional response in a challenging moment, and it forced the manager to make non-investment decisions to provide liquidity.
While the title of the article is somewhat tongue-in-cheek, it is reasonable to believe that the emotional behavior of investors has some impact on the way an active manager manages their portfolio. The chart below reveals an interesting trend. Recall that tracking error measures the distance between returns over time. This chart measures the 3-year rolling tracking error of the peer group of U.S. active managers in the large blend category in Morningstar, relative to the S&P 500.
We can draw one of two conclusions from the decrease in tracking error from 3.5-4% in 1970, to approximately 1% today. Either the ability of active managers has decreased over time and they are unable to outperform at the same level, or they have responded to the constant comparison to benchmark by their investors (and the inflows and outflows that follow) and have decided to be less different than they used to be.
It is hard to argue that the track record of performance by active manager mutual funds isn’t somewhat influenced by investor behavior. Whether active managers would outperform if they didn’t have to deal with investor behavior is impossible to know. We do know that there are many extremely successful active managers with enviable track records, but they rarely run mutual funds. Like Mr. Greenblat’s Gotham Capital, which averaged 50% annual returns before fees from 1985-1995, they are often private vehicles with lock-up provisions or, at the very least, they have an understanding that patience is required for long-term success. In a day and age when information is available 24/7 and performance comparison is the norm, it is nearly impossible for most investors to endure high tracking error.
We do believe that most investors are better off in passive equity strategies, but not necessarily because active management doesn’t work. Perhaps some investors would have the emotional fortitude to endure high tracking error; however, as the chart above shows, the actions of many other investors force active managers to adjust their approaches, making the entire concept largely unappealing. While the lesson of patience and long-term investing may be hard to implement in equities, it is just as applicable to portfolios. Whether looking at a portfolio of stocks or a portfolio of asset classes, the most successful investors identify a strategy and stick to it, regardless of short-term results.