Active Management: Where Does Paying Up Pay Off?

Disclaimer: The article below discusses certain investment strategies, some of which I am currently using in my personal portfolio and some of which I am not.  Do your own due diligence before making an investment decision.  It’s your money; you’re the best person to judge what is best to do with it.

Active management has been demonized as a high-fee, Wall Street boondoggle for years.  Indeed, the word seems to have gotten out, as the shift from active management to passive management has accelerated in recent years.  According to Forbes, the share of passive investments has increased from 12% to over 36% in just 15 years:

Not a day goes by without some article in a financial publication discussing the death of active management.  Vanguard Group, the inventor and leader of passive management, has passed $4.5 trillion in assets under management and is growing faster than everyone else in the investment management industry combined.  In fact, Vanguard owns more than 5% of the outstanding shares in 468 out of 500 companies in the S&P 500.  The S&P 500 measures the largest companies in the US, and has an average market cap of $45 billion.  Maybe the discussion of too big to fail needs to move from the banking sector to investment management!

For the average investor, investment management fees should be minimized and much of their portfolio should sit in passive investments.  But we’re choosing to be above average and are not afraid to do our homework, so let’s ask the question: does active management make sense anywhere, and if so, where is it worth it to pay up?

Active Management’s Bad Reputation

Active management gets a bad rap, and for the most part, deservedly so.  There are at least 8,000 actively managed mutual funds (it is surprisingly tough to get a total number).  The combination of high fees and poor performance has pushed investors to a passive approach.  However, the obsession over high fees can have damaging consequences.  If the manager is truly skilled, then paying higher fees can be worth it.  Net returns are all that matter in the end.

Instead of using the gross return, look at the net return which factors in the management fee, trade cost, and other expenses.  If a manager can consistently do better than their benchmark over a three year or five year timeframe, and the management team remains intact, the fund may be worth a closer look.  Many investors pay close attention to the one year return number, but it is unreasonable to expect any manager to outperform year after year.

Beyond return, risk is also an important concern.  As I’ve written about in the past, the risk of an investment isn’t volatility; it’s drawdown.  If a manager can get close to the benchmark return while dramatically reducing drawdown risk in bear markets, it’s a good bet that the manager has skill and investing in their fund could be worth it.  Often, the return numbers tell only part of the story though.  Follow Warren Buffet’s advice: “Rule number one, don’t lose money.  Rule number two, don’t forget rule number one.”

Active management underperformance is less due to a lack of skill and mostly due to structural problems within the financial services industry.  Index funds and other passive investments do not suffer from these same issues.  Let’s take a look at the biggest reasons for underperformance.

  1. Asset Gathering: The typical evolution of a fund manager goes something like this:
    1. Have an idea or reputation that allows you to gather seed capital for an investment strategy
    2. Outperform over one and three year periods
    3. Gather assets like crazy by securing good press, getting on some of the big Registered Investment Advisor (RIA) networks, or having great salespeople
    4. See your great performance drift to mediocre or worse.  You do not generally hear about strategies that underperform early on.  They tend not to make it out of the seed investment phase.  Those funds that do outperform have an economic incentive to gather assets.  A bigger asset base equals bigger fee revenue which equals bigger bonuses for the managers and bigger profits for the fund company.  What bigger assets do not equal is better performance.  Asset gathering is directly correlated to decreasing performance and is one reason why some fund managers close their funds to new investments.
  1. Dilution of Best Ideas: But why exactly would a larger asset base equate to poor performance? Fund managers can only research so many stocks, bonds, or real estate companies, and can only have so many great ideas.  Once you reach a certain size, you run into issues relating to trading or holding a large amount of stock.  Trading large amounts of Apple is easy as the stock averages over $4 billion in daily volume.  A company like Weyerhaueser, a forestry and paper company that is also in the S&P 500 and considered a large cap company, averages only $100 million in daily volume.  Most investors prefer to stay below 5% or 10% of the average daily volume, meaning they can only trade $5 million or $10 million per day.  This effect is even more pronounced for mid and small capitalization stocks.  Barnes & Noble, a small cap stock in the Russell 2000 index, averages around $10 million per day in stock trades.  Tough to build any kind of position there and still be able to sell out if needed.  For a fund with billions in assets, you are forced to hold a large number of positions, diluting your best ideas and ultimately becoming…
  1. Closet Index Fund with Tracking Error: The large number of assets and limits on trading large blocks of stocks forces fund managers to hold a large number of positions. Outperformance through time comes from building concentration positions in the right companies.  It’s how private equity managers and C-suite executives make the big money, and it’s how fund managers outperform.  Unfortunately, once you reach a certain size, holding those concentrated positions doesn’t work logistically.  In effect, the fund becomes a closet index fund that merely tilts in one direction or another.  Charging 1% or more to make tactical tilts makes the hurdle on those bets paying off much higher.
  2. Greater Competition: If you are looking for a reason to be optimistic about active manager performance in the future, this could be it. Twenty years ago or more, increasing competition in the fund management space was a negative for performance.  With the rise in passive investing, and the plateauing or even declining number of mutual funds available, active management has as good of a shot at outperforming in the next five to ten years as ever before.  Index investing leads to weird dislocations in the market, as an index is merely following rules and not looking at fundamentals.  With fewer active managers to take advantage, this could lead to opportunities for those that remain.

The Data

The data on active management is pretty cut and dry; active management underperforms in general.  S&P Dow Jones puts together an incredible amount of information on this, and the results speak for themselves:

  1. US Equities: 88% of large-cap managers underperform the S&P 500 Index over 5 years, 90% of mid cap managers underperform the S&P Midcap Index, 85% of REIT (real estate investment trusts) managers underperform the S&P US REIT Index, and an incredible 4% of small cap managers underperform the S&P 600 Index! US equities are some of the most efficient markets in the world.  It is tough to add value as an active manager here.

  1. International Equities: International stock markets tend to be a little less developed than the US. Trading large cap European stocks is not nearly as efficient as it is in the US.  Yet even with that advantage for active managers (and that’s a huge advantage), the performance there is only marginally better.  “Only” 67% of international fund managers fail to outperform their benchmark over a five year period.
  2. Fixed Income: As compared to stock markets, fixed income or bond markets are some of the least efficient markets. Bonds are still traded over-the-counter, with no readily available exchange or central “book” with which to compare prices.  With those advantages, one would expect to see active management perform well, and relative to stock managers, fixed income managers do show some improvement.  In relatively efficient bond markets, such as US Treasuries, active management underperforms.  There are only so many levers to pull, such as changing duration or playing the yield curve.  However, when some of the less liquid bond markets are included, such as municipals, corporate bonds, or mortgages, active management can make sense.  Investment-grade credit managers perform fairly well.

Where Active Management Works & What to Look for

Active management underperformance speaks for itself. However, there are some asset classes where active management still makes sense. The most important things to look for when determining whether or not to use an index fund or active manager, and whether or not the active manager has a chance at outperforming include:

  1.  Use at least 3-year and 5-year performance numbers: Investing in last year’s high performing fund is a losing game. On the flip side, selling out of a fund that had a single bad year (assuming it’s not too bad) is also a losing game. Focus on three year and five year performance numbers, if not longer. Ensure that the timeframe matches the current management team’s tenure, but don’t judge based on a one year number.
  2. Look for areas where active management has a chance: For US stocks and REITs, trying to pick a manager and outperform an index fund is tough. Sure, 12% of large cap US stock managers outperformed over the last five years, but are you sure you can pick one of those funds? The odds are against you, and just like chasing performance, trying to pick these funds is a losing game. Corporate bonds, frontier stocks, and possibly international or emerging stocks all offer a decent chance at outperformance. If you are going to spend the time and effort looking for active managers, these are the places to do so. Otherwise, just use the index funds.
  3.  Compare net of fee returns and look for tax efficiency: When looking at returns compared to a benchmark, make sure you use net of fee returns in order to compare apples to apples. Most index funds are .10% or less in fees, while the average active fund can be 1% or more. Fund performance is occasionally presented gross of fees, which is what the fund returns but not what you would receive. In addition, if the fund is going to be held in a taxable account, you’ll need to compare the tax efficiency of the funds relative to each other. High turnover strategies (e.g. lots of trading) versus longer hold strategies have different tax liabilities. If you’re investing in a taxable account, such as your F-You fund, you’ll need to look at both net of fee returns and net of tax returns. Sometimes poor tax management at a fund can overturn otherwise better performance.
  4.  Look for large divergences in performance: I debated putting this as number one on the list because in the end, divergence in performance is a top determinant of whether or not active management works. This concept has been discussed before in the context of private investments. If a category or type of investment has a large performance difference between, for example, the top and the bottom quartiles, then paying for good active management and spending the time finding it pays off.

a. US equities: For large cap US stocks, the 1st and 3rd quartiles have a spread of only 2.4% over 5 years. This is not worth your time and effort to try to find the 1st quartile manager. Even small cap stock managers have a spread of only 3% over 5 years.

b. Global stock: Even global stocks, including emerging markets stocks, have only a small spread between the top and bottom performing managers over any significant period of time. Put these above US stocks but still near the bottom of your list for time spent.

c. Fixed Income: Fixed income funds are the only major funds that have any spread in performance. Because the expected return is less for fixed income than for stocks, a spread of 2% or 3% is very significant. Spend your research time here first.

5. Pay for skill, not luck: This is, admittedly, a very difficult thing to do, and one that will be the subject of a future post. There is heavy math involved. The main concern is that a manager is earning their outperformance based on what they say they’re going to do and not just luck. If they make individual stock bets as a fundamental investor, make sure that they are not making their returns off of market timing. If they do sector tilts, make sure they’re not primarily making money off of a big single name win or two.

6. Be careful with Smart Beta: Smart beta, factor strategies, low volatility strategies or style bets all fall under a relatively new investment pitch. The idea is for an actively designed strategy, but one that is implemented passively. Fees on these often fall somewhere in between an index fund and an actively managed fund (although they tilt closer to an active management fee). For example, a fund may invest based on rules relating to pricing (P/E ratio), dividends (dividend yield), or balance sheet strength (cash or debt). These strategies have been followed by investment managers from the beginning of time; smart beta just systematizes them. Smart beta strategies advertise themselves as volatility reducers or portfolio diversifiers. What we see in practice, however, is large correlation to the broader market and as great of a chance of underperformance as active management. What is an improvement is the modest reduction in fee. By all means, take a look at smart beta strategies, but perform the same level of analysis as you would on any other active manager.

7. Private investments make sense to pay up for: Certain private investment categories are worth paying for good managers, with venture capital being the most prominent. If you are able to get into a top tier venture capital fund, then gladly give them your money, regardless of the fee. Investing with a Benchmark, Greylock, Sequoia or Andreessen type VC firm gives you a good chance to build substantial wealth. However, many hedge funds and credit strategies fail to pay for their fees. Long/short equity hedge funds can be replicated using ETFs, creating a stretch form of index investing. Middle market lending funds can be replicated using Business Development Companies (BDCs). As with any other strategy, do your homework, but know that some private investments have greater potential with active management.

Active Management – Buyer Beware

There are investment managers out there who can consistently beat the market.  They just don’t need money from you or me!  Active management has seen bad press and a lack of growing assets.  Underperformance is common, and finding the diamond in the rough is challenging.  Focus your efforts on the asset classes that have a chance for outperformance, such as certain fixed income markets.  Other markets, such as US equities or REITs, should just be happily indexed.  When looking for active managers, make sure to compare after-fee and after-tax returns, and ensure that you’re paying for skill, not luck.

Keep building my friends.

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