Why Active Management?
• There are three key questions that need to be answered to decide whether or not to use active management.
• There is cyclical behavior when it comes to relative performance between active and passive management. Lately, the winds have favored passive investing.
• Identifying a few flaws in index investing.
• Finding good active managers, however, is only one way we add value for clients.
The question of why to use, or not use, active investment management (versus passive investment management) remains popular with investors. We have frequently written on the topic.
While active and passive management each have their strengths and weaknesses, we use both for clients depending on the situation. That said, we strongly favor active management for a variety of reasons. In this report, I'll review some of those reasons.
First, let's review some basic definitions. Passive investing, often called index investing, simply tries to match the return (before fees) on an underlying index or benchmark. Passive investing provides a reliable relative return generally at a lower cost (given management doesn't need to pay for research, etc.). Active management, meanwhile, is a strategy where management believes it can add value above and beyond the benchmark by identifying securities that will outperform.
The Key Philosophical Questions
What criteria should an investor employ to decide whether or not to utilize active management? There are three questions an investor needs to answer.
1) Are the markets inefficient (i.e., offering regular mis-pricings to be take advantage of)?
2) Are there money managers who can identify and take advantage of those mispricing opportunities?
3) Do you, or your advisor, have an investment process to find those managers?
Let's address these questions.
Are the markets inefficient? Do investors ever make decisions based off non-fundamental factors? Do investors invest based off past performance? Invest off emotions? Are buyers or sellers ever motivated to transact due to timing or liquidity considerations? Do investors sometimes over-react? Do investors ever react too slowly? Are some markets ever temporarily manipulated? I could continue the list, but I believe there is ample evidence that show the markets are often inefficient.
Are there managers who can add value? Studies show that most managers don't. The flip side to that coin, however, is that some managers are adding value. The managers that do, often have a few common characteristics. First, they have a disciplined philosophy and process. They have a plan and they stick to it. Second, they tend to have a value orientation within their investment mandate. This orientation means they emphasize an attractive price paid given underlying companies' fundamentals.
Can somebody identify above-average managers? Warren Buffett, generally considered by many to be the most accomplished stock-picker alive, recommends that investors should use index funds, yet, he actively invests. Bill Gross, generally considered by many to be the most accomplished bond-picker alive, recommends that investors should use index funds, yet, he actively invests. David Swensen, generally considered by many to be the most accomplished asset allocator alive, recommends that investors should use index funds, yet, he actively invests. Why do they do this? In short, they know how difficult it is to add value, but they believe they have the research capabilities to add value above and beyond market benchmarks.
At Adviser Investments, we believe we also have the ability to identify investment managers that will add value over time. While we obviously have not always picked above-average funds, in the aggregate we have. And, we expect that we will continue to do so moving forward. We have a disciplined, structured and tested investment process.
Let's be honest about the bulk of mutual fund "research" available to investors;. it's pretty crude. While there are clearly some high-quality research units out there that we respect, for the most part many decision-making processes are fairly basic and simple - and usually based more off marketing points than investment merits. Generally speaking, the research to pick mutual funds and money managers is nowhere near as structured and disciplined as it is among traditional equity and fixed income analysis. Therein lies our opportunity. At Adviser Investments, our investment team has experience, impressive tools (both built in-house and third-party tools), and access to portfolio managers (we meet personally with hundreds of managers a year). Given our team and process, we have clear informational advantages in our ability to collect and process more information and in turn we believe we will continue to add value in the years ahead.
The Cyclical Nature of Passive vs Active Management
Everything cycles within the markets. Leadership within economic sectors, leadership between company sizes (i.e., large caps vs small caps), and leadership between styles of stocks (i.e., value stocks vs growth stocks) all cycle. In time, the first shall be last and the last shall be first. And the same can be said for investment strategies, including passive versus active strategies.
Typically, there are a few reasons active management strategies might underperform passive strategies due to cyclical reasons. First, actively managed funds generally carry some cash while index funds don't. This "cash drag" can negatively impact the relative performance of actively managed funds over time, especially during times of strong bull markets. The last few years are no exception. The S&P has doubled off its March 2009 lows, for instance, so just having 3-5% in cash (a fairly typical number for a mutual fund) over that time has a real cost.
Another environment where passive can outperform is when there is relatively low return dispersion (i.e., return difference) between sectors and between top and bottom performing stocks. Adviser Investments analyst Greg Kelly wrote on this topic recently in an Analyst Spotlight. In short, there has been low return dispersion in recent years, which has been a clear headwind for active management. Needless to say though, intra-market dispersion is also cyclical. Expect dispersion to expand and more opportunities to appear for active management.
Indexing - Some Flaws
There are a few flaws regarding index funds I would like to call attention to:
First, they are actually much more active than they might appear. Committees or formulas - or both - make regular changes to various benchmarks. They are not static bogeys. The S&P, for instance, will often throw out stocks of companies in the S&P 500 benchmark and replace them with better performing companies. Clearly, benchmarks are not as passive as they may seem.
A bigger issue in my opinion, is that most passive investing is based off benchmarks that are capitalization-weighted (i.e. a company's weight in the index is simply a function of its market capitalization) instead of being based off fundamentals such as revenues or earnings. I understand why this is done (since it captures how all money is actually invested, which is by definition "the market"), but a result of this is that one will ultimately overweight over-valued stocks (stocks that have run up in price relative to fundamentals) and underweight under-valued stocks. In other words, index investing is really another form (albeit mild) of momentum investing.
Another interesting issue is that many indexers want to claim the moral high road to investing. From where I sit, that's wrong. Investing in a company just because it has a high market cap - and to increase a position only because its price (or shares outstanding) has gone up - is not really investing. It's actually pro-cyclical behavior that only helps amplify bull and bear markets. Investing on fundamentals, however, such as making decisions to invest based off assessments of revenues, earnings, etc. means that money is being re-allocated from less attractive assets, sectors, and companies to more attractive assets, sectors and companies. This process - and investors' ability to participate in the growth -- is a good thing. And it's in everybody's long-term interest.
Indexing has its advantages, whether or not one is using an index mutual fund or a passively invested exchange-traded fund (ETF), and low cost is by far the leading reason. All else being equal, it's obvious that a fund with a lower cost will outperform a fund with a higher cost. For this reason, we make fund costs an important determinant (among many factors) when selecting funds for clients.
Though we use both actively and passively managed mutual funds and exchange-traded funds (ETFs), our clear preference is for actively managed mutual funds because that takes advantage of our core competency of finding the best managers. However, some clients still like ETF portfolios. That's fine. We can build ETF portfolios with the same basic over-all market and risk characteristics that we do for our mutual fund portfolios. While clients with ETF portfolios lose what we believe is our long-term value-add of manager selection, they still get the value of:
- Identifying what is an appropriate asset allocation and risk level given their personal situation,
- Broad exposure to multiple asset classes (unless, of course, they are in a dedicated equity or non-equity portfolio),
- Active decisions on the valuation of various asset classes, and
- The basic blocking and tackling of professional portfolio management such as risk management, re-balancing, and tax management (for taxable investors).
So whether a client decides to focus on active or passive management, their ability to reach their financial goals can still be enhanced by the many ways professional investment management and counsel can add value.
As always, if you have any questions, please feel free to contact me.
Rusty Vanneman, CFA, CMT
Chief Investment Officer