The Wall Street Journal recently published a series of articles under the title “The Passivists.” Highlighting the merits of a passive investment approach, authors tackle topics such as the fruitless endeavor of trying to pick winning stocks to the “Do Nothing All Day” investment approach taken by Nevada’s $35 Billion pension fund. For each article we provide a synopsis as well as our own additional comments to build upon the great work highlighted in this series.
First in foremost, in the debate of active vs. passive investing, CHOOSE PASSIVE!
Now that we have gotten that out of the way, let’s talk about this particular article from the Wall Street Journal and the merits behind it.
Co-CEO, CIO and president of MFS Investment Management, Michael Roberge, gives his take on how investors can take a hybrid approach to their portfolio through the use of both active and passive strategies. In his own words, “passive funds have great appeal in an extended period of rising asset prices such as the one we have experienced since the global financial crisis. In periods of higher market volatility, however, active stock picking and strong risk management could also help buoy overall portfolio performance.”
Sounds great right? The unfortunate part is that there is little evidence that managers can actually do it successfully. Let’s just look at MFS Investment’s track record as an example.
How Easy Is It?
We analyzed the performance all 87 actively managed mutual funds to see if the firm was delivering on their sales pitch. Here is what we found:
- 53 (61% of all funds) displayed a NEGATIVE alpha compared to their Morningstar assigned benchmark since inception
- Only 1 fund (1.15% of all funds) displayed a POSITIVE alpha that was statistically significant at the 95% confidence level compared to its Morningstar assigned benchmark
- 27 (31%) displayed a POSITIVE alpha compared to their Morningstar assigned benchmark
- 7 (8%) of the funds had no alpha to report since they had been around for less than 1 year.
You can find more details about our analysis of their performance in The MFS “Active Advantage”….Really?
As you can see, even MFS has a really tough time outperforming their benchmark consistently overtime. In fact, the vast majority (61%) of their funds have failed to do so.
So what other basis does the Co-CEO have for his recommendation for investors to utilize both active and passive strategies in their portfolios?
False Reliance on “Active Share”
Mr. Roberge cites a paper entitled “How Active is Your Fund Manager? A New Measure That Predicts Performance” by Martijn Cremers and Antti Petajisto. They find that “funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence.”
For those who are unfamiliar with the term, “Active Share” is defined as the share of the portfolio holdings that differ from the benchmark index holdings. For example, if there is an active manager that is tracking the S&P 500, her active share would be determined by how much differently she overweights or underweights particular stocks compared to how they are weighted in the S&P 500.
There is a systematic flaw with the reliance on “Active Share” to sort future winning managers from future losing manages. As Andrea Frazzini from AQR Capital notes, “the difference in active returns between high and low Active Share funds is due to their benchmarks.” More specifically, investors that focus on funds with a high Active Share are really just tilting their portfolio towards small and mid cap managers.
As we know from the academic literature, small cap stocks have outperformed large cap stocks over long time horizons; a relationship publicly acknowledged in Rolf Banz’ 1981 paper “The Relationship Between Return and Market Value of Common Stocks” and more widely recognized in Eugene Fama and Kenneth French’s groundbreaking 1992 paper “The Cross-Section of Expected Stock Returns.”
Based on this simple correlation between Active Share and small cap stock exposure, Mr. Frazzini concludes, “we find no significant statistical evidence that high and low Active Share funds have returns that are different from each other. We conclude that Active Share does not reliably predict performance, and that investors who rely on it to identify skilled managers may reach erroneous conclusions.”
There is even a more simplistic reason as to why we cannot expect Active Share to be a reliable indicator of performance. If we know that the universe of managers, as a group, holds close to the entire market, then every dollar of outperformance must be offset by a dollar of underperformance. This principle applies to managers who are taking large bets (Active Share) compared to indexes. Some will outperform and some will underperform, but it’s impossible for the majority to do either.
What is more likely the reason for Mr. Roberge’ recommendation to “do both” has to do with protecting his firm’s profits rather than giving great investment advice. He fully understands the way the wind is currently blowing in the investing community and he is do his best to stay relevant.
You can find the original article published in the Wall Street Journal here.
About the Authors
Tom Allen is an Accredited Investment Fiduciary (AIF®), Certified Cash Balance Consultant (CBC) and a Chartered Financial Analyst (CFA®) Level III Candidate. Tom received his Bachelor of Science in Management Science as well as his Bachelor of Art in Philosophy from the University of California, San Diego.
Mark Hebner - Founder, Index Fund Advisors, Inc.
Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.