Tradeless Nirvana

Behavioral Finance Indicates Superiority of Active Management: A Rebuttal

Tradeless Nirvana

There are some investment advisory firms who believe in the notion that active management can outperform passive management due to the behavioral biases inherent in all investors. For example, Minnesota based Blue Water Capital (assets under management: $26,818,479 as of 4/21/16) makes the recommendation to their investors that there may be sufficient data-based evidence that allocations to long-term bonds and long/short equity funds may actually lead to better long-term results for investors. Why? Because investors are more likely to stick with these types of strategies versus passively managed index funds.

The author of this particular article entitled Behavioral Finance and The Active Investing Advantage gave 3 reasons why he believes following a passive approach to investing with index funds may not pan out as a good solution for most investors.

  1. Passive investors are unlikely to stay invested over the long run in order to obtain full advantage of index investing
  2. Stocks may not be expected to outperform bonds in low interest rate environments
  3. Proper investment comparison of pure equity portfolios of index funds versus active funds yields more favorable results for active investors.

We will address each of these points.

First, take a look at the current trend of surging inflows into passive funds and outflows from active funds. Since 2011, we have seen outflows of $5.6 Billion in active funds and inflows of $1.7 Trillion into passive funds. On July 19, 2016, CNBC reported that year-to-date 2016 inflows to passive equity funds was $229 Billion and outflows for active equity funds was $236 Billion (CNBC sourced Morningstar). While impressive, Blue Water Capital believes that trend shouldn’t be expected to continue once we hit market turbulence like we experienced during the Tech Bubble in the early 2000s or the financial crisis in the late 2000s. In other words, they predict that investors will likely abandon passive funds after markets have declined. They point to the logic that most index funds are market capitalization weighted. After markets have increased, investors will become more concentrated (or overweighted) in certain industries, like the technology sector during the early 2000s, which will make the magnitude of the next market decline even more substantial.

This is similar logic that is applied by proponents of fundamental indexing (i.e. Research Affiliates) in which a market cap weighted approach to indexing leads to those indexes being overweighted in "overvalued" stocks (lower expected returns) and underweighted in "undervalued" stocks (higher expected returns). Here is the problem with that logic, it is based on the assumption that investors can devine when stocks are over or undervalued, versus fairly valued, at any point in time. How do we know that the stocks with the largest market capitalization (Apple, Exxon Mobil, Google, etc.) are not trading at a fair price based on a reasonable risk-appropriate expected return? In short, we don’t! Passive investors accept the economic principles of free markets setting fair prices and for some crazy reason active investors think they know the point in time when millions of willing buyers and sellers around the world agreed to trade at unfair prices. To quote Rex Sinquefield, "So who still believes markets don't work? Apparently it is only the North Koreans, the Cubans and the active managers." 

Further, to suggest that investors are more likely to abandon a passive strategy versus an active strategy is nonsense. It relies on the assumption that active fund managers are better able to navigate markets after they have gone down. As the author suggests, “there is reasonable evidence” that this is true. The fact is that there is very little evidence that this is true. It is heavily dependent on the time period that you analyze. We have written on this topic before and have cited Modern Fool’s Gold: Alpha in Recessions published in the Fall 2012 edition of Journal of Investing, which debunks the hypothesis that active managers outperform after markets have declined. Remember, there are two sides to every trade, so for every active manager that wins there must be one that loses.

In reality, investors are likely to abandon any long term investment strategy after markets have been volatile. It is incumbent upon their financial advisor to help them maintain discipline after all kinds of market gyrations.

The next issue has to deal with the expected returns of certain asset classes after interest rates have declined. The author gives two dominant reasons why active investing may be prudent after markets experience a low interest rate environment. The author states that there “is the observed tendency for active funds to do better when interest rates rise, and passive funds to do better when interest rates fall.” First of all, interest rates are unpredictable, so nobody knows when they will rise or fall and secondly, there is very little academic research that backs up this claim. Remember, a passive investor is a product of both the active managers who have won and the active managers who have lost, so it is impossible to say that active management as a whole will outperform passive investors in the future. It is more accurate to say that a subset of active managers will outperform after interest rates have declined, but a subset of active managers will outperform passive managers in any type of interest rate environment.  The key is being able identify which active managers will beat a risk-appropriate passive strategy in the future. Many studies have indicated that there are no reliable indicators for picking the next winning active manager or even knowing where interest rates are going. You have about the same odds as just choosing one at random.

The second reason is built off of the first as a conditional statement. If active investors outperformed in low interest rate periods (wrong), then incorporating different assets such as long term bonds or long/short funds should have proved beneficial for investors. Citing a performance comparison of 25-year zero coupon bonds and the S&P 500 since 1981, the author suggests that long term bonds may be a viable alternative to stocks. The problem with this approach is that the author is using hindsight in making this recommendation. Of course long term bonds did well from 1981 to today because it was a period where interest rates declined. The opposite would be true in a period where interest rates had increased. Again, because nobody can accurately predict the future movement in interest rates, it is best to use caution when approaching the idea of incorporating long term bonds or trying to predict the future. 

Last, the author suggests that comparisons of passive vs. active strategies have not been an “apples to apples” comparison. Specifically, “there is abundant evidence that investors do not have the discipline to buy and hold, and that a diversified portfolio is the far better comparison to make. This is because for long periods of time other asset classes besides stocks have outperformed, and one can reasonably assume that the smaller the losses a portfolio suffers after a downturn, the fewer investors that will bolt.” The author then goes on to say that incorporating long/short equity strategies will likely dampen the downside pain, but this assumes the active managers know when the downside is coming. He then goes on to reference a line chart that shows the growth of a dollar for multiple hedge fund styles versus the S&P 500 from 1994-2014.

Let’s approach this with some basic logic. Long/short strategies are active strategies that rely upon manager skill in either forecasting the future or picking the winning stocks, bonds, or other alternatives. Then, of course, they use leverage in attempts to enhance the marginal profits. If active managers struggle with doing these things on the long side of the equation, why should we believe that their troubles would turn around because they are able to go short? In actuality, they are just doubling down on their inherent troubles of trying to beat the market. Further, citing hedge fund indexes is very misleading. Because hedge funds do not fall under the Investment Advisor Act of 1940, they are not required to report their returns. Their reporting is completely voluntary, and why would a hedge fund manager want to report a bad year? They wouldn’t. Many academic studies have indicated that the major hedge fund indexes are full of survivorship bias and selection bias, which paints a much rosier picture for hedge fund performance as a whole.

It seems that some investment advisory firms have attempted to take behavioral finance and justify an active investment strategy because of it. This is completely false. It is true that many investors exhibit certain biases when it comes to investing and we acknowledge that many investors make poor investment decisions, especially after markets have been turbulent. But it is completely wrong to extrapolate these facts into an active investment strategy that any investor can profit from. Between cherry–picking specific time periods (after rates have fallen) and referencing datasets that have inherent biases (hedge funds), this argument is flawed. A proper remedy for behavioral biases in investors is to recognize that nobody is good at predicting future market directions, and therefore to invest in a passive risk-appropriate portfolio of index funds. Finally, working with an independent financial advisor, with a fiduciary standard of care, should help prevent investors from becoming their own worst enemies.