Come On Hartford, You Know Better!


We recently came across the Second Quarter 2015 White Paper from Hartford Funds, which attempted to address the recent investor trend of shifting more and more money to passive investment strategies. But their message was a warning to investors stating, “Much ink has been hastily spilled recently in obituaries for active management. Most of the negativity has focused on the rise of passive investing, which has enjoyed strong performance during the past five years. But simply because one style of investing has come into favor does not mean others are going the way of the dodo.”

The authors of the so-called “white paper” continue their argument by stating that there have been times in the past where active has won and where passive has won and there is probably a need for both inside of an investor’s portfolio. In essence, there is a cyclical nature of active and passive investing, hence the title of the white paper.

You can imagine this piece being circulated to thousands of advisors, brokers, and clients around the globe, enticing them to take action, or at the very least question ever going solely into passive investment strategies. But like most “white papers” that come from some of the biggest active fund investment firms, most investors should either hit delete or place this straight into their “circular file.” Here’s why...

As you can probably tell by now, we have tried many ways to talk about statistics in a way that is not overbearing (or at least downright boring) to our clients and investors around the world. The issue we have with this “white paper” is actually twofold: first is based on semantics and the other statistics. And, of course we will try to explain it in a way that doesn’t make you want to place this article in the same file as the white paper from Hartford.

Let’s first talk about semantics. The authors make a blanket state of “active typically outperforms passive management during market corrections, because active managers have captured alpha on the upside.” In other words, active mangers, generally speaking, are really good at market timing. Now although there is not a single shred of evidence that this statement is true, at least in the academic literature, it is also impossible to begin with. Active management as a whole cannot beat passive, at least when properly benchmarked. A subset of active managers can, but you cannot say that about the whole. This is because active management as a whole is passive management. It is the entire market. The only difference is net returns, which the winner will always be passive since they have lower costs.

Hartford gives the example of active mutual fund managers in the “US Large Blend” category in Morningstar and compares their net returns against the S&P 500, which is in fact a US Large Blend benchmark. If these managers were truly sticking within the S&P 500, then only a subset would be able to outperform. But as you can guess, most managers end up migrating into mid-cap companies. Here is a great example: Suppose IFA wanted to start an active investment fund and we categorized ourselves as US Large Blend. If we were really in the business of revenue and not fiduciary service, we could buy more mid-cap companies and more value companies to take advantage of known dimensions of expected return, charge 1.00% for it and call ourselves geniuses. The problem is, we didn’t do anything all that special. But boy would we get rich doing so.

The other issue we mentioned has to do with statistics. Hartford provided point estimates going all the way back to 1985. They compared the performance of the entire Active Large Blend category against the S&P 500, showing that active managers won some of the time and the index won some of the time. The bar chart below shows the relative over and underperformance of active US Large Blend managers against the S&P 500 from 1985 to 2014.

The average outperformance of the US Large Blend managers was 0.43% per year over the time period, which active money managers will always tell you “adds up over time,” but the standard deviation around that average is 3.06%, meaning that investors could expected to be either up 3.50% or down 3.50% in 2 out of every 3 years. That is not a small number. As you imagine, we tested to see how many years it would take us in order to be confident (95% that is) that this 0.43% was going to materialize. We will use an analogy. We would have had to go all the way back to when Jane Austin’s Pride and Prejudice was first published (1813) in order to be confident today that the 0.43% was in fact certain. And as we mentioned in one of our articles, in order to control for in sample bias, we would have had to really go back to when Shakespear’s Tempest was first presented (1611).  To summarize, we can be confident in Hartford’s analysis about as much as we can be confident that the universe revolves around the Earth.

The authors also make the claim that active managers have historically done very well during market corrections, meaning that they are good at timing the downside of the market. This is hilarious because is insinuates that the downside is more predictable than the upside. Doesn’t make any sense. But we have digressed. Below is another bar chart showing the relative outperformance of the active managers within the US Large Blend Category versus the S&P 500 for 20 market corrections that have happened over the last 30 years.

As you can see, the average outperformance during market corrections is 1.10%. This does in fact have a T-Stat greater than 2, but once again, we need to correct for sample bias. We would need to wait another 17 market corrections in order to ensure that this trend is in fact significant. You can also see that this number is dramatically different once we control for the 2000 outlier, which happened to be during the tech-stock boom.

While Hartford is trying to make best of their situation in which investors are walking away from their active toxic waste towards a more reliable strategy, their white paper is not really an attempt to do what is best for their clients. This is really to save the amount of revenue they have been generating from their active investment strategies since their inception. While they still like to make claims about active versus passive that seem black and white, the reliability of their conclusions is zilch. In the meantime, we will enjoy our Pride & Prejudice and Tempest and maybe wait until we inhabit another planet in the next 200 years before we jump on this train.