Old Ruin

A Golden Age for Active Investing? We Think Not!

Old Ruin

Alexander Friedman of GAM Holding AG recently opined on CNBC.com that (to paraphrase Mark Twain) the recent reports of the demise of active managers are greatly exaggerated. Friedman acknowledges the mass migration from active to passive, noting that passive funds now account for about 17% of worldwide equity mutual fund assets compared to 10% ten years ago. Friedman also admits that the average active manager has under-performed benchmarks in recent years and “in many cases, the underperformance is striking.” However, according to Friedman, the past does not portend the future, and the ascent of indexing implies that we are actually on the cusp of a golden age for active investing. Friedman spells out exactly what he means when he says, “It is going to be a stock-pickers market again.”

In several past articles such as this one, we have debunked the myth of the stock picker’s market. Like other advocates of this idea, Friedman claims that as more capital is allocated to passive products, pricing inefficiencies—which active managers seek to identify and exploit—rise. Our answer to this claim is that even if there has been an increase in “pricing inefficiencies”, then active investors have the same level of exposure to those inefficiencies as passive investors. For examples, indexers in the S&P 500 Stock Index have a 3.6%1 exposure to Apple but so must the average active large cap manager. Furthermore, simply because a company has experienced a large increase in market value does not mean that it is now a “pricing inefficiency”. Regarding Apple, we have this article arguing that it is under-valued even at a $635 billion market capitalization. Of course we could find articles arguing it is over-valued, but the fact that thousands of willing buyers and sellers are agreeing on its current price tells us that it is most likely to be correctly valued, and the additional dollars supplied by buyers of index funds should have little impact on its current price, especially since many of those dollars came from selling active funds that also held Apple.

Friedman also claims that index fund investors have been hit extra hard by sell-off in energy stocks prompted by the recent drop in oil prices “due to their fixed—and in many cases overweight—exposures to the sector.” Friedman specifically cites junk-bond exchange-traded funds (ETFs) as having lost almost twice as much as broader index of high-yield debt since the end of August, partly because of their bigger allocation to energy companies.  To us, this means that these ETFs were probably based on some very narrowly defined junk-bond index and therefore probably would not have been recommended by most passively-oriented investment advisors. Again, passive investors had the same overall exposure to energy stocks as active investors, as a group. Mathematically, there simply is no getting around it.

Friedman also makes the tired argument that index funds have benefited from high past correlations attributable to Fed polices such as quantitative easing that will not continue. Our answer to this argument is that the relevant factor for the potential success of active managers is not correlation but dispersion, which measures the range of returns in the cross-section of individual stocks. We have yet to see a year where the level of dispersion is too low to preclude the possibility of outperformance for active managers.

For us, one disappointment in Friedman’s article is that he refrained from naming any specific active managers whom he expects to be the beneficiaries of this new golden age. If he had, we would have flagged it to review a few years from now, as we did with Andrew Feinberg in this article. While there is no doubt that regardless of when we look, there will have been a few active managers that beat their benchmarks. The problem is that those managers will be completely different than the managers who will beat their benchmarks in the subsequent time period. As we have documented in past articles such as this one, there is no persistence in performance beyond what we would expect from luck alone. Below are the two charts from that article.

 

In past articles, we have referred to manager picking as a mug’s game, and we do not expect that articles such as Friedman’s will prompt investors who have wisely stepped off the treadmill of manager picking to return to it. If there ever truly was a golden age for active management, it was golden for the fund managers and their employers—not their investors who have wasted an enormous amount of money.

 


1Based on the current holdings of the Vanguard 500 Index Fund as of 10/31/2014, according to Morningstar (accessed on 12/15/2014).