Active management is alive and well - and it’s so much more than just stock picking
February 16, 2022
4-6 minutes reading time
“Most active managers underperform the market net of fees”. You’ve probably heard this before. A quick Google search will lead you to hundreds of articles on this topic - with the general conclusion that around 80% of actively managed funds underperform their benchmarks over the long-run. In other words, about 80% of the time, active managers fail to consistently pick a basket of securities that can beat the market.
While the stats aren’t wrong, they’re not always referenced in the right context. Among the culprits are many investment managers, robo-advisors in particular, whose index-fund-driven business models depend on marketing this artificial polarized notion of “active vs. passive” investing.
We believe there are dangerous flaws to this one-sided narrative, for two reasons:
- There’s really no such thing as “passive” investing
- Active management involves a whole lot more than just stock picking
For individual investors, the risk is that they make the decision of where to allocate their hard-earned money based on incomplete information. The bigger picture, as always, is never so black and white.
First of all, there’s no such thing as making “passive” investment decisions.
“Every investment decision is an active decision” - famous words from BlackRock, the world’s largest asset manager and index fund provider. And that’s what “passive” investing really is - security selection according to a market index. Making the decision to actually invest in any of these market indices is, by nature, an active decision.
With that, it is important to understand what it really means to invest in index funds. Most market indices (such as the S&P 500) are weighted by market capitalization, which means the larger companies hold more weight, and smaller companies hold less weight. In turn, this means that large companies become increasingly larger over time, as more of every incremental dollar invested is automatically allocated toward the largest companies.
“Passive” indexing is really a play on momentum, and there are times that this approach will work against you. A drop in the stock price of larger companies will have a greater negative impact on your portfolio. And throughout the economic cycle, there are times that smaller companies will outperform larger companies, as we saw in the latter half of 2020 and early 2021.
To be clear, we’re not saying that an indexing approach is bad - we just think it’s important that investors understand its pros and cons. Whether you choose to pick your own stocks, or choose to let a market index pick your stocks for you, or choose between investing and not investing for that matter - you’re making an active decision.
So what else is there to active management besides stock-picking?
Believe it or not, stock-picking is actually not a portfolio’s primary value driver.
What those active management studies measure is the ability of investment managers to select a basket of securities that perform better than the market they’re in.
But what about the selection of markets themselves?
A landmark study by Brinson et al. found that over a 10-year period, asset allocation (the practice of how your portfolio is split across various markets) explains 93.3% of your portfolio’s variance in returns. By contrast, only 2.8% was attributed to security selection.
A well-constructed portfolio isn’t allocated to just one asset class - it is diversified across different asset classes and diversified within those asset classes as well. For proponents of “passive investing”, portfolio construction is usually limited to just stocks and bonds. Active investment managers, on the other hand, may have more sophisticated offerings and provide broader diversification through alternative asset classes such as commodities, digital assets, infrastructure, real estate, and sometimes even private debt and private equity.
Before even thinking about security selection, an investment manager has to set the portfolio’s asset allocation - this is arguably the most overlooked aspect of active management. There are many ways to construct a portfolio, and having the right asset allocation is paramount to achieving the desired risk-adjusted return.
When we finally arrive at security selection, it then comes down to an active decision between an index-weighted, or custom-weighted basket of securities.
Some markets are simply more efficient than others.
The context that’s often excluded when referencing those active management studies is that they are mostly conducted across the US/developed large-cap equity markets.
Once we start to look at other markets, the narrative changes quite substantially.
The SPIVA Scorecard from S&P Dow Jones is one of the most robust and widely referenced industry research that tracks active manager skill across all global markets. The stats below are taken from their latest study as of mid-2021.
Sure enough, 82.5% of actively managed funds in the US large-cap equity market lagged their benchmark over a 10-year period. Similar numbers were calculated for other large-cap developed equity markets such as Canada and Europe.
The efficient market hypothesis (EMH) postulates that company share prices reflect all available information, and therefore consistent alpha generation (outperformance relative to a benchmark) is impossible. Well, large-cap companies in developed markets happen to receive the largest amount of media attention and capital flows, which means they have the largest number of market participants (shareholders), and therefore have the greatest means of price discovery. So yes, these markets are pretty efficient.
In contrast, only 55.4% of actively managed funds in the US mid-cap growth equities market underperformed their benchmark over a 10-year period. In less efficient markets, in this case smaller companies with less “visibility”, clearly there are more opportunities to exploit pricing inefficiencies and generate alpha.
In deciding on security selection within an asset class, it is important that one first understands the sandbox they’re playing in. In more efficient markets where it is tougher to generate alpha, an indexing approach is likely good enough most of the time. In less efficient markets where there is greater potential to generate alpha, an investment manager’s skill can have a sizable contribution to portfolio returns.
Let’s talk about the active managers that do outperform.
It may come as a surprise to know that an entire industry exists in assessing the skill of other investment managers. Many institutional investors, knowing they lack the in-house expertise in certain markets, will look to outsource security selection to asset class specialists.
Outside of obvious factors such as historical performance, the future success of active managers is often determined by their investment philosophy, investment process and operations, as well as the quality of their people. Being able to select consistently outperforming active managers is a unique skill in itself.
Many of the world’s top investment managers may also utilize alternative investment strategies (i.e. hedge fund strategies), which can shelter your portfolio from market swings, can amplify your returns, and can turn a profit even when prices decline. Alternative investment strategies tend to employ leverage and short-selling, which are powerful but potentially risky tools.
While alternative investment strategies have historically been inaccessible by retail investors, this is starting to change, and sophisticated investment managers are starting to offer these highly active strategies to clients. Even still, being able to select appropriate strategies and successfully integrate them into portfolios is no easy task. A good investment manager will know how to best position these strategies within a total portfolio to achieve the desired risk-adjusted return.
What about fees? Don’t they also contribute to active managers’ underperformance?
There’s no question that fees matter, and excessively high fees eat into investment performance over time. Worse yet: when those fees aren’t justified by value being delivered to investors - it’s no wonder so many retail investors are cynical about active management.
There needs to be greater emphasis on value creation. With inflation at multi-decade highs, interest rates on the rise, and generally lower long-term return expectations across public markets, active management is more important than ever. As an investor, maybe you’ll get by with just a basic portfolio of stock and bond index funds, maybe you won’t - but why pay the same and settle for less? You should be demanding more from your investment manager.
In the absence of perceived value, fees understandably represent the bottom line for many - but it also can be a slippery slope. Like any other consumer product or service, the lowest fee isn’t always the best option.
We believe investors deserve better. With OneVest, saving on fees doesn’t mean compromising with a basic portfolio. All our investors get active asset allocation, access to broader asset classes, rigorous investment manager research and oversight, as well as a fee-optimized portfolio that combines very low-cost index funds with highly active strategies that many other investment managers don’t offer. Investing with OneVest means investors get the best of both worlds, and with account minimums of only $1, anyone can get started today!