Recent reports want you to believe it
The popular press
For a while now, there have been ever more strident opinions in the press around the business of active money management. The latest salvo was released after a study by S&P Dow Jones Indices (the annual SPIVA scorecard) showed how many managers had been unable to beat their benchmarks over periods ranging from the last year to the last ten years (ending in 2015). The poor performance figures were widely reported in headline articles in the likes of the influential Economist magazine (“The Tide Turns”, 26 March 2016) and the Financial Times (“86% of active equity funds underperform”, 20 March 2016), among others.
This negative wall of opinion has grown louder in the aftermath of the extraordinary global monetary conditions that have unfolded since 2008 – a point that we will explore in a bit more detail later on. The gist of these complaints is that the vast majority money managers are unable to beat their benchmarks, that their fees are too high, and that they are soon to be replaced by robots or by passively managed funds (those that simply – and supposedly cheaply – track an index without any thought for what they might be paying for the assets in their clients’ portfolios), or possibly both. In short, active managers’ days are numbered. On the face of it, this is merely a rational response to what has been a pretty dismal performance record for the vast majority of actively managed funds, certainly for the past eight years since the Global Financial Crisis (GFC).
The facts about performance
“90% of what passes for brilliance or incompetence in investing is the ebb and flow of investment style.” – Jeremy Grantham
In the investment business, one cannot but be frequently reminded of the persistent psychological biases that distort our thinking and make us act in ways that are less rational than we ought to be (by “us” I mean “us humans”). One such pernicious tongue twister is known as “recency bias”. The Skeptic’s Dictionary defines this succinctly as “the tendency to think that trends and patterns we observe in the recent past will continue in the future”. In short, it makes us pay greater attention to recent events and data points and less to events farther back in time, even while we know perfectly well that by far the most pertinent trends in investing are cyclical, or mean reverting. All of the investment bubbles through history, from the most recent (the 2007 housing bubble in the US) to the distant tulip mania of 1637, were the children of this common flaw of human thinking.
I make this point to contextualise the recent spate of greater underperformance by active managers since about 2010. And make no mistake: the numbers are not flattering (Figure 1).
Figure 1: Percentage of US & European Equity Funds outperformed by benchmarks
Source: SPIVA® U.S. Scorecard; SPIVA® Europe Scorecard
What seems to be implicit in these and other recent reports is that the business of active management has always been something of an overrated activity and that the world is finally cottoning on to this. The power of recency bias is such that no one seems to have questioned whether the recent years of dismal performance might be cyclical, whether there might be a link between the world’s extraordinary economic position since the GFC and performance, or what the chances are that these recent patterns might be reversed. Moreover, one is hard pressed these days to find any comment on the obvious utilitarian role active managers play in the process of rational capital allocation and/or the vital policing of wayward corporate behaviour that active investors routinely carry out.
Here then are some cautionary facts, lest we throw the baby out with the bath water:
Figure 2 shows the correlation between US active fund excess returns and prevailing interest rates. It is reasonably compelling evidence for a striking relationship between long-run interest rate environments and active managers’ ability to outperform a broad-based benchmark. Falling rates since the middle of the eighties has seen a steady erosion of average excess returns. Figure 3 shows the resulting flow of funds towards passive funds. Flows into passive funds really took off in about 2005, just as active fund excess returns turned negative.
Figure 2: US Active fund excess return vs rate environment
Source: Barron’s, 12 Jan 2015, Nomura Securities
Figure 3: Investors shun active funds for passive options
Source: Morningstar Inc, Kristi Walker for the Boston Globe
One can’t help but be reminded of the wholesale stampede into tech funds in 2000, or the popularity of commodity companies in the run-up to 2008. Closer scrutiny of Figure 2 reveals that, between 1961 and 1983, the median cumulative return (i.e. cumulative performance) of mutual funds in the USA rose to as much as [ds_popup_explanation data=’Based on the work o Mezrich et al at Nomura Securities; as reported in Barrons, “Returns of the Stockpickers”, 12 Jan 2015′]70% better than the S&P 500[/ds_popup_explanation]. (This period coincided roughly with the “Volcker years” of inflation-slaying and rapidly rising interest rates.) That’s an excess return above the benchmark for the average actively managed mutual fund of more than 2.4% per year, for 22 years.
Predictably, nobody complained about the uselessness of active managers then. Nor can much mention of this extraordinary track record be found in today’s press pages.
Although no-one can see an imminent end to low interest rates, our collective blindness to these economic supercycles in the current debate could signal that we might not be too many months away from reversion of the recent underperformance trend of active managers.
Price discovery and capital allocation
The global economy’s present woes are nothing if not the consequences of poor capital allocation on a massive scale. Sloppy price discovery – neglected in the greed of the stampeding herd, or ignored for the sake of political expediency – is at the heart of almost all of the economic disasters in history. Yet all and sundry are lately advocating the merits of passive investing, an activity in which not one iota of intellectual sweat is spilled over this most vital of functions of the investment industry. If the capital allocators are all asleep at the wheel without a thought for the value – or lack of it – of what they are paying (i.e. buying the index) it is easy to see how such misallocation of capital can be ruinous for savers everywhere.
In a recent comment, [ds_popup_explanation data=’Gavekal Research, “Heading Passively To The Poorhouse”, 10 May 2016′]“Heading Passively to the Poorhouse”[/ds_popup_explanation], Charles Gavekal mentions the fallacy of composition, in which the erroneous assumption is made that what is good for some small part of the economy must be good for the economy as a whole. The most famous absurdist example of this is that the experience of sleeping on a single feather is not particularly comfortable, therefore sleeping on an entire feather bed must be excruciating. In the same way, it might be beneficial for some investors to abandon the idea of allocating their capital to undervalued assets and withdrawing it from overvalued ones (effectively leaving up to others to do it on their behalf), but ultimately disastrous if everyone was equally lazy.
In a world in which passive investors are the only survivors of the species, there would be no sensible restraint on mechanically allocating the next dollar to the same assets as all of the previous dollars, with obviously dire consequences for returns and hugely increased risks of asset bubble formation, to mention some of the more obvious structural problems associated with this blind form of investing.
More than ever in recent memory, the sclerotic global economy needs an unfettered, ruthlessly competitive network of motivated capital allocators. That is, if we are to prevent greater and more damaging booms and busts than in the past. Active fund managers’ vital role in such an efficient ecosystem is diminished at our collective peril.
By Pierre Marais
Portfolio Manager
