Swedroe: Excuses For Active Managers

March 09, 2015

As sure as the sun rises in the east, the start of each year brings with it a fresh wave of assurances from the “gurus” who appear in the financial media that this year will be a stock picker’s year. And as sure as the sun sets in the west, the year invariably ends with various excuses for why the past year was a difficult one for active managers, and why next year will surely be different.

 

A perfect example of this, one that falls squarely into a category that Jane Bryant Quinn humorously called “investment porn,” is the Real Clear Markets article by Alexander Hart, “Why Active Managers Underperformed in 2014.”

 

We’ll review the various excuses made in the article for why active managers had a bad year, and in so doing, reveal that there really is no wizard behind the curtain.

 

Blaming The Small-Caps

The first excuse is that small-caps underperformed, and many large-cap managers own some small-cap stocks. Thus, their small-cap holdings dragged down their overall performance. While it’s true that many large-cap active managers hold some small-cap stocks, this excuse holds about as much water as a sieve.

 

To start, active managers claim that, unlike indexers, they have the ability to style drift, shifting funds to the stocks or asset classes that will outperform. Unfortunately, the evidence shows this is an advantage “fraught with opportunity”—it’s not one that active managers can systematically exploit. The failure of 80 percent of active large-cap managers in 2014 demonstrates that point.

 

While there have been a few years when small-cap stocks outperformed and a small majority of active large-cap funds (aided by their holdings of small-cap stocks) outperformed Vanguard’s S&P 500 ETF (VFINX), there are more years when small-caps outperformed and a majority of large-cap funds underperformed, despite their advantage in holding some small-cap stocks. (VFINX’s corresponding ETF is the Vanguard S&P 500 ETF (VOO | A-97).)

 

For example, of the last 10 calendar years, small-cap stocks outperformed large-cap stocks in six of them: 2006, 2008, 2009, 2010, 2012 and 2013. During those years, VFINX’s Morningstar percentile ranking was 24, 38, 54, 31, 38 and 44, respectively. The only year of the six when VFINX didn’t outperform a majority of active funds was 2009. The fund’s average ranking for the six years was 38.

 

Despite their advantage in holding some of those outperforming small-cap stocks, an average 62 percent of active large-cap managers underperformed in years when small-caps outperformed. And these figures contain survivorship bias.

 

Poorly performing funds are closed or merged out of existence. If this bias were eliminated, the relative performance of active managers would look even worse, and perhaps we wouldn’t have even a single year when VFINX underperformed a majority of the active large-cap funds.

 

What About The Small-Cap Managers?

We can also expose this excuse as a sham by looking at the flip side of Alexander Hart’s argument. Just as large-cap active managers would be hurt if they own small-cap stocks when they underperform, small-cap active managers who hold some large-cap stocks would benefit from the outperformance of those large-cap stocks.

 

Thus, we should expect to see small-cap active managers outperforming a small-cap index fund in such periods, as they benefit from their holdings of large-cap stocks. In the four calendar years of the last 10 in which small-caps underperformed—2005, 2007, 2011 and 2014—the percentile rankings of Vanguard’s Small Cap Index Fund (NAESX) were 42, 30, 44 and 14.

 

That’s an average ranking of 33. Despite the advantage small-cap active managers had in those years—the ability to hold some large-cap stocks—NAESX still outperformed two-thirds of its active rivals. (NAESX’s corresponding ETF is the Vanguard Small-Cap ETF (VB | A-99).)

 

I would add that there was only a single year in the last 10 (in 2008, NAESX’s percentile ranking was 53) when a majority of active small-cap managers outperformed a benchmark index fund. Again, keep in mind these results contain survivorship bias. It’s possible, if not highly likely, that there wasn’t a single year in which the majority of actively managed small-cap funds outperformed. One excuse exposed.

 

Foreign Stocks Lagged …

The second excuse for active management’s poor record is that international stocks underperformed in 2014. That’s a problem for active managers of domestic funds who style drift and own international stocks.

 

Of course, those same active managers are the very ones who claim the freedom to search the globe for the best opportunities is an advantage, allowing them to go wherever the best returns are. If it’s truly an advantage, then it shouldn’t matter that international stocks underperformed because these gurus would be shifting assets to the best performers. Let’s go to our trusty videotape:

 

Over the last 10 calendar years (2005-2014), the MSCI EAFE Index outperformed the S&P 500 a total five times: 2005, 2006, 2007, 2009 and 2012. If the theory espoused by Alexander Hart holds true, we should expect to see the majority of actively managed domestic funds outperform during those years because many of them benefit from owning some international stocks.

 

Unfortunately, during those years, Vanguard’s 500 Index fund produced an average percentile ranking of 45. Thus, even with the known survivorship bias in the data, in the years when international stocks outperformed, VFINX still managed to outperform the majority of active managers in its category.

 

As with most myths, this one contains a grain of truth, allowing it to persist. In the five other years when the S&P 500 outperformed the MSCI EAFE, VFINX produced an ever-higher percentile ranking of 30. In relative terms, the fact that some domestic funds own international stocks did help their relative performance in years when international stocks outperformed. However, that advantage wasn’t sufficient to allow a majority of active managers to outperform—it’s just that a smaller percentage underperformed.

 

Unexpected Interest Rates

The third excuse offered by Hart involves a big surprise to the markets. While almost everyone was forecasting rising interest rates in 2014 (100 percent of economists in a survey got that one wrong), rates actually fell. Hart noted that active managers had been positioned for rising rates. As a result, they underweighted the sectors (such as utilities) that benefited from the fall in rates.

 

This is as flimsy an excuse as one can create. Isn’t the supposed advantage of active managers that they can protect you from the unexpected? After all, if something is expected, then that expectation is already built into prices. Unfortunately, the evidence indicates that much of the returns to stocks result from unexpected events. And there is no evidence of an active manager’s ability to accurately forecast the unexpected. That’s another reason, besides their high costs, active managers fail to outperform with great persistence. Besides, as I’ll explain in the next section, in aggregate, active managers cannot overweight or underweight any stock, sector or asset class.

 

Investor Flows Caused Underperformance?

The fourth excuse offered in the article also doesn’t stand up to scrutiny. Hart argues that because investors were fleeing actively managed funds and instead pouring money into index funds, this performance chasing resulted in the outperformance of index funds.

 

Investors adding more money to passively managed funds than actively managed ones is a trend that’s been going on persistently for decades as investors, both individual and institutional, become more aware of—and fed up with—the persistently poor performance of actively managed funds.

 

If this is truly a problem for active investors, it’s only likely to continue to get worse and worse as the movement away from active investing continues.

 

But here’s another important fact, since all stocks must be owned by someone. Passive investors simply own the market-cap weighting of each stock in an index. Active managers in aggregate must also own the same market-cap weighting of each stock.

 

In other words, if a certain stock makes up 1 percent of the total market cap, index funds will have 1 percent of their holdings in that stock. That also means, in aggregate, all active managers must have 1 percent of their holdings in that stock as well. Indexers, or passive investors in general, don’t underweight or overweight any stock or asset class. Thus, it cannot be that, in aggregate, active investors do either.

 

Now, it’s possible that actively managed mutual funds may have underweighted a particular sector or asset class. But all that really means is another group of active investors (such as hedge funds or private equity) overweighted the same sector.

 

Putting Aside The Excuses

Hart specifically stated that 2014 was unusual because a year when indexing outperforms is infrequent. Nothing could be further from the truth. Anyone who reviews the biannual S&P Active versus Passive Scorecard (SPIVA) would know that. Every year, without fail, the majority of active managers in almost every asset category will underperform, whether it’s a bull or bear market.

 

It only takes a bit of simple arithmetic to demonstrate that must be true. And that is exactly what Nobel Prize-winner William Sharpe did in his paper, “The Arithmetic of Active Management.”

 

Sharpe provided the analysis that makes clear why active managers underperform. While in aggregate they earn the same gross returns as passive investors, they also have higher costs. Thus, they must earn lower net returns, the only kind you get to spend.

 

Sharpe concluded: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”

 

He also explains that statements attempting to provide explanations for why active management will outperform are “made with alarming frequency by investment professionals. In some cases, subtle and sophisticated reasoning may be involved. More often (alas), the conclusions can only be justified by assuming that the laws of arithmetic have been suspended for the convenience of those who choose to pursue careers as active managers.”

 

Every year, active managers come up with a variety of excuses for their failures. Sometimes it’s the same old excuses, and sometimes they come up with new ones, like rising correlations. None of them are valid.

 

Summary

In 1998, Charles Ellis wrote his outstanding book, “Winning the Loser’s Game.” In it, he demonstrated that while it certainly is possible to win the game of active management, the odds are so poor that it’s not prudent to even try.

 

In our new book, “The Incredible Shrinking Alpha,” my co-author Andrew Berkin and I explain that while Ellis was certainly correct to call active management a loser’s game 17 years ago, there are four major themes conspiring to make the quest for alpha an ever-more frustrating one.

 

For example, 20 years ago, about 20 percent of actively managed mutual funds were generating statistically significant alpha. Two recent studies both found that the figure today is about 2 percent. And that’s before the impact of taxes. And taxes are often the largest expense of actively managed funds. How many investors would willingly play a game where the odds of winning are so low?

 

Yet, so many investors continue to do so. It’s the triumph of hype, hope and marketing over wisdom and experience. Remember, just as at the crap tables or roulette wheels in a Las Vegas casino, as Ellis noted, the surest way to win a loser’s game is to choose not to play.

 

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.

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