Many people argue in favor of active management over passive management because they believe that "experts" actively managing a portfolio will be able to outperform the relevant passive alternative. The wisdom of this view has been debated for decades. We do not plan to review the arguments in this issue, but do note that the experiences of 2008 will likely lead to increased focus on the challenges of active management—and the benefits of allocating at least the core portfolio to a well-structured passive portfolio. Given current equity valuations, we think the time is right for investment committees to revisit their allocations to a well-structured passive strategy.
Active Management In 2008
The dust is still clearing on 2008—a horrendous year for the capital markets. Hidden within the dreadful returns of the market averages was the relatively uninspiring performance of active managers. By one measure, it was the worst calendar year of performance for a mainstream portfolio of active managers going back to 1990—exactly when manager excess returns were needed most!
Hedge funds, arguably the ultimate active management vehicle, fell 21.0% in 2008 as measured by the Hedge Fund Research Institute's Hedge Fund of Funds Composite Index—virtually matching the -22.1% slide of the traditional 60/40 stock/bond "balanced" portfolio. This invites the question: Where was the manager skill, the ability to sidestep the worst of the equity markets? Free from the constraints of traditional manager guidelines, hedge funds can short securities (they are, after all, hedge funds!), employ leverage, and trade derivatives. Excluding government bonds, shorting was 2008's only path to positive returns. Perhaps the hedge funds were squeezed by the credit contraction. As Keynes once quipped, "The market can stay irrational longer than you can stay solvent." This especially rings true for the leveraged, but that doesn't provide much comfort for the hedge fund investor.
Interestingly, traditional managers with no leverage and only long exposure to mainstream stocks and bonds returned similarly poor performance. As Table 1 shows, the median active manager in 2008 underperformed the commonly used benchmark in four of the six core asset categories.
The poor performance of active managers is not without precedent. As Table 1 shows, it has happened a number of times in the past 19 years. Core plus fixed-income underperformed the BarCap Aggregate by a whopping 8 percentage points in 2008—its worst year ever. Small-caps had their second-worst year with the median manager trailing the Russell 2000 Index by 2.6 percentage points. International equity active managers posted their third-worst year since 1990, while large-cap value managers posted their fifth-worst year. And these numbers are before fees.
The impact of the active management shortfall in 2008 is more sobering when we combine these active and passive asset class results into a classic 60/40 stock/bond portfolio. Under this mix, we find that a portfolio of median active managers trailed a passively implemented portfolio by 3.4 percentage points, before fees. This shortfall more than doubled the previous worst calendar year (1998) when the active implementation would have only cost 1.4 percentage points in relative performance (again before fees!).
Granted, making an assertion about active management with just one year of data is contrary to the "long-termism" embedded in our investment culture. However, the cumulative hurdle of higher fees becomes relentless over longer time periods.