Swedroe: Goldman’s O’Neill Comes Up Short

Global co-head of Goldman Sachs’ investment management arm tries—and fails—to make the case for active management.

In a podcast interview posted last week, Tim O’Neill, global co-head of Goldman Sachs’ investment management division, warned investors that if passive investing gets too big, the market won't work.

He then added: "So in terms of the size, a market needs both active and passive investing, because if everybody’s a passive investor, there’s no one to buy from. And if passive becomes a certain oversized percentage of the market, the market doesn't function.”

O’Neill, who previously called passive investing “a potential bubble machine,” said that both strategies—active and passive—are necessary. But in the interview, O’Neill admitted: “It’s been a difficult seven years for active investors because the markets have risen so consistently and persistently higher. So most active managers have, net of fees, underperformed the benchmark.”

He went on to describe another “problem” with passive investing: “Of course, it’s all on autopilot. And when you get to periods of misvaluation, over or undervaluation, you need active decision-makers.”

Ulterior Motives?

Before we start unpacking O’Neill’s comments, it’s important to understand that he works for Goldman Sachs, a firm that needs and wants investors to buy into the game of active investing. Goldman Sachs and other Wall Street firms know the odds of active management outperforming its appropriate benchmarks are so low that it’s not in your interest even to play.

However, these firms need you to play so they (not you) can make money. And they earn it by charging high fees for active management that persistently delivers poor performance.

The financial media also wants and needs investors to play the game of active management. The more people they have “tuning in,” the more advertising dollars they stand to earn. When investors become hooked on investment noise (or what author Jane Bryant Quinn called “investment porn”), it produces profits for them. That’s one reason the financial media is filled with articles like the one that discussed the interview with O’Neill.

In short, the interests of the vast majority of the financial media unfortunately are not aligned with the best interests of investors. With that in mind, let’s address some of the points O’Neill made during his podcast.

What If Everyone Indexed?

We begin by considering the following statement: “If passive becomes a certain oversized percentage of the market, the market doesn’t function.” This is another version of the question: What if everyone indexed? (This topic is also addressed in detail in my book, “Wise Investing Made Simple.”)

It’s certainly true that if everyone indexed, society would lose the benefits that active managers provide. The price-discovery activities of active managers improve the accuracy of financial prices and allow for an efficient allocation of capital. Thus, passive investors don’t want everybody to become one. However, because we are so far away from that being a reality—for now and for the foreseeable future—it’s just a theoretical issue.

Today, perhaps 40 percent of institutional assets and just 15 percent of individual assets are invested in passive strategies. And while the trend toward passive investing is strong (and in my view, inexorable), perhaps about 1 percent of assets shift into passive strategies each year.

A Massive Transfer Of Wealth
Now let’s consider the cost of the societal benefits provided by active managers. In his 2008 paper, “The Cost of Active Investing,” Kenneth French found that investors spend 0.67 percent of the aggregate value of the market.

He calculated that, if all investors paid passivelike fees and there were no hedge funds, the cost of investing in 2006 would have been just 0.09 percent. The bottom line is that, in aggregate, French estimated active investors are engaging in a massive transfer of wealth—about $80 billion annually (based on a market capitalization at the time of about $12 trillion).

Despite the enormity of these costs, French’s estimate is too low. His calculation doesn’t take into account the incremental burden of the generally higher taxes incurred by active investors with taxable holdings. The good news for passive investors is they get to be “free riders,” benefiting from the activities of active managers without paying the costs.

And importantly, I think it’s safe to say we don’t need the more than 8,000 actively managed mutual funds that exist today, or the more than 10,000 hedge funds currently in operation, to keep markets efficient. Surely the figure actually required to keep markets efficient is a lot smaller.

Remember, the markets were found to be pretty efficient in the 1950s, when there were perhaps 100 mutual funds and the hedge fund industry was in its infancy. How many Renaissance Technologies, SAC Capitals, D.E. Shaws and Warren Buffetts do you need to keep markets functioning in an efficient manner?

The bottom line is that, yes, we surely do need some level of active management to ensure markets function properly. However, we don’t need something anywhere near the size of the industry we have today.

Active Management Is In A Slump

We’ll next address this statement from O’Neill: “It’s been a difficult seven years for active investors because the markets have risen so consistently and persistently higher. So most active managers have, net of fees, underperformed the benchmark.”

While O’Neill is correct that active managers in all asset classes have persistently underperformed throughout the bull market, it’s a complete myth (another one that Wall Street and the financial media need you to continue to believe in) that active managers outperform in bear markets.

As numerous academic papers on the subject have found, the evidence is quite to the contrary. We’ll look at the results of two such studies.

Active Management In Bear Markets

To test the hypothesis that active managers outperform in bear markets, Vanguard examined active fund returns for the period 1970 through 2008. The firm analyzed the seven periods during that time in which the Dow Jones Wilshire 5000 Index fell by at least 10 percent, and the six periods during that time in which the MSCI EAFE Index fell by at least 10 percent. The results were published in a 2009 issue of Vanguard Investment Perspectives.

Despite acknowledging survivorship bias—poorly performing funds disappear and are not accounted for—Vanguard found:

• It does not matter whether an active fund manager is operating in a bear market, a bull market that precedes or follows a bear market, or across longer-term cycles. The costs that arise from security selection and market timing prove a difficult hurdle to overcome.
• “Success” in a bear market can be explained, at least in part, by style exposures. For example, during the bear market of September 2000 through March 2003, the Russell 1000 Value Index fell just 21 percent, while the U.S. total market lost more than 42 percent. Once active funds were compared with their style benchmarks, there was no consistent pattern of outperformance. Past success in overcoming this style exposure hurdle doesn’t ensure future success. The degree of attrition among winners from one period to the next indicates that successfully navigating one, or even two, bear markets might be more strongly linked to simple luck than to skill.

Vanguard concluded: “We find little evidence to support the purported benefits of active management during periods of market stress.”

Vanguard’s conclusion is confirmed by the findings from Standard & Poor’s 2008 Indices Versus Active (SPIVA) scorecard. Standard & Poor’s concluded: “The belief that bear markets favor active management is a myth. A majority of active funds in eight of the nine domestic equity style boxes were outperformed by indices in the negative markets of 2008. The bear market of 2000 to 2002 showed similar outcomes.”

As the evidence demonstrates, the belief that active managers are likely to protect investors in bear markets is simply another myth propagated by Wall Street. It also shows very clearly the fallacy in O’Neill’s following comment: “Of course, it’s all on autopilot. And when you get to periods of misvaluation, over or undervaluation, you need active decision-makers.”

Finally, we can consider the performance of Goldman Sachs’ own active mutual funds.

Has Goldman Been Adding Value?

In a May 2015 article for Advisor Perspectives, I analyzed the performance of Goldman Sachs’ actively managed equity funds. I compared the performance of Goldman Sachs Asset Management’s (GSAM) to similar offerings from two prominent providers of passively managed funds, Dimensional Fund Advisors (DFA) and Vanguard. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)

To keep the list to a manageable number of funds, as well as to make sure I examined long-term results through full economic cycles, my analysis covered the 15-year period of April 2000 through March 2015. I used the lowest-cost share classes when more than one class of fund was available for the full period. In the cases where GSAM had more than one fund in an asset class, I employed the average return of the funds in my comparison.

The table below shows the performance of 14 Goldman Sachs funds in 10 asset classes.

Following is a synopsis of the most important takeaways from the data in the table above:

• In the nine asset classes for which there are comparable DFA funds, the GSAM funds provided a higher return in just one, U.S. small value.
• In the eight asset classes for which there are comparable Vanguard funds, the GSAM funds provided a higher return in just three of them.
• A GSAM portfolio equal-weighted in the nine asset classes for which there are comparable DFA funds returned 6.0 percent. The average expense ratio was 0.89 percent. An equal-weighted portfolio of DFA funds returned 8.0 percent a year, outperforming the comparable GSAM portfolio by 2.0 percentage points a year. Moreover, the average expense ratio of the DFA portfolio was only 0.33 percent. The underperformance of the GSAM funds was about four times greater than the difference in expense ratios. In supposedly inefficient asset classes where active managers contend they have an advantage, specifically international small and emerging markets, GSAM funds underperformed.
• In the eight asset classes where comparable Vanguard funds were available, an equal-weighted portfolio of funds from GSAM returned 6.4 percent. Its average expense ratio was 0.86 percent. An equal-weighted Vanguard portfolio returned 6.9 percent, 0.5 percentage points more than the GSAM portfolio. The average expense ratio for the Vanguard portfolio was 0.13 percent. In this case, the higher expenses of GSAM’s funds explained more than 100 percent of the difference in returns.

Goldman’s Own Words of Advice

I think a fitting conclusion to this piece is the following. In 1996, Philip Halpern was the chief investment officer of the Washington State Investment Board (a large institutional investor). He and two of his co-workers wrote an article on their investment experiences.

They authored it because their experience with active management was less than satisfactory and they knew, through their attendance at professional associations, that many of their colleagues shared, and therefore corroborated, their own experience.

Their article included this quotation from a Goldman Sachs publication: “Few managers consistently outperform the S&P 500. Thus, in the eyes of the plan sponsor, its plan is paying an excessive amount of the upside to the manager while still bearing substantial risk that its investments will achieve sub-par returns.”

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.