There are many well-known anomalies in finance. The most notable of these anomalies include the momentum effect, the low-volatility effect (in which high-volatility stocks produce lower returns on average than low-volatility stocks) and the poor performance of IPOs, penny stocks, stocks in bankruptcy and small growth stocks with low profits.
But perhaps the biggest anomaly is why the majority of investors—both individual and institutional—continue to favor actively managed funds when there is an overwhelming body of evidence demonstrating that, even though active management is a game that’s possible to win, the odds of outperformance are so poor that it’s not prudent to try.
That evidence, and the logic associated with it, is why author Charles Ellis called active management the loser’s game. In his 1998 book, “Winning the Loser’s Game,” Ellis explained that the surest way to win a loser’s game (such the craps table or the roulette wheel in a Las Vegas casino) is to choose not to play.
It’s also why Warren Buffett offered this advice in his 1996 annual letter to Berkshire Hathaway shareholders: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”
Explaining Active Management’s Popularity
Ron Bird, Jack Gray and Massimo Scotti—authors of the 2013 study, “Why Do Investors Favor Active Management To the Extent They Do?”—sought to understand why investors place such a large proportion of their funds with active equity managers, given the discouraging evidence on active management’s ability to add net value.
One obvious explanation for favoring active management is that investors may be unaware of the peer-reviewed evidence on the very low probability of net outperformance and successful manager selection. They may also be unaware of certain biases in the data, such as survivorship and incubator bias. And lack of knowledge can be exacerbated by media advertising, which favors active management.
To further examine this issue, the authors conducted two online surveys, one of chief investment officers (CIOs) of predominantly large Australian pension funds and another of asset consultants. They found that, in general, CIOs and consultants do attempt to make decisions in a rational, evidence-based framework. However, their attempts are undermined by other forces. Despite the evidence, 86 percent, 82 percent and 77 percent of small, medium and large plan assets, respectively, were actively managed. And half of all plans were completely actively managed.
Following is a summary of the authors’ findings:
- Agent Influences: External agents, especially consultants but also a fund’s fiduciaries and investment staff, have conflicts of interest. Unfortunately, it’s not in the business interest of consultants to recommend passive strategies. The authors noted that one consultant surveyed stated: “The case for passive is strong. I would like to use it more but am not empowered to by our business model.” Another observed that “when practicing as a consultant, [I] was bluntly told by senior management that recommending passive management was not good for business.” For pension plans that used consultants, the average weight of actively managed assets was 83 percent versus 78 percent for those that didn’t. Similarly, for plans that used consultants, just 18 percent defined themselves as “extremely passive.” The figure for “extremely passive” plans that didn’t use consultants was 33 percent. The conflict of interest also holds for internal staff, because “much of their work involves selecting and monitoring active strategies. Active managers capitalize on this bias by ‘servicing’ clients, something that index funds, which necessarily compete on costs and execution, can ill afford to do.”
- Behavioral Factors: An all-too-human trait is overconfidence. Thus, while they acknowledge the low likelihood of winning the quest for alpha, decision-makers believe that somehow they will be one of the few who succeed in choosing an active manager that outperforms. In other words, they live in Lake Wobegon, where everyone is above average. The survey found that about 70 percent of pension plans reported they could consistently choose top-quartile performers. Unfortunately, the evidence demonstrates that few people, if any, actually have this ability.
The illusion of control provided by active management can also push decision-makers toward excessive levels of trading activity. A third behavioral trait that can lead to choosing active management is the excitement of “gambling.” One survey respondent was brutally honest. He stated: “I enjoy punting on the share-market. I know I would be much better off being passive! It’s a bit like eating McDonalds—I know it’s bad for me, but still I eat it.”
Society strongly favors proactivity in all areas, and sees passivity as unacceptable. Funds and their managers must be seen to be doing something. The authors noted: “In no other field of human or organizational endeavor does it pay to be passive. Indeed, because passivity is commonly seen as the epitome of indolence and irresponsibility, boards may adopt the ‘common-sense’ imperative that passive managers don’t do any work for the fund. This is exacerbated in Australia by competition in retirement savings, which encourages funds to try to outperform each other through a search for alpha.”
Decision-makers influence behavior. One respondent stated: “I know the evidence, but if I suggested passive to my board they’d fire me.” And many boards are driven by consultants who have a vested interest in active management.
Because many respondents are probably aware of the weak rational support for active management, they play a “blame game” that further hinders objective decision-making. Said another way, hiring active managers gives them someone to blame if things don’t turn out well. One survey responded stated: “I really don’t know why I have so much [active management] when over 12 years they’ve added nothing.”
The authors summarized their views stating: “Although in principle, formal governance structures clarify roles and responsibilities, in practice decisions are made in ways that support the psychological and financial interests of the agents, including trustees, internal investment staff, asset consultant, and managers. The complexity and interconnections of the reasons for favoring active management are unlikely to yield to simple solutions. Most fundamentally, funds do need more technically adept and independent trustees with the time, temperament, skill, and commitment to understand and act on the active/passive decision in the best economic interests of the principals.”
Until that happens, the anomaly of pension funds favoring active management will persist, despite the evidence demonstrating that it’s a loser’s game.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.