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Overview

Since the onset of the global financial crisis in late 2007, there has been an increasing number of papers and articles in financial journals and the popular financial press pointing out that actively managed investments of all types (stocks, bonds, alternative assets) did not fare well relative to passive investment strategies. In this American Century Investments Viewpoint, we provide four fundamental reasons why those who have forecast the demise of active investment management are mistaken, in part due to one of the most common errors of behavioral finance—the Recency Effect (placing undue emphasis on the recent past to form future expectations).

Reason #1: 2008 Was an Extreme Tail Event

Much of modern investment theory and practice is based on statistical analysis combined with expert judgment and insight. The spread—or distribution of possible returns around an expected value—and correlations of returns between various investments are two examples of statistical tools professional money managers use on a regular basis as part of their decision-making and stock-picking processes.

In statistical parlance, a “tail event” describes some rare, very unusual but nonetheless to be expected event. In the vernacular, these extreme events have many names: the “100-Year Flood,” the “Big One” (for San Francisco residents who worry about a sequel to the massive earthquake that occurred in 1906) or a “hot hand” (if you find yourself winning at the blackjack table in a way that seems to defy the odds). These events lie at the upper or lower tails of what history and experience would predict are possible outcomes given the overall distribution of rainfall, tremblers or general skills of blackjack players.

2008 was a tail event in nearly all financial markets, and unfortunately, one on the lower tail of annual returns. The chart below takes one equity index, the Standard & Poor’s 500 Index of large-cap core stocks, and plots estimates of annual total returns for this index over 81 years from 1928 (just before the infamous 1929 market crash) to last year. The 81 years of estimated returns are plotted as a histogram to illustrate the frequency of returns by 10% increments ranging from -50% to -40% on the lower tail, to 50% to 60% on the upper tail. Within each increment, the years are rank-ordered vertically from the lowest return year at the bottom to the highest return year at the top in that category.

As the chart illustrates, 2008 was the second worst year for the S&P 500 in the 81 years based on Professor Damodaran’s estimates for the long-term historical returns. Only 1931 was worse. That covers a broad expanse of history from the perspectives of market conditions, economic outlooks, and political fashions in the U.S. From a statistical perspective, with 79 of the 81-years since 1928 providing better returns than last year, 2008 falls into lowest 2.5% of returns over the 81 year period, making it a bona fide lower “tail event” in the history of modern investing. (Some readers may be surprised that years with well-known market crashes didn’t fare as badly in this analysis. The reason is these crashes, such as 1929 and 1987, occurred late in the year and were preceded by substantial run-ups of prices. In comparison, 2008 was a year that went downhill from the start to the end of the year).

Unfortunately, tail events, in whatever form they take, can lead to major misperceptions. For example, that blackjack player with the hot hand might conclude that skill alone is the explanation for his success and end up betting the house with all of his previous winnings, only to wind up with a series of losing hands that give back everything he won or more. Or imagine what must have passed for reasonable logic regarding the future of the city of San Francisco right after the 1906 quake: “Nice climate and port, but little potential to ever become a major U.S. city given its position on a large and active geological fault line.”

Based on the very negative and unusual market returns in 2008, one misperception which gained traction in the minds of some investors is that active investment management as an investment strategy doesn’t work. A look back at 2008 reveals that, at the height of the market meltdown starting last September, correlations of returns between various asset classes skyrocketed and prices of all assets (except safe havens such as short-term Treasuries) fell in tandem.

But consider the circumstances: There was a global credit crisis where many markets simply ceased trading. This cascaded over to the equity markets, which plummeted. Fear and panic replaced rational pricing and investment decision-making for a brief period. Even the time-tested techniques of active investment management were never expected to work in such a highly unusual and crisis-driven environment. To expect so would be akin to being disappointed that your gutters and downspouts weren’t keeping up with all the rain for the brief period while a violent thunderstorm raged over your home.

Barring the highly unusual tail event that we experienced in last year’s markets, active investment management does work and is a critical tool to achieving your long-term investment goals. In fact, the environment where active investment management does best is the 90% of years between both the extremes on the lower and upper tails of market performance. In the very bad years (or the lower tail, like 2008), no active investment strategy works well. And ironically, active management also struggles in the very good years (the upper tail) not because active management doesn’t work, but because in these years nearly anything works and active management is at a temporary disadvantage to passive strategies simply because of the slightly higher management fees it incurs.

Reason #2: We’ve Had This Debate Before (and Will Again)

Active investment management includes a wide variety of strategies for analyzing and identifying mispriced assets in capital markets (be they stocks, bonds, commodities, currencies, etc.) and building a portfolio that will benefit most when the markets correct for these mispriced assets, thereby delivering superior investment returns. The process is a dynamic and ongoing one where inexpensive stocks are bought, and stocks which have repriced to fair value (or overpriced) are sold. Active managers are given an investment mandate or universe (e.g. mid-cap growth stocks) and challenged to beat a benchmark representing the returns of all stocks in that universe.

Passive investment management—sometimes called index investing—makes no attempt to identify mispriced assets or distinguish between attractive and unattractive investments. A passive manager buys all the stocks in a targeted benchmark (e.g. the S&P 500 for a large-cap core manager), then manages that portfolio to meet (not beat) this benchmark. As a result, fund expenses (such as research costs and turnover) are typically lower than with active managers.

For years, a debate has waxed and waned over the merits of active investment management, given its expenses. While it was the financial academic community which first questioned the efficacy of active management (based on the Efficient Market Hypothesis or EMH), with the advent of passive investment management funds and firms the debate has shifted to the direct comparison of investment performance between these two segments of investment managers.

The original argument (from the academic community), based on the EMH, stated markets are rational and efficient with security prices systematically reflecting their underlying values. In that type of world, how could any active manager generate alpha (even without consideration of expenses)? If they did, it had to be complete luck and could not be sustainable or reproducible. However, after some time, even the academics realized that historical performance of active investment managers could not be explained by efficient markets, even with the introduction and correction for “survivorship bias.” As a result, the academic community created a new field of “Behavioral Finance” to explain why markets and security prices were not always correctly priced— or in other words, a tacit admission that the EMH was flawed.

The current (more nuanced) argument for passive investing deals directly with the impact of active management fees. The argument acknowledges that markets are not fully efficient. It notes that behavioral finance has shown how investors are not fully rational in their decisions. There can be herd behavior (everyone jumping into the same stocks), bubbles, and panics. However, this new argument states that with all the active managers out there, the opportunities to generate alpha are small in number, magnitude and duration before (through the very act of active investing) prices adjust to correct any
mis-valuations. In addition, the small magnitude of these alpha opportunities (in tens of basis points) is completely offset by the additional fees active managers charge their investors. The result of this argument is a kind of blanket (or generalized) conclusion that active management doesn’t pay for itself and, therefore, passive management is a smarter solution.

Unfortunately, this argument (like the one that preceded it based on the EMH) has some serious holes in it. The most important of these holes is that the relative performance of active versus passive investment is highly timeframe dependent. There are historical periods, depending upon your selection of start and end dates, when passive investing strategies beat active investment strategies. And there are other periods when active management strategies clearly outperform.

Not all active managers underperform their passive benchmarks. In addition, how active management fares in general is highly dependent on the current market environment, as the following charts illustrate for active large-cap and small-cap managers relative to two popular benchmarks for these investment strategies.

Another argument for the potential benefits of active investment strategies is the history of return spreads. There has a broad (nearly 10%) and fairly consistent return dispersion between the top vs. bottom quartile of stocks over time that represents a wide opportunity set for active managers to work with. In this opportunity set, they can generate alpha by picking winners and avoiding losers. Passively managed funds invest in all these stocks (winners and losers) by definition.

And, looking deeper than overall broad index returns, certain industries have demonstrated an even broader dispersion of returns (top minus bottom quartile) due to their complexity, lack of analyst coverage, or underlying structural change. The same is true for certain geographical markets, especially outside the developed capital markets of the U.S., Europe, and Japan.

Reason #3: The Growth of Passive Investing

A third argument for the benefits of active investment management goes back to the undeniable success that passive investment strategies have had in garnering assets over the past 25 years. As the chart below illustrates, the huge growth of passively managed funds has created even greater opportunities for active managers to generate alpha since these passive funds blindly buy whatever is defined by their index/ benchmark regardless of whether the stocks are undervalued, overvalued, or properly valued. As more assets under management shifted to passive investment strategies (ironically based on the EMH which even academics have since moved away from), this shift expands the opportunity set for professional active managers to exploit both mistakes made due to behavioral finance among individuals and blind actions by professional passive managers whose only mandate is to match the performance of a benchmark.

Reason #4: We Have Entered a World of the “New Normal”

A number of market commentators and senior investment professionals (such as Bill Gross at PIMCO) have expressed a view that the recovery from the current recession will mark a fundamental change from past recoveries, with lower long-term rates of economic growth and diminished overall market returns. Ian Davis, global managing director for the consulting firm McKinsey and Company, recently published the following comments in an article in the McKinsey Quarterly titled “The New Normal.”

“It is increasingly clear that the current downturn is fundamentally different from recessions of recent decades. We are experiencing not merely another turn of the business cycle, but a restructuring of the economic order. For some organizations, near-term survival is the only agenda item. Others are peering through the fog of uncertainty, thinking about how to position themselves once the crisis has passed and things return to normal. The question is, ‘What will normal look like?’”

One important predicted outcome of the “New Normal” is how this recovery will unfold— how the U.S. economy will behave as a result of the substantial pain caused to households and businesses by our recent financial crisis and recession. Unlike after past recessions where the rate of overall economic growth jumped to 3-4%—based on a combination of growth in the workforce (~1%), labor productivity growth (~2%) and some impacts due to capital productivity based on new technology and innovation (~1%)—the New Normal will be an environment where long-term sustainable growth will average 1-2% in real terms.

Why the forecast decline in long-term economic growth? The reasons include reduced consumer spending, which peaked at 70% of GDP in 2005, along with the growing and high indebtedness of the private sector overall including households and businesses. Add to this the profound impact this latest financial crisis has had on consumers, especially the Baby Boom generation which will begin to reach age 65 in less than two years, in terms of their overall net worth (401(k) accounts, home prices and sense of overall employment security given the dramatic rise in unemployment).

The key point is that company returns in this New Normal environment will continue to be broadly distributed, representing an opportunity space for active managers to create value. While the overall mean for this dispersion of returns will likely be shifted down from the 10-20% range enjoyed for most of the 1980s and 1990s and some of current decade, the range of dispersion will persist. With this shift down in the overall mean of returns, active management will become even more important. An active return of 250 basis points (2.5%) when the overall market is up 20% is good. It makes a meaningful (12.5%) contribution to the overall return of an actively managed portfolio. However, in a New Normal world where the market may be up only 4% in a given year, a much lower 1% active return represents an even more substantial contribution (25%) to overall returns.

Another piece of good news about the New Normal is that it doesn’t imply that the tools, skills, and insights of active management will no longer apply or work. In fact, as noted above on how the contributions of active returns comprise an even greater percentage of overall return in a lower growth, the lower market return makes these skills even more important. To paraphrase the McKinsey article again:

“Through it all, technological innovation will continue, and the value of increasing human knowledge will remain undiminished. For talented contrarians and technologists, the next few years may prove especially fruitful as investors looking for high-risk, high-reward opportunities shift their attention from financial engineering to genetic engineering, software, and clean energy. The result will be an environment that, while different from the past, is no less rich in possibilities for those who are prepared.”

In other words, the New Normal world is likely one where smart stock selection by skilled investment professionals with insight into the fundamentals of individual companies will likely be an important source of value creation for investors.

Summary

Active investment management has recently “taken it on the chin” primarily because of the recent global financial market crisis. However, there are four very good reasons to emphasize active investment management as part of your overall portfolio investment strategy.

1. The first reason is a basic contrarian argument: 2008 was a significant outlier in terms of market returns looking over the past 81 years. Active investment management was never intended to outperform when all the time-tested insights of valuation temporarily failed due to broad financial panic.
2. The second reason looks back in history to note that the active versus passive investment strategy debate has been (and will continue to be) with us for years. Not unlike the ongoing debate in our country between conservatives and liberals, the merits of each argument are highly time dependent and cyclical.
3. The third reason is due to the historical success of passive investment strategies in gathering assets under management. As they have grown, they account for a greater percentage of the market which is not being invested based on fundamental valuation techniques, only index following. This gives active managers more room to exploit mistakes by passive managers who “blindly invest” in the market.
4. The fourth reason looks forward to what our national and global economy will look like in recovery. There are powerful and persuasive arguments that the future will not look at all like the financial markets we’ve become accustomed to over the past 25 years. And in a lower-growth, lower-return environment, active investment management has significant potential to add value over what blind passive strategies can achieve.

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