Active Management Really Works
June 23, 2009
Understanding the debate
There is no debate more heated in the investment community than the dispute about active versus passive management. However, the context for the debate is somewhat limited. The vast majority of investors are buy-and-hold, strategic (passive) asset allocators, meaning they devise asset allocations for their portfolios that typically do not change over time. Usually the modifications made are called “lifestyle” changes, which typically occur as an investor gets closer to retirement and their portfolio asset allocation is altered to be more conservative to provide a more stable asset base for anticipated portfolio withdrawals. Once the portfolio is reallocated for retirement, there may be no further changes to asset allocation policy for the lifetime of the investor.
The portfolio asset allocation becomes the “target” allocation for the portfolio, and most investors are taught to rebalance the portfolio back to the fixed target percentages for each asset class based on either a calendar method or a rules-based method. As we have seen in earlier chapters, the academic and theoretical basis for this strategic, buy-and-hold approach has its roots in Modern Portfolio Theory and the Capital Asset Pricing Model. Because markets are considered to be efficient, and investors are considered to have perfect economic foresight, there is no need to change the asset allocation of client portfolios because the assumption is that today’s capitalization-weighted allocation of global markets is always efficiently priced.
However, it is somewhat baffling that in the practical world of individual investors and investment professionals, this insistence on buying and holding asset classes due to efficient markets does not translate to the level of investing each asset class in the portfolio. The majority of investment advisors choose to use active fund managers when they invest the asset classes they have selected for their clients, as opposed to passively investing in index funds for each asset class. Apparently financial advisors believe that active fund managers, in the form of mutual fund or separate account managers can outperform their specific asset allocation benchmarks, which ironically is a strong statement that markets are not, in fact, efficient.
Therefore, one conclusion that can be reached about this inconsistent state of affairs is that many investors believe that fund managers can beat the performance of efficient markets, but they, themselves, cannot. Why? Perhaps the two groups are somehow genetically wired so that only one can actively manage money. It is very ironic that many financial advisors will vehemently deny that they are active managers when it comes to asset allocation strategy, while at the same time vehemently defend their use of the active fund managers that they use to invest client portfolios. It is possible that in the case of some investment advisors their insistence on using active managers for the investment of asset classes is due to a very practical need to differentiate their services from other advisors. After all, if everyone is a passive, buy-and-hold, strategic asset allocator, then being able to sell “better” active managers at the asset-class level to prospective new clients becomes very important.
There is a further irony to the insistence of investors on using active fund managers for the investment of asset classes, while also insisting that they (the investors) should be passive in their asset allocation decisions regarding asset classes. The academic world has been studying the ability of active fund managers to outperform passive indexes since the late 1960’s, and the results have not been kind to the idea that active managers can outperform. In fact, dozens of studies have shown that the average active fund manager cannot outperform either the Capital Asset Pricing Model, or a passive benchmark of stocks. The results of these studies have been well publicized in the media, and informed investors are well aware of them. In addition, the proponents of index fund investing often repeat the message that active management does not add value compared to passive management. These venerable and wise investment sages (John Bogle, the founder of Vanguard Investment Group, is a good example) are held up to be friends of the consumer who understand, better than the rest of us, why active management does not work. Over and over again, the message is that active management is a waste of time and money, and investors should simply own the market itself. It is a message that permeates the consciousness of professional and non-professional investors alike. Yet, the majority of investors still utilize active managers to invest the various asset classes in their strategically asset-allocated portfolios. Clearly, while the average fund manager may trail the passive indexes for each asset class, investors feel that their fund manager will not.
It is true that the majority of academic studies conclude that active management does not add value for investors. However, a closer look at how many studies were conducted reveals several flaws in their methodology that are not as well-known as the accepted conclusion about active versus passive management. For example, many of the earlier studies were based on a small universe of actively managed funds, probably because the databases to analyze large amounts of fund data were not yet available. The earliest studies evaluated less than 200 funds, hardly enough to be a meaningful sample. Another problem with the studies had to do with choosing a benchmark. Large groups of style-specific funds were often compared to a broad market benchmark like the S&P 500 Index, which often led to conclusions that were colored by investment style as opposed to active management itself. Perhaps the biggest problem with the historical studies that attempt to answer the question of whether or not active managers can add value to portfolio performance above the expected returns as determined by the CAPM model, or broad market benchmarks, is that these studies look at one dimension of return, which is called tracking error. They compare portfolio and index performance without making any qualitative assessment about the securities that are owned in each.
What if an academic study proved that individual fund managers actually do outperform their benchmarks with persistence in a statistically significant way? If truly active fund managers, as opposed to closet indexers, were shown to be able to beat their style-specific benchmarks, then perhaps the idea that investors should put their brains to sleep because markets are efficient would become less attractive. As it happens, two researchers at Yale University have conclusively shown that the most active fund managers actually do significantly outperform their style-specific benchmarks. Their study is important because it helps to allay the fear that using judgment and experience in constructing portfolios is futile.
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