Why Active Management Comes Up Short
We all know that indexing is cheaper than active management, in which a fund manager selects specific assets for investment. But the question is why has passive investing been so successful during the past few years? Asked differently, why has active management — especially since the financial crisis — had such a dismal run?
Theories abound — none are completely dispositive, but all have some merit in explaining the reasons for underperformance. Let’s consider each:
• Too much competition: As Charles Ellis, a former member of both the Yale endowment fund and Vanguard’s board (our podcast is here), observed:
Gifted, determined, ambitious professionals have come into investment management in such large numbers during the past 30 years that it may no longer be feasible for any of them to profit from the errors of all the others sufficiently often and by sufficient magnitude to beat market averages.
Hence, even a market that is not perfectly efficient quickly eliminates almost all of the potential alpha, or above-market returns. Being smart, hard-working and savvy may create only a short-lived advantage -- or none at all.
• Main Street has given up on Wall Street: The average retail investor over the past 15 years or so has endured the dot-com boom and bust, the housing bubble, a full-blown financial crisis followed by an awful stock-market crash, a whipsawing commodities market and almost zero returns on cash savings. These investors now suffer from finance fatigue and have little interest or faith in anything that Wall Street is selling.
Is it any surprise that many investors, after having been so badly beaten up, have decided to take their ball and go home? And by ball, I mean capital, and by home, I mean low-cost index funds.
• Stricter enforcement of insider trading laws: There’s been a run of finance-industry scandals, a very short list of which ranges from Bernie Madoff’s Ponzi scheme to gaming closing times for mutual funds to spinning initial public offerings. In the past few years, the Justice Department seems to have rediscovered insider trading.
Why? Because it’s a) relatively simple to prosecute; b) there’s often lots of unambiguous evidence and; c) the odds of a conviction are high.
• Internet has leveled the playing field: How much information that once was the province of a select few is now in the hands of all?
It was a huge game-changer when Yahoo message boards begin to fill up with posts from people doing legwork on individual companies. When someone reported that XYZ Tech’s employee parking lots were filled with cars 24/7 — including weekends — anyone paying attention understood that business was booming and that sales were going to beat investor expectations. For the few who grasped that, this was a period of large trading profits.
This advantage exists only when a small number of people know what a large number of people are going to find out too late to act on. Wheneveryone knows, the advantage disappears.
• Too much capital chasing too little alpha: According to Nobel winner William Sharpe, there is only a finite amount of alpha, implying that trading is a zero sum game. Thirty or so years ago, there was greater information asymmetry. When pension and endowment funds were smaller and less invested in alternatives (like hedge funds, venture capital and private equity), there was more alpha to be divvied up among fewer players.
• Alpha is really only factor-based investing: What was once believed to be outperformance might be explained by specific portfolio characteristics, such as momentum, earnings quality and other features. Once these so-called factors and any additional risk are accounted for, the alpha all but disappears.
Nobel Prize winner Eugene Fama and Kenneth French developed the five-factor asset pricing model in which they found that various factors can account for “between 71% and 94% of the cross-sectional variance of expected returns.” In other words, alpha is more the result of these specific factors than most investors realize.
Other theories abound: Active managers have failed to adapt to the unique circumstances of the Federal Reserve’s monetary policy in response to the financial crisis; it’s easier than ever to put together complex, math-driven investment portfolios that would have been impossible in the past; the rise of passive investing is only a temporary shift and eventually the cycle will turn.
I suspect that the changes we have witnessed are of a permanent nature -- active management might again have its day in the sun, but those days will be fewer and further between than they have been in the past.