March 26, 2013

Active vs. Passive Index Investing

After over a decade in the investments business I can honestly say that active management (specifically security selection...I have a different view on asset allocation) does not outperform passive management. Most portfolio managers and investment firms do nothing but suck up client assets with fees. They put on a sophisticated show, but at the end of the day most managers underperform the market by the amount of fees they charge, if not more.

The investments business is first and foremost a marketing business. The pageantry surrounding the investment managers is simply part of the marketing. Of course, most investment managers believe their own hype and think they actually can outperform the market. But when it comes down to it, the numbers don't lie. Most managers can discuss complex economic developments, dive deep into a company's financials, tear-apart corporate management spin, and so on, but this 'sophistication' doesn't translate into outperformance, for the most part.

It's all a charade. 

The academic evidence shows this. Standard and Poors itself puts out a regular report comparing the aggregate performance of active investment managers with the performance of passive benchmarks. While at times the active managers outperform, this outperformance is usually short-lived.

Of course, with the worldwide growth of ETF assets investors and advisers are clearly beginning to understand that active management is a farce. After two massive bear markets (one in the early 2000s, one in 2008/2009) during which active managers failed to protect from the downside, many individual investors began to make the switch into ETFs from actively managed mutual funds.

While the S&P research suggests that in aggregate active managers cannot outperform, some argue that this methodology to evaluate active vs. passive management is flawed. Specifically, they suggest that aggregating active management performance doesn't disprove that select individuals can outperform. Moreover, the aggregate active manager universe doesn't distinguish between investment managers that are stock-picking with conviction for low fees vs. managers that are 'closet indexers' and charge high fees. In fact, history has shown that there are a few managers that can add value consistently over time. Warren Buffett and Peter Lynch are examples. 

Warren Buffett's track record (via Berkshire Hathaway) is below. You can see that it has fairly consistently outperformed the S&P 500 over its history. So isn't this proof that it IS possible to outperform the market?


Maybe, maybe not. Berkshire Hathaway's performance proves that it is statistically possible for a person (or entity) to outperform the stock market on a regular basis, but it doesn't prove that active management works or even was the cause of this outperformance. One has to consider that out of the tens of thousands of portfolio managers throughout the world, there is a statistical probability that at least a couple will have impeccable track records. Just as it is possible that someone, somewhere in the world can roll a six dozens of times in a row, it is possible that someone can outperform a broad benchmark dozens of years in a row. 

Warren Buffett is no dummy. So if there is someone who can outperform the market he would be the guy. But it is entirely possible that his luck - like many other very smart portfolio managers - is simply mis-attributed as skill. After all, with the ever-changing and infinite number of business and economic variables out there how can one stay on top of their investment theses without a bit of luck? 

To be fair, a great case can be made for active management - at least during certain types of market environments. According to Goldman Sachs, it becomes easier for someone to outperform the market under the following conditions:

1. Correlations are low or falling.
2. P/E ratios are contracting
3. Over a long time-period
4. When the fund and fund manager are allowed to deviate significantly from the benchmark

To provide a balanced view, I am linking a report by Goldman Sachs called 'Rethinking the Active vs. Passive Debate'. While I am still very cynical about mistaking someone's luck with skill, I do think GS makes a good case to show that there may be some merit to active management.

Regardless, my experience speaks for itself. The vast majority of active managers attempting to outperform via security selection cannot outperform their benchmarks on a consistent basis.