"Active Managers Trail Benchmarks in 2016" proclaims a recent article in Investment Executive. Even more worrisome is the fact that according to a story in The Wall Street Journal, about 82 per cent of all active U.S. funds trailed their benchmarks over the past 15 years. The numbers are similar in Canada, as well. No wonder the number of ETFs listed on the Toronto Stock Exchange has more than doubled since 2011.
Why is it almost impossible for reported numbers to show that active managers beat benchmarks? But beyond that, what may make it actually difficult for active managers to outperform benchmarks?
With regards to the first question, the S&P Indices Versus Active Funds (SPIVA) reports, on which the Investment Executive and The Wall Street Journal based their reporting, do not compare apples with apples. They group together closet indexers as well as narrowly focused funds, and given that about 40 per cent of mutual funds in Canada and the United States are closet indexers, the numbers are biased against showing an outperformance of active managers. Almost half of the universe of mutual funds, being closet indexers, will never outperform their benchmarks; in fact, after fees, they will underperform.
There is a simple explanation why so many mutual funds are closet indexers. Conflicts prevent portfolio managers from doing the right thing, as their key priority is to not lose their job and not lose funds under management, and so the safest thing for them to do is to herd and gravitate toward the index – they become closet indexers. It is such behaviour that prevents them from outperforming.
If, however, one looks at funds that invest in concentrated portfolios and/or deviate significantly from benchmarks, these funds tend to outperform according to recent academic studies. For example, Marcin Kacperczyk, Clemens Sialm and Lu Zheng published two articles in The Journal of Finance in 2005 and 2007, in which they found that the more concentrated a fund was – in other words, the less diversified – the better it did. The outperformance resulted from selecting the right sectors or stocks, not from market timing. Martijn Cremers and Antti Petajisto, in a 2009 Review of Financial Studies paper, reported that those U.S. funds that deviated significantly from the benchmark portfolio outperformed their benchmarks both before and after expenses. Finally, a 2015 study at UCLA, titled "Fundamental Analysis Works" co-written by Soehnke Bartram and Mark Grinblatt, shows that "one can earn risk-adjusted returns of up to 9 per cent a year with rudimentary analysis of the most commonly reported accounting information. Such abnormal profits are a result of fundamental analysis and taking advantage of market inefficiencies."
In other words, fund managers underperform the index not because they lack stock-picking abilities, but rather because institutional factors force them to overdiversify.
With regard to the second question, active managers have difficulty outperforming in a rapidly rising market – the one we have witnessed over the past 10 years. This is mostly because active managers hold large amounts of cash, especially as the market gets more and more expensive, which makes them underperform in a rapidly rising market. Whereas the index is always fully invested. In a down, flat or mildly rising markets, however, active managers have an easier time outperforming, such as in the 1960s and '70s.
Additionally, the S&P 500 index is a hard competitor to beat to start with. This is because normally (and regularly) problem companies are replaced in the index with companies with better financials and performance. For example, many of the Nasdaq leaders in the late '90s and early 2000s that drove the market sharply higher and then tanked no longer exist in any index. In other words, active managers always compete with the best group of companies the index contains. And more importantly, active managers have to beat this "best-stocks" index after fees and after all other costs associated with running an active fund.
So let's be fair, give credit where credit is due and stop this active manager bashing. Active management is not doomed. Good active managers will survive and will keep making a good living out of active management, especially in an environment of increased volatility in the months and years ahead. A slowdown in economic growth around the world, particularly in China, as well as a slowdown in productivity, lower population growth, aging baby boomers and lower government spending will lead to an increase in stock-market volatility. An expensive market in an environment of artificially low interest rates that have encouraged leverage both at the individual and corporate level will also contribute to rising volatility, both realized and expected. In this environment, active managers, such as value investors, will shine.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.
George Athanassakos