Popular myths are hard to debunk. There are many myths out there, but today, I'd like to focus on just two: The first is that active portfolio managers underperform passive portfolios, and the other is that higher interest rates always lead to lower stock prices.
First, does stock picking add value? Finance researchers and passive portfolio management proponents have long argued that active managers deliver little value to their clients. For example, research published recently by S&P Dow Jones Indices found, in Europe, 80 per cent of active equity funds failed to beat their benchmark over the past five years, with the figure rising to 86 per cent over the past decade. Figures are not that different in North America. The worst fund performances were in the Netherlands, Switzerland and Denmark, where 100 per cent, 95 per cent and 88 per cent of active managers, respectively, failed to beat their benchmark over the past five years.
My view has always been that active portfolio managers underperform not because of a lack of stock-picking abilities, but rather because of institutional factors that force them to overdiversify.
In my experience, the average fund manager is more concerned with losing his job or assets under management than doing the right thing. As a result, many managers don't really try to pick stocks. They become closet indexers, or they diversify indiscriminately to make sure they never stray too far from the crowd. This is the safest thing to do. And, of course, a closet indexer can never outperform; in fact, he will underperform when we account for management expenses.
Most of the discussion in the media and in finance courses with respect to active portfolio management relies on old academic studies that naively looked at the average equity mutual fund. However, more recent academic research has disaggregated mutual funds and has better focused on what active managers (non-closet indexers), such as value investors, actually do.
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.
However, the strongest evidence in support of active portfolio management comes from a recent study at UCLA titled Fundamental Analysis Works co-written by Soehnke Bartram and Mark Grinblatt. The authors show that prices do not reflect the most recent accounting statements, and so one can earn risk-adjusted returns of the magnitude of up to 9 per cent a year "with rudimentary analysis of the most commonly reported accounting information." Abnormal profits thus earned are not because of omitted risk, but a result of fundamental analysis and taking advantage of market inefficiencies.
Second, recent hawkish pronouncements about interest rates by U.S. Federal Reserve Board officials have put fear into stock investors' hearts as most believe a rise in interest rates is always bad for stock prices. But can we have a rising stock market, even in a rising interest rate environment? Is a rise in interest rates prompted by a strengthening U.S. economy bad for the stock market?
A rise in interest rates may not necessarily be bad for stock markets, as long as economic growth conditions are such that interest-rate increases are lower than the increase in the rate of profit growth.
Investor return expectations are usually tied to the current level of interest rates. As interest rates rise, so does their expected return. This, in turn, pushes down the price investors are willing to pay for a dollar in earnings – the so-called price-to-earnings multiple, or P/E. As the P/E multiple declines, so do share prices.
However, this argument ignores the growth rate effect in the valuation model. In the long run, based on the equity valuation model with constant growth to infinity, the true rate to discount future corporate profit is not just the expected rate of return, but rather the expected rate of return less the growth rate in profit.
Will corporate profits increase fast enough to compensate for the rise in interest rates? Historically, the rise in interest rates sometimes coincided with sharply improving economic conditions and growth rates, and so resulted in a rising stock market. Nowadays, the chances of fast economic growth are hampered by the many imbalances in the system, and so one has to wonder where the growth in profits will come from.
As a result, despite the historical evidence that sometimes bull markets coincided with rising interest rates, a rise in interest rates in the current environment may not be followed by a bull market. In fact, it could turn out to be the opposite, assuming growth rates do not follow the rise in interest rates.
So there you have it. General statements about active portfolio managers' underperformance and the effect of interest rates on stock markets mask the true story; the devil is always in the details.
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