We continue to recommend that our clients invest in passively-managed index funds, which are funds that simply track a market benchmark like the S&P 500 stock index, often just by buying a stake in all of the underlying securities. This compares to actively-managed funds run by portfolio managers seeking to beat the market benchmarks through smarter sector weightings or better stock selection.
We also typically recommend that investors follow a passive asset allocation strategy based on their age and risk tolerance rather than dynamically adjusting allocations to try to respond to market circumstances. We think it’s better to stay the course on long-term allocation strategies while periodically rebalancing by selling asset classes that have gone up a lot, thus driving the weighting above the long-term target, and buying asset classes that have gone down a lot.
We have tremendous respect for hard-working, talented active portfolio managers and we continually challenge our assumptions, but there are several reasons why we favor passive investing. First, decades of academic research on the concept of efficient markets—most of which can be traced back to Dr. Eugene Fama’s work in the 1960s—suggests that publicly-traded assets tend to reflect all publicly available information and maybe even non-public information. In other words, stocks and bonds are eerily prescient in factoring in all relevant news into their prices. The moment something changes, asset prices reflect it.
Second, the empirical evidence suggests that most actively managed funds underperform their benchmarks. In April, S&P Dow Jones published its 15th annual S&P Indices Versus Active (SPIVA) scorecard, and the vast majority of actively managed funds, both stocks and bonds, failed to beat their benchmarks over a 15-year period. Over the 15-year period ending Dec. 2016, 92% of large-cap equity, 95% of mid-cap equity, and 93% of small-cap equity managers underperformed their benchmarks.
Third, and clearly related to the second point is that active fund management costs a lot of money. Smart people and great data aren’t cheap. It’s not necessarily that good fund managers can’t pick stocks and bonds, but it’s very difficult to consistently beat the market by a wide enough margin to offset the significant costs associated with active management.
Lastly, we believe the overwhelming majority of retirement outcomes are determined by activities at the foundation of the hierarchy of financial needs—studying, working, budgeting, saving—rather than the top—beating the market. Active management through smarter asset allocation or better stock picking may provide a small advantage to some investors, especially the very wealthy with high risk tolerances, but most investors should focus on living within their means, saving as much as they can, and investing in a prudent, passive, tax-efficient and low-cost manner.
With that said, we think there could come a day when the scales tilt too far toward passive management and create inefficiencies in markets that active managers can consistently exploit. Theoretically, passively invested fund flows could eventually create situations where both good and bad stocks move up or down together, creating opportunities to buy good stocks that trade down for no reason and sell bad stocks that trade up for no reason. We do not believe we have reached that point.
We acknowledge that there are great portfolio managers in the world but believe it’s extremely hard to find them. And when money starts to chase after those with the seeming golden-touch, it becomes much harder for the managers to outperform.
So what are the attributes of great actively-managed fund managers? How would we describe them?
Brilliant. Let’s face it, when you are trying to beat markets that rapidly react to all the changes in the world, it helps to be able to “think different” to borrow a 20-year old phrase from Apple. Most successful fund managers not only process information quickly, they can come to counter-intuitive, differentiated conclusions.
Efficient. To consistently beat the markets, fund managers need to be able to run their businesses efficiently so they can keep their expense ratios low. That doesn’t necessarily mean being frugal, it more likely means spending a lot of money on high-impact people, processes and projects that can lead to unique insights.
Diligent. It’s a bit cliché, but great fund managers typically work really, really hard. There are no short cuts to success, and some of the best fund managers I know work essentially all the time and often spend most of their time traveling the world to find rare nuggets of wisdom.
Focused. Typically, great fund managers are focused in a couple of different ways. Their strategies are often focused on specific securities, sectors, geographies or themes. When focused in that way, they are more likely to be able to have a deeper understanding of specific market forces than other investors. Their portfolios are also likely to be focused, or concentrated, on a small number of securities. It is much easier to have unique insights on a dozen stocks than it is to have unique insights on one hundred.
Patient. Far too many institutional investors are fixated on quarterly earnings or near-term macroeconomic data rather than long-term fundamentals, and good fund managers with patient capital can use that myopia to build positions in securities that may take time to pay off.
Prudent. There are a lot of good managers that pick good securities 9 out of 10 times but the 10th is such a loser that it kills their performance. Great fund managers build in a margin of error that helps limit their downside risk. And great investors reject a lot more ideas than they embrace. Most great investors are defined more by the trades they don’t make than the trades they do.
Opportunistic. Great fund managers and their financial backers leave room for flexibility in the deployment of capital. Most successful funds can take short positions, or place bets that securities will decline. They might also have the freedom to use options or multiple asset classes to reflect their market expectations. In Michael Lewis’ book The Big Short, Dr. Michael Burry was running a stock fund when his research led him to the conclusion that mortgage default rates would increase. He fought with his investors to convince them that buying esoteric credit default swaps was the best way to reflect his expectations for a housing collapse. Not all of his investors were thrilled and pulled out of the fund, but those that gave Dr. Burry that flexibility made multiples on their investments when the bets started to pay off in 2008.
Active. Great fund managers are typically active not just in their allocation and selection process, but also in how they engage with company management and Boards of Directors. While the term activist investor often connotes corporate raiders looking for quick pay offs from cash distributions or other short-term actions, true activism means working collaboratively with managers and directors to achieve the best possible long-term outcomes.
As you might imagine, most fund managers don’t have all or even most of these attributes. If they do, and demonstrably beat the market over a multi-year period, they typically raise great quantities of capital from investors. And when a great performing $100 million fund is suddenly sitting on $1 billion of capital, it becomes much harder for the manager to continue to outperform. And what happens if the manager, or maybe just key analysts, leave the fund? Past performance is no guarantee of future results, as they say.
Great fund managers are hard to find, difficult to track and—with some exceptions—nearly impossible for most individual investors to justify, but that won’t stop us from continually monitoring the markets and evaluating portfolio managers to make sure that our bias toward passive management remains wise.