Why is Active Management So Difficult?
You have to feel sorry for active managers.
According to the year-end 2021 SPIVA Scorecard research from S&P Dow Jones, here is the percentage of actively managed US equity funds that underperformed the S&P 1500 Index over various time periods ending December 31, 2021. It paints a grim picture.
- 72% for the three-year period (80% on a risk-adjusted basis)
- 75% for the five-year period (81% on a risk-adjusted basis)
- 86% for the ten-year period (93% on a risk-adjusted basis)
- 90% for the twenty-year period (95% on a risk-adjusted basis)
S&P Dow Jones research has made similar findings for every type of actively managed fund compared to its relevant benchmark, year in and year out.
Not only is their performance lackluster, but the survival rate for active managers is woeful, as well. S&P Dow Jones found that over the past 20 years, nearly 70% of domestic equity funds have been merged or liquidated out of existence.
With so many brilliant people devoting their careers to active management, why are their results so disappointing? Here are ten reasons.
- Active Management Is Not a Science. Water freezes at 32 degrees Fahrenheit. Light travels at 186,000 miles per second. The Earth travels around the Sun once every 365 days, 5 hours, 59 minutes, and 16 seconds. We have no equivalents in investing.
- Markets Are Complex Adaptive Systems. Financial markets are comprised of millions of heterogeneous participants who may apply different decision rules to their activities. The size and shape of the playing field, and the rules of the game, are always changing.
- Value Is in the Eye of the Beholder. It is common to hear an active manager talk about whether markets or stocks are “over-valued” or “under-valued.” This implies that there is a “normal” or “correct” value, and that the manager knows what it is.
For the last 50 years (1972-2021) the average trailing 12-month P/E ratio of the S&P 500 Index was 19.66. So, on average, investors were willing to pay $19.66 per share for $1 of earnings. But during that period, the S&P’s P/E ranged from 7.39 in 1980 to 70.91 in 2009. There is no rigid, mechanical way to determine the “normal” or “correct” value.
- There Are Many Well-Armed Competitors. Despite the move toward passive investing in recent years, there are still many talented professionals trying to extract value from the financial markets. These well-armed competitors make the markets even more efficient and make it even harder for an active manager to gain an advantage.
- Not Every Good Idea Is a Good Investment. Active managers make bets. There are always forces at work that can turn even the most well thought through bet into an empty intellectual exercise. There are always more variables than can be reasonably accounted for. Active managers are always playing the odds. Not every bet pays off.
- Fees and Expenses. The fees and expenses associated with active management are generally higher than those associated with passive investing. This means the bar is set higher for active managers. To shine, they must beat both the passive managers, who charges lower fees, and their relevant benchmarks, which contains no fees.
- Compared to What. All research on the merits of active management uses some form of measuring stick like an index or a peer group. What if the manager was not trying to beat the benchmark or does not really fit into the peer group? When we lump disparate managers together into arbitrary categories and determine their success using a common measuring stick, we need to be careful about the conclusions we draw.
- Timing Is Everything. How patient should we be in deciding whether an active manager is a winner or a loser? What if a manager regularly underperforms for three years and then has an amazing year that more than makes up for the underperformance? If a manger sees where the world is going, but it takes a long time for others to catch up to the manager’s vision, is the manager good or bad?
- A Few Good Days. We’ve all seen the charts that show what happens to performance if you miss just a handful of the best days in the stock market. Less than 1% of the trading days can make the difference between excellent performance and a loss.
This makes it difficult for active managers, particularly for those who practice some form of market timing or tactical asset allocation. This is also why perma-bears, who are constantly predicting doom and hoarding cash, are usually better at generating headlines than putting money in their clients’ pockets.
- A Few Good Stocks. A paper by Professor Hendrik Bessembinder documented that the best-performing 4% of stocks explain the entire net gain for the stock market between 1926 and 2016. This makes active management challenging because active managers are shooting at a relatively small target.
Many Obstacles to Overcome
Active managers can play an important role in helping clients reach their financial goals. But it is important to understand the many headwinds they must overcome in their efforts to add value relative to passive managers.