Active Investing in the Age of Disruption. Evan L. Jones

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Active Investing in the Age of Disruption - Evan L. Jones


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fees consistently for decades. In an analysis completed in June 2019 by the S&P Indices Versus Active (SPIVA) project, only 21% of large actively managed US mutual funds outperformed the S&P 500 over the previous five years. Additionally, research performed by both Vanguard and Morningstar showed 90% of large cap US mutual funds failing to outperform the S&P 500 from 2001 through 2016.

      The recent market environment has not had as pronounced a negative effect on cash flows into the mutual fund industry simply because the average mutual fund manager in the 2010s focused on tracking error (volatility around their benchmark) and diversified away both the ability to outperform or underperform the market materially.

      The challenges of the current environment will remain for a long time, and only a disciplined process designed on the core investment tenets that create outperformance will enable managers to be successful. Competent capital allocators can find alpha-producing managers to enhance their returns through a thorough due diligence process and an understanding of the alpha potential for different strategies and the pieces that need to be in place for a manager to outperform the market. Again, not an easy task, but it is achievable. Endowments, foundations, and family offices have the long-term track records demonstrating the significant value added from partnering with alpha-creating active investment managers.

      In an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.

       —Eugene Fama, economics professor and Nobel laureate

      Re-embracing the beliefs of the efficient market hypothesis is understandable from an allocator's perspective when outperformance falters the way it has in the 2010s. However, the theory is often misunderstood and misused in the debate over active and passive investing. Many people define the theory as, you can't beat the market. Nowhere does it actually say, no one can beat the market. The theory put forward by Eugene Fama states there are three forms of the efficient market hypothesis (EMH): strong, semi-strong, and weak. These forms vary in strength of theoretical statement on markets being efficient and offering the potential of outperformance, but most important it is based on the concept of average active investment returns. There are investment managers who can and have outperformed the markets. Historically, the extent of the outperformance by investment managers is dependent on strategy (geography, sector, market cap size). Although one in five experienced managers may outperform consistently over time in the US large cap space, closer to one in two managers outperform in niche sector markets or markets outside the US. It is important to understand what an average performance will achieve, but equally important to strive and prepare to be above average.

      If I subscribed to the efficient market theory I would still be delivering papers.

       —Warren Buffett, investor

      Espousing the theory of efficient markets and moving capital to passive alternatives has an additional benefit to capital allocators: job security. No capital allocator ever underperformed the market by being in passive alternatives. From a career perspective moving to passive investing is a very low risk decision, especially when everyone else is moving the same direction. Expectations and the pressure to outperform are lower for chief investment officers if clients and fiduciaries believe that active investing cannot produce alpha. Past failures to produce alpha through active manager selection can be written off as an industry failure, not an individual capital allocation firm failure. A move to passive investing will drop expectations to a level that will always be met. No alpha expectations from clients, constituents, and board members will mean no underperformance (hence no stress) by the chief investment officer and investment team. The outcome, of course, is that they have now, also, given up any chance of outperforming.

      The challenges created by the confluence of global central bank intervention and the accelerating pace of technology have created a negative self-reinforcing cycle for active managers The investment decision process and the core tenets of outperformance are challenged, which hurts investment returns. Poor returns drive money flows out of actively managed funds and into passive alternatives. These negative fund flows create more pressure on active investment managers to perform, which drives short-term decision making. Of course, short-term focus and chasing returns leads to more poor performance and more flows into passive alternatives. Once started, this is a tough cycle to stop.

Schematic illustration of the flow diagram of a self-reinforcing cycle.

Graph depicts the S and P five hundred dispersion of the top and bottom decile from the year one thousand nine hundred and eighty-six to June two thousand and nineteen.

      Source: Adapted from BoA Merrill Lynch US Equity & Quantitative Strategy Group (August 2019).


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