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.
It is very clear from my own investing and watching other active managers that outperforming the market, although difficult, is possible. Unfortunately, the 2010s were particularly difficult, and many of the best managers in the world have struggled to produce returns. Large established hedge funds have closed their doors in frustration. Efficient market theorists may point to enhanced communication via the internet, quantitative models, and fair disclosure laws as limiting factors, but there is another answer behind the recent alpha degradation.
Self-reinforcing cycle driving poor performance
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.
Why do these forces pressure investment decisions?
Massive central bank intervention creates a market driven by macro issues. The focus is on central bank statements and interviews of bureaucrats on how they foresee the next six months. Central bank–driven low rates push all investors into riskier assets, because traditional low-risk investment alternatives provide uncompelling returns. When capital allocators cannot achieve their defined investment return goals due to low bond yields, they have little choice but to take on more risk in the form of higher equity exposure to achieve objectives. This demand for equity and risk capital creates high valuations and enables weak companies to flourish. Allocators believe the central banks will act as support to markets making the additional risk more palatable. The central banks try to fulfill the need for low volatility and market stability for the good of the markets and the economy. Another dangerous cycle is created as global central banks manipulate investors into pushing asset prices higher to spur the economy, but in doing so have increased the risk profile of the investment community, which, of course, could lead to potential losses negatively affecting the economy. This means central banks must go to even greater lengths to maintain low levels of volatility and support the financial markets. Easy access to capital, low rates, and low volatility cause another headwind for hedge fund managers, which is the dispersion of stock returns among companies. Good companies and bad companies alike do well in upward-trending macro-driven markets. Successful investment managers achieve outperformance by selecting the strong companies and shorting the weak companies. When there is very little difference in returns, it is hard to create alpha. An analysis produced by the BoA Merrill Lynch Quantitative Strategy team in Figure 1.4 illustrates the level of dispersion in the returns of the top-performing quintile and bottom-performing quintile of stocks in the S&P 500. High dispersion is a positive environment for alpha creation, because there are more distinct winners and losers for a manager to choose in the security selection process. Low dispersion (more stocks moving in unison) is a headwind to alpha creation. It is clear from the analysis that dispersion has been below average since 2010, when central bank intervention began.
FIGURE 1.4 S&P 500 dispersion of the top and bottom decile from 1986 to June 2019
Source: Adapted from BoA Merrill Lynch US Equity & Quantitative Strategy Group (August 2019).
The central bank low rate–driven environment pushes investors into risk assets, which often equates to investment in high-growth, no-earnings companies. This increased willingness to invest in companies without earnings amplifies