Active management is having another dreadful year in 2014. Here are the results for U.S. stock funds through October, courtesy of Bank of America:
Index fund proponents have clearly laid out the arguments against active funds over the years:
- Higher fees.
- Higher turnover and trading activity.
- Tax inefficient.
- Cash drag.
- Stock picking is hard.
- Market timing is nearly impossible.
- Increased competition in the industry.
- Low persistence in winners over time.
- Beating the market is a zero-sum game.
The usual conclusion is that a dart-throwing monkey could do a better job of picking stocks than active portfolio managers. This is a gross oversimplification, but beating the market is difficult nonetheless.
There is another factor at play here that doesn’t get nearly as much attention as it should. Paul Sullivan discussed this issue in an excellent piece on the investment industry that he wrote for the New York Times:
Fifty-four percent of institutional investors said they feared they could lose their job if they underperformed for only 18 months; 45 percent of people managing money at asset management firms said they felt the same.
“Career risk is much more profound than we anticipated,” Ms. Duncan said. “It’s difficult to change because it’s very much embedded in everything. It’s the culture, the fee structure, it’s based on assets under management, and they’re rewarded for this.”
It’s hard enough to beat the market under normal circumstances. When you add in career risk to the equation, things can get out of hand in a hurry. Unrealistic expectations placed on these large allocators of capital flow straight through to the active portfolio managers they invest in, which makes for a near impossible situation for investors and fund managers alike. In the end, no one wins using that kind of time horizon or level of patience.
There’s a tendency to get extreme consequences when you combine a number of human misjudgments all at the same time when aiming for a particular outcome. Charlie Munger calls this the lollapalooza effect:
When several models combine, you get lollapalooza effects; this is when two, three, fours forces are all operating in the same direction. […]
More commonly, the forces coming out of these one hundred models are conflicting to some extent. And you get huge, miserable trade-offs. But if you can’t think in terms of tradeoffs and recognize tradeoffs in what you’re dealing with, you’re a horse’s patoot. You clearly are a danger to the rest of the people when serious thinking is being done. You have to recognize how these things combine.
It also doesn’t help that the narrative for active management is constantly changing over time depending on where we are in the investment cycle. At different times investors would like correlated returns when markets are rising, uncorrelated returns when they’re falling, absolute returns during a correction, downside protection against a crash, the ability to go both long and short in a sideways market, the ability to be tactical and time the market at the inflection points and, of course, you have to consistently beat the market.
Even the greatest investors of all-time have bad quarters, years or even entire market cycles. No investor can be all things at all times. And if they could they certainly wouldn’t open up their fund to the investing public.
Think about being a portfolio manager for a minute. When you’re performing poorly, investors rush to the exits to redeem and you are forced to sell shares when you should be looking for opportunities to buy. When you are performing well, investors shower you with contributions and force you to buy more shares at higher prices. The best performers are rewarded with much larger funds, which makes it that much harder for them to outperform going forward.
When a portfolio manager is outperforming the market and overconfidence seeps in, it’s like they’re doing you a favor to allow them to invest money on your behalf. When the script flips and they’re underperforming, it’s the investor’s turn to have the upper hand.
It’s rare to have good behavior at the same time from both investors and portfolio managers. It’s not impossible, but it’s rare. The due diligence process required to choose active managers is not easy, especially for the average investor. But even if you have a legitimate process in place to find superior funds, you still have to manage your own emotions and place realistic expectations on the strategies you choose to be able to see them through a full cycle.
This is why the best actively managed strategies will be the ones that are easy to explain and understand. If you don’t understand it or the fund manager can’t easily explain it, the odds are that you will make hasty decisions and perpetuate the cycle of underperformance.
It’s very difficult to beat the market over longer time frames. This doesn’t mean it doesn’t happen; it’s just not that easy. But investors, both individual and professional, often make it even harder for active managers to outperform.
The institutional imperative and the lollapalooza effect are a big reason for this.
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