Active management: Why even try?
There is a course of thinking that claims it is silly to even consider active management. The argument goes that since the vast majority of active managers underperform their benchmarks, the odds are so stacked against success that it doesn't make sense to try. Another argument suggests that success is merely a function of luck; there are bound to be some winners.
While it is true that the majority of active managers underperform, it is wrong (and intellectually lazy) to conclude that the reason must be because it's impossible to do so. The fact is it's no mystery at all why so many active managers fail and the problem, in a word, is inefficiency.
Many active managers, for example, are inefficient in where they apply their skills. In markets with lots of information and very liquid securities, the dispersion of active manager returns tends to be small since there are so few opportunities to uncover something new. Managers who focus on very large stocks or core fixed income have very little chance of outperforming by a large enough margin to justify active management fees.
In addition, many active managers are inefficient in how they construct their portfolios. The vast majority of equity mutual funds have active share of less than 80% (Note: Active share is the portion of the portfolio that is different from its benchmark). This means that you are paying active management fees for a large degree of exposure that could otherwise be achieved through cheap index funds. Arguably, one should only pay active management fees for best ideas – those that are different than the benchmark.
Finally, many active managers are inefficient in their cost structures. Substantial costs are often incurred for marketing and distribution activities that provide little value for investors and absolutely detract from returns. Further, technology has substantially reduced a huge portion of management costs and yet few if any of these savings get reflected in reduced management fees.
None of these insights is new or controversial. They comprise the findings of investment luminaries such as David Swensen, Charlie Ellis, Peter Bernstein, Jack Bogle and many others. On one hand, they show that most active managers fail because they aren't even built to win, at least not at investing. In other words, most active firms do not differ enough from their benchmarks to more than offset their management fees, even if their stock selection is successful. They are built to fail - and do so, unsurprisingly.
On the other hand, these insights also provide the lessons and point the way to building an active management operation that precludes structural obstacles to success. Low costs and a focus on best ideas, in the form of high active share, are key ingredients to successful active management - and are far from impossible to attain.
While it is true that the majority of active managers underperform, it is wrong (and intellectually lazy) to conclude that the reason must be because it's impossible to do so. The fact is it's no mystery at all why so many active managers fail and the problem, in a word, is inefficiency.
Many active managers, for example, are inefficient in where they apply their skills. In markets with lots of information and very liquid securities, the dispersion of active manager returns tends to be small since there are so few opportunities to uncover something new. Managers who focus on very large stocks or core fixed income have very little chance of outperforming by a large enough margin to justify active management fees.
In addition, many active managers are inefficient in how they construct their portfolios. The vast majority of equity mutual funds have active share of less than 80% (Note: Active share is the portion of the portfolio that is different from its benchmark). This means that you are paying active management fees for a large degree of exposure that could otherwise be achieved through cheap index funds. Arguably, one should only pay active management fees for best ideas – those that are different than the benchmark.
Finally, many active managers are inefficient in their cost structures. Substantial costs are often incurred for marketing and distribution activities that provide little value for investors and absolutely detract from returns. Further, technology has substantially reduced a huge portion of management costs and yet few if any of these savings get reflected in reduced management fees.
None of these insights is new or controversial. They comprise the findings of investment luminaries such as David Swensen, Charlie Ellis, Peter Bernstein, Jack Bogle and many others. On one hand, they show that most active managers fail because they aren't even built to win, at least not at investing. In other words, most active firms do not differ enough from their benchmarks to more than offset their management fees, even if their stock selection is successful. They are built to fail - and do so, unsurprisingly.
On the other hand, these insights also provide the lessons and point the way to building an active management operation that precludes structural obstacles to success. Low costs and a focus on best ideas, in the form of high active share, are key ingredients to successful active management - and are far from impossible to attain.
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