The Great Debate

|
Includes: EPS, IVV, LLSP, RSP, RWL, RYARX, SDS, SFLA, SH, SPLX, SPUU, SPXL, SPXS, SPXU, SPY, SSO, UPRO, VFINX, VOO
by: Loic LeMener, CFA

Summary

Due to the cyclicality of performance, if you’re using recent returns (3-5 years) as the primary determinant of when to hire and fire an active manager, you have very little.

If you’re not willing to put the work in to understand and follow your active managers, use index funds.

While investing using active management holds the potential for out performance, it takes a lot of work, patience and discipline to have any hope of using active management effectively. Calibrate.

Much ink has been spilled over whether investors should use active or passive management in their portfolios. Often, the loudest critics on either side of this debate are firms defending their own interests, "torturing the numbers" to sway the crowd towards an "obvious" decision. As with many aspects of the investment management world, this is an emotionally charged issue, and those emotions can lead to poor decision making.

What's needed is a fair and objective framework to help you decide what is best for your own portfolio.

Weighing Pros and Cons

In the simplest terms, passive management, also called indexing, is a long-term style of management where mutual and exchange traded funds mirror a market index, such as the S&P 500. Conversely, active management refers to a manager making investment decisions using research, forecasts and experience, in an attempt to outperform a benchmark index.

Let's start with the simpler side of the debate. Indexing has several uncontested advantages, including low cost, transparency, tax efficiency, and no chance of significant underperformance. This is an attractive set of attributes, but what are the downsides of indexing?

There are two big ones:

•There is no chance of outperformance (i.e., assured mediocrity.) Indexing takes away the hope of outperformance. This may be acceptable if we believe we don't have a better option.

•Market-cap weighted indexes (which include most of the major indexes) are popularity weighted indexes. The higher a company stock goes, the more weight it carries. As Rob Arnott says, "The Achilles' heel of indexing is that when you have a bubble and a stock is trading way higher than it should, you have your peak exposure at its peak price." For example, the S&P 500's highest industry weighting just before the tech bubble burst was technology, and its highest weighting just before the financial crises in 2007 was financials. Ouch!

Side Note:

One flavor of study that drives me absolutely nuts is when supporters of indexing use the fact that this year's best managers are often not the best managers of the following year--and a lot of times in the bottom half of their peer group-as "proof" that active managers have no skill. This makes about as much sense to me as asking if the people who ran the fastest first mile in a marathon are the same people who ran the best second mile. Who cares! As great investor Seth Klarman1 said, "…If someone asked me to invest their money with the goal of turning a quick profit over the next six or twelve months, I'd have no idea how…You might as well go to a casino…" Or, in Charlie Munger's words, "In investment management today, everybody wants not only to win, but to have a yearly outcome path that never diverges very much from a standard path except on the upside. Well, that is a very artificial, crazy construct." I have never, ever, read from one of the greats of investing that their goal was to maximize returns over a twelve month period. In fact, if you understand how much randomness dominates the short-term, shooting to maximize returns over periods as short as twelve months is, to me, a tell tail sign of being a novice investor.

Active management's advantages and drawbacks are largely the opposite of indexing. Its advantages are a potential for outperformance and the ability to shun absurdly popular and overvalued companies. Meanwhile, the disadvantages include higher cost, higher taxes, less transparency and the potential for underperformance.

While investing in bonds and equities is a "positive-sum game" (you are participating in the economic growth of the world), active management is a "negative-sum game." All active investors are investing in the same pool (the global securities market), and therefore, if you are overweight a stock, somebody, somewhere, has to underweight it. Globally, the performance of all active managers has to be the market return minus their extra fees.

Of course, the key question with active management is: can I pick managers that are above average enough to make up for their extra fees? I believe that with the right framework, you can.

The Biggest Problem

While how to pick an active manager is beyond the scope of this paper (see our Insights Paper, "The Art of Manager Selection" )there is enough industry and academic research to support the idea that by using some commonsensical filters, you can fish for an active manager in a pond where the odds of outperformance are tilted in your favor.

Consider a study from Capital Group1, which looked at manager performance between 1994 and 2014, filtering active managers using two simple criteria: low cost and that the portfolio manager was personally invested in the fund they were managing. The results were dramatic: 100% of domestic managers and 90% of international managers outperformed their benchmark over a 10-year period.

Unfortunately, picking an active manager that performed over the long-term is not the critical problem. The biggest problem in this debate, and for investing in general, is that investors use recent returns as validation of whether something "worked." Take two visceral examples:

•The Fidelity® Magellan® Fund was run by investment legend Peter Lynch, who delivered an astonishing 29% average annual return between 1977 and 1990. But Fidelity found that the average Magellan investor actually lost money!2

•The last decade's best performing U.S. diversified stock mutual fund (ending December 29, 2009) was the CGM Focus Fund, which had an average annual total return of 18.2%. The average investor's return in that same fund over the same time period was -11%, a 29% under-performance!3

How is it possible that investors in both cases underperformed the very fund they were using by 29%?

Performance chasing. Investors bought these managers after a hot streak and sold them off once they had a period of poor performance. A perceptive reader will notice that what you're doing, in effect, is selling the manager low and buying them high-not exactly a winning strategy.

As these statistics reveal, the biggest problem investors face is jumping strategies mid-stream due to emotion. When an investor sees their recently brilliant fund manager start to lag the market and even lose money, fear of loss can quickly lead to unthoughtful decision making. Smart managers can look dumb for a long time. Index investors suffer from similar emotional biases. Indexes, by definition, experience 100% of the downside of what they are indexing. How many people abandoned their S&P 500 index fund late in the financial crisis? Too many.

Lessons in Discipline

Every active portfolio manager underperforms; the key question is, "why are they underperforming?"

There are good and bad reasons to underperform. Probably the best reason to underperform is that a portfolio manager is sticking to disciplined, fundamentally based investing in the middle of a bubble. Let's take a look at some of America's best managers in the biggest U.S. stock market bubble of all: the late 90s technology bubble.

Here are some charts from Frederik Vanhaverbeke (the author of Excess Returns). What's interesting to note is that among this collection of great investors, not one kept up with the tech-heavy Nasdaq and only one, Warren Buffett, kept up with the less tech-heavy S&P 500.

Did all these legendary managers get stupid at the same time? Or is it that they knew that chasing a technology bubble, which has happened many times in history and where the only hope of success is timing when to get out, was highly imprudent.

When you chart out the Nasdaq's ~80% drawdown, it's clear this stable of portfolio managers were simply being disciplined tortoises in an era of technology hares.

This brings me to a seldom discussed attribute of disciplined investing. When the market is losing its head in a bubbilicious wave of optimism, it is a badge of honor to underperform. It is this very discipline that causes short-term underperformance (as long as the bubble is raging) to capture long-term performance (once the bubble bursts.)

This is why it's so important to judge managers over a full investment cycle - a bull and a bear market. Often, the hot portfolio managers of the day are hot because they are being reckless and their gains are temporary illusions.

This is further complicated by people's emotional timeframes. Many investors judge their portfolio managers' performance across a 2-to-3-year period. For an underperforming manager, a typical scenario goes like this:

Year 1: Investors are disappointed/irritated Year 2: Investors are mad

Year 3: Investors fire the portfolio manager

Therefore, there is a big mismatch between people's emotional timeframes and an investment era's timeframe, which can last as long as 6 to 9 years. The problem with this myopic view is that active managers will underperform consistently in certain eras. For example, consider a chart of some of the world's best managers' underperformance streaks (chart again from Mr. Vanhaverbeke):

What is striking (and remember that this is a cluster of the very best in the business) is how long some of their droughts last. For example, from 1980 to 2004, Lou Simpson, who managed GEICO's portfolio for Warren Buffett, "produced an average annual gain of 20.3%, compared to 13.5% for the S&P 500. In that time, he had only three negative years, and only four years of less than double-digit returns."4

Yet, he had an entire 10-year period where he underperformed his benchmark (probably the decade ending in 1999.) In fact, most of these legends had 5-to-6-year droughts in performance. Thus, if you use shorter term performance as a primary factor in hiring a manager, you are almost sure to sell them at the wrong time.

Taking the Long View

A more appropriate framework to judge active managers is to think of the market in phases or eras. If the current environment is an era of low caution and bubbly valuations and you have a disciplined value investor in your stable of portfolio managers, a year-by-year assessment of performance is useless. You know there is a high likelihood the manager is going to underperform as long as the speculative trend continues.

One comforting fact is that you can be 100% sure an era will end. In the financial markets, change is arguably the only certainty. Understanding the current era relative to a portfolio manager's strategy is essential to giving you the patience and confidence to hold onto them.

Ever wonder what financial professionals mean when they say they are "long-term investors?" We mean wait until the next era, judge an active manager not only on what is going on today but also on how they perform once the markets transition to the next era.

As noted, by certain metrics, May 2015 was the second highest valuation of all time for the U.S. stock market. Indexing is much more attractive when the index you are investing in is reasonably valued or cheap. When indexes are reasonably valued, it allows you to "sail" with the index as opposed to using active management to "row" by identifying better than average stocks within the index.

Unfortunately, flows into index funds have been enormous late in this bull market. As you can see from the chart below, investors have been selling their active managers in droves to go buy index funds.

Click to enlarge

While I have no biases against indexing for the long-term (given that you know what you're getting and that you'll be disciplined about it), the timing of this tidal wave of assets to indexing looks like pure performance chasing to me. People are likely to have a rude awakening when their index fund experiences 100% of the downside of the next bear market. Then you're likely to see news headlines like "active managers are back!" and "index funds are dangerous!"

Click to enlarge

As the chart above shows, passive versus active management itself goes through eras. The popularity weighted indexes enjoy good times as the popular stocks of the day get even more popular during a bull market, and then they suffer tremendous losses when a bear market comes along and hits the most popular (expensive) stocks the hardest.

The firm G.M.O. put out a great paper this year predicting active managers over and underperformance relative to their index.5 The punchline was simple yet eye opening. Most funds are not pure to their index. A fund benchmarked to the S&P 500 for example will usually own some cash, some non-S&P 500 stocks and even a few international stocks. While this extra diversification hurts if the fund's main benchmark is the highest performing index of an era, it also softens the blow on the way down. Unless, of course, an investor sold their fund in the interim for an S&P 500 index fund.

An Antidote to the Dilemma

If you are going to jump into using active management, there is only one way to ensure you do not sell your active managers at the wrong times, and that is by doing enough research to acquire a deep understanding of the manager's portfolio strategy and investment thesis and continually updating your assessment of that manager through qualitative reasoning.

This is why Warren Buffett, even though wildly successful with active management, recommends most people index. He knows that for most people, investing is simply not a big enough part of their lives to do the necessary research.

This is also the key to knowing when to fire a manager. You fire them when the reasoning no longer appeals to you, when the strategy shifts in a direction of which you don't approve, when their "why" no longer inspires confidence. Although admittedly tough to do, this process should be independent of recent returns.

Given this insight and analysis, here are some definitive answers for investors when it comes to active versus passive management:

•Due to the cyclicality of performance, if you're using recent returns (3-5 years) as the primary

determinant of when to hire and fire an active manager, you have very little hope of success.

•If you're not willing to put the work in to understand and follow your active managers, use index funds.

•By extension, if you use a financial advisor, and they can't explain the "why" of the performance in their funds, they should be indexing.

•If you decide to index, don't use recent returns to validate or discredit your approach. Indexes will

have long periods of both great and awful performance; you just have to know that going in.

•If you're going to use active management, you must first develop a belief system and then seek portfolio managers that use a similar belief system. When they underperform, you're much more likely to stick with them.

•Ideally, you want a manager who has a strategy that you 100% buy into, who has a wonderful long-term track record but who has underperformed recently for identifiable reasons.

•Nobody can outperform all the time, but with a disciplined process, we believe it's possible to find active managers that outperform over time.

•While investing using active management holds the potential for outperformance, it takes a lot of work, patience and discipline to have any hope of using active management effectively. Calibrate your expectations accordingly.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.