The Death Of Active Management

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Includes: BEGRX, CFIMX, DFLVX, FPPTX, LLPFX, LMVTX, OAKLX, SEQUX, SGIIX, SOR, TWEBX, VFINX
by: Eric @ SERVO

Summary

We've known for some time that active management as an industry adds no value beyond asset allocation decisions.

The Goldfarb 10 proves that even hand-selected lists of managers with exceptional past performance offer no advantage in the search for future market-beating performance.

Even if active managers did beat the market, you would never achieve those results; your bad timing would consume all of their "alpha."

In 2004, famed Sequoia fund manager Bob Goldfarb provided his friend Louis Lowenstein a list of investment funds that became known as the "Goldfarb 10." These were supposed to be the premier investment managers in the market; they all practiced the timeless "value" approach to investing made famous by Graham & Dodd's Security Analysis written 70 years earlier.

First, a little background. Even in 2004, investors were coming around to the idea that active management as an industry was not creating any value relative to their risk-adjusted (controlling for stock, small cap and value exposure) benchmarks. But there was this lingering belief that a few exceptional managers remained, and that they could (#1) be spotted in advance and (#2) be relied upon to generate above-average future returns. Goldfarb, who had navigated Sequoia to exceptional results over the years, was at least as qualified as anyone in the industry to compile such a list - probably more so.

What the Goldfarb 10 members could claim is that they all held up extremely well during the 2000-2002 tech stock collapse; anyone can look backwards and see who did well and who did not. But value stocks in general performed extremely well, and a rising tide lifts all boats. Could these managers continue to produce extraordinary results going forward without such favorable conditions, or would the legacy of the Goldfarb 10 be the final nail in the active management coffin?

We now have almost 13 years between the origin of the Goldfarb 10 and today. There are two lessons from this exercise which I'll summarize below after the data.

FUND

SYMBOL

2004 to June 2016

First Eagle Global

SGIIX

+9.2%

Clipper

CFIMX

+4.5%

FPA Capital

FPPTX

+5.5%

Legg Mason Value

LMVTX

+2.0%

Longleaf Partners

LLPFX

+4.0%

Mutual Beacon

BEGRX

+6.2%

Oak Value

DEAD

fund disappeared

Oakmark Select

OAKLX

+6.8%

Sequoia*

SEQUX

+5.0%

Source Capital

SOR

+7.8%

Tweedy Browne Value

TWEBX

+5.3%

AVERAGE

+6.0%

Vanguard S&P 500 Index

VFINX

+7.3%

DFA US Large Value fund

DFLVX

+7.9%

* Added to bring the list back to 10 managers; surely Goldfarb considered himself suitable for his list. Complete data HERE.

The first lesson is obvious. Active management, in all forms, is dead.

How can we not conclude otherwise? This was supposedly a collection of the most successful investors in the industry, compiled by one of its most legendary members. In the next decade and a half, over 80% of them failed to outperform the S&P 500 fund. Only one, the First Eagle Global fund, managed to outperform the entire value stock asset class as represented by the DFA US Large Value fund, doing so by just +1.3% per year. The biggest loser that's still around (who knows how bad Oak Value and its successor, the RS Capital Appreciation fund did before they were both put out of their misery), Legg Mason Value, underperformed by almost 6% per year! The entire group underperformed the S&P 500 by 1.3% per year, and 1.9% a year compared to the DFA US Large Value fund.

The second lesson is not reported in the table above but even more important for readers. It is this: even if there are exceptional managers, you as an investor would never experience their success.

Why? You're human. You would buy and sell at the wrong time, costing yourself several percentage points in returns each year and any manager alpha would be lost to your bad behavior.

How can I say this so confidently? Outside of countless independent studies that confirm it, this is exactly what investors in the Goldfarb 10 experienced. Behavioral gap data on Legg Mason Value is missing from the Morningstar database, and cannot be retrieved on Oak Value or Source Capital (but in at least the first two, we can safely conclude it's awful). For the remaining 8 funds, investors lost 1.4% per year in returns over the last decade due to poor timing. This means that the +6.0% per year average returns from the chart above are probably closer to +4.5% net of individual investors buying and selling decisions. How bad is this? Consider you could have achieved that return from bonds!

Much is made of the difficult investment landscape we face today - record low interest rates and above-average valuations on the S&P 500 (and I emphasize S&P 500, almost nothing else). Everyone claims to have a nuanced approach to overcoming the challenges. I don't hear anyone starting off much simpler: avoid the unnecessary costs of active management, which can rob you of 1% to 2% annually in potential returns (even more after taxes), and avoid the costs of bad behavior, which can also add up to 1% or 2% a year over time. Active management might be dead, but the odds that your portfolio can achieve your long-term goals don't have to be.

Disclosure: I am/we are long DFLVX.

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

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