Originally published on July 26, 2016
By Jason Voss, CFA
Several years ago, I interviewed C. Thomas Howard of AthenaInvest to learn more about his firm's unique implementation of behavioral finance. This turned out to be one of the best-performing pieces of content Enterprising Investor has ever run. But it isn't just AthenaInvest's originality that's so compelling, so too is its strong performance.
Howard also has an interesting pedigree as a recovering and almost lifelong finance professor turned practitioner. Recently, he has focused his attention on another problem: determining whether or not active management is dead. In addition, he is dedicated to uncovering ways active managers can improve their performance - and he has the academic chops to back up his story.
CFA Institute: Is active management dead?
C. Thomas Howard: There is a strong drumbeat to this effect within the industry. The growth of index funds, at the expense of active equity funds, reinforces this notion. But active management is alive and well within the equity mutual fund industry. In a recent comprehensive study, I found that as many as 90% of active equity managers are superior stock pickers, a result that runs contrary to much conventional wisdom.
The reason so many active funds end up underperforming is not for lack of skill, but is the result of subsequent portfolio management decisions. Among other things, funds that asset-bloat (i.e., become excessively large), benchmark-track, and overdiversify destroy the excess returns generated via superior stock picking. They do these things for rational reasons. They grow large because they are compensated based on assets under management (AUM) fees, they manage to the benchmark (which leads to closet indexing) because consultants and platforms demand it in order to be considered for new flows, and they overdiversify because emotional investors expect a lot of stocks in a portfolio. In my study, I've termed these performance impediments collectively as "portfolio drag," a bane within the industry.
Given the opportunity to manage portfolios based on their preferences, the vast majority of fund managers would deliver superior performance to investors. Those funds that don't asset-bloat, benchmark-track, or overdiversify do generate superior returns. It is into these truly active funds that investors should put their money. But alas, the industry is structured to incent funds to become closet indexers, the very value-destroying entities investors should avoid.
What are the factors leading to this fiction?
Many academic studies find the average equity mutual fund underperforms, a conclusion with which I agree. Many contend this is due to a lack of skill, a conclusion I do not agree with. In my studies, I find widespread skill, but I also find widespread portfolio drag which leads to the underperformance.
Making matters worse is the challenge of correctly identifying truly actively managed funds. With so many funds managing assets to deliver benchmark performance rather than alpha, while charging actively managed fees, the mix of fund managers skews performance results lower, since their stated objective of growth, for example, really means "growth that mirrors the benchmark."
Another factor when selecting a fund is the focus on fees. The funds with the largest asset bloat, and thus the greatest portfolio drag, will have the lowest fees, but will be unable to generate superior returns due to size. As they say, it is hard to sneak around with $50 billion. Include the US Department of Labor's fiduciary rule and robo-advisers, and there is ever more emphasis on costs. The availability bias plays a major role here, as information on fees is highly accessible, while skill is not.
Let's drill down into those adjunct methodologies: What is wrong with them?
There are a couple of aspects of statistical testing that contribute to the conclusion that skill is rare.
First, many studies focus on life of fund performance. That is, in order to be considered a skilled fund, one must outperform over the full life of the fund. However, even if the fund is skilled over an extended time, and my research reveals that skill remains fairly constant over time, performance will decline as portfolio drag increases with fund age. In other words, fund asset bloat, benchmark track, and overdiversifying increases as funds grow older. The result is that the "life of fund" performance measures dramatically understate the pervasive skill within the industry.
Second, the focus is often on individual fund rather than on collective across fund through time performance. There is so much noise in equity markets that it is virtually impossible for a skilled fund to generate statistically significant performance. For example, a fund generating a 4% annual alpha needs over 30 years of such performance to be statistically significant. Making things worse, age-driven increases in portfolio drag, given fund growth, make such a finding even more problematic.
A related issue is that tracking error is the standard error used for estimating significance. But in order to generate superior performance, the fund must look different from its benchmark, thus experiencing tracking error, which in turn reduces the chance a study will find significant performance.
How would you change them?
Based on my previous response, I conclude standard statistical tests are stacked against finding individual fund skill. This is a frustrating situation for the many skilled managers within the industry. As a result, the best that can be done is to identify collective, statistically significant performance after adjusting for portfolio drag. I present such an approach in my research, "Why Most Equity Mutual Funds Underperform and How to Identify Those That Outperform." I find that 90% of active equity funds are skilled, with 80% able to more than cover their fees. Skill is not scarce, it is pervasive within the industry.
I also produce other results that run contrary to conventional wisdom. The best funds, those that are skilled with low portfolio drag, charge higher fees and are attracting new fund flows. It is reassuring that these truly active equity funds are bucking the trend of net outflows.
Sorting funds based on fees leads investors away from the best funds. I find it better to sort first on low portfolio drag, and then on fees.
There is a related issue regarding industry credentialing. Organizations providing certification for investment analysts, such as CFA Institute and Investment Management Consultants Association (IMCA), among others, send mixed messages to the industry. On the one hand, they provide education and credentials for buy-side and sell-side analysts. Studies show that these two groups add value to the investment process. However, these organizations also credential consultants and platform analysts, which, studies show, destroy value in the investment process due to the constraints they impose on active managers. It is not overstating the case that credentialed consultants and platform analysts are major contributors to the collective dismal performance of active equity managers.
It would be nice to see credentialing organizations add value rather than destroy it in the investment process. This can be done by developing education programs that encourage all analysts to help identify profitable investment opportunities, rather than having a significant portion of them impose arbitrary constraints on active managers.
Such changes would help the industry transition to a new equilibrium in which there are only two broad categories of equity funds: truly active equity funds and low-cost index funds. This transition is already well underway with the rapid growth of index funds and ETFs at the expense of active funds, accompanied by an index fee race to the bottom. Outflows from the closet index funds helps to narrow the consideration set.
These beneficial tectonic changes should be accompanied by a new framework for encouraging truly active equity funds. My research suggests that such funds have AUM less than $1 billion, an R-square with a benchmark of between 0.6 and 0.8, and relative portfolio weights greater than 30% across their top 10 high-conviction positions.
The new equilibrium will result in an industry of truly active equity along with low-cost index funds, with nary a closet indexer in sight.
Talk to me about the additional fiction that active management is a zero-sum game.
A strongly held belief within the investment industry is that stock picking across active equity funds must be a zero-sum game. Such an assertion is true for the stock market as a whole, as stock picking must have as many losers as winners. But this does not have to be the case in every market segment.
The US stock market has a current total market value exceeding $38 trillion. Active US equity mutual funds hold $3.6 trillion, about 9% of all equities. So, it is entirely possible for the average stock held by funds to outperform at the expense of the other 91% of the equity universe.
Arguing that stock picking among equity funds must be a zero-sum game is akin to arguing it is impossible to drown in a lake of average depth of three feet. That lake may have pockets 20 feet or more deep. Both represent indefensible statements.
In particular, this study estimates that the average stock held by active equity mutual funds earns an alpha of 1.3%, confirming that mutual funds do earn superior returns. Indeed, this must be the case in order for equity funds to cover their fees and, in turn, earn a near-zero collective alpha.
What research is there that supports your point of view?
There are two long and growing lines of research supporting the view that superior stock picking skill is the rule rather than the exception. The first finds truly active equity funds outperform. In these studies, the level of fund activity is measured by tracking error (the higher the better), benchmark R-square (lower the better), active share (the higher the better), and portfolio-weighting best idea stocks (the larger the better), among other measures.
These results raise the question of why simply being more active allows the fund to outperform. If managers lack skill, as is so widely believed, then simply taking more high-conviction positions, for example, will not generate better performance. So, it must be the case that many managers are skilled stock pickers. This is what the second line of research finds.
Using a variety of approaches, a series of studies found that best idea stocks outperform other low-conviction stocks in a portfolio, as well as outperform the fund's benchmark. Thus, being truly active and having skill reinforce one another as the source of superior performance.
For those interested, I provide an extended discussion for both of these research streams in this article.
What is AthenaInvest doing to compete in this environment?
AthenaInvest consistently pursues narrowly defined equity strategies and takes high-conviction positions. We keep portfolio drag to a minimum. Our focus is on building long-horizon wealth, and as such, we do not attempt to manage short-term volatility and drawdown, and thus work with our clients to help them avoid making value-destroying decisions based on the emotions triggered by such events.
Measurable and persistent behavioral price distortions are identified by means of extensive research which is embedded in the academic literature. Once identified, we then design and manage a portfolio, harnessing the distortion. We refer to this approach as Behavioral Portfolio Management.
Over the years, our equity portfolios have been among the top performers in their respective categories, and our AUM has grown rapidly. Our success is confirmation that superior performance and AUM growth is possible in today's equity markets when you are a truly active equity manager. And it is consistent with our research and other academic research regarding active management.
Active management is alive and well within the equity industry!
Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.