In Defense Of Active Management

by: EB Investor


Fund flows have shown a steady increase as investors get rid of active managers for passive investment vehicles.

Most of the research touting passive investing has failed to use real world analysis, relying instead on unrealistic academic assumptions.

In the real world disciplined active management can uncover opportunities for investors to compound their wealth over the long run.

For years now the asset management industry has been criticized by everyone from the financial media, to academia. As a result, there has been a wave of investors ditching their active managers for low cost index funds, or following an "evidence based approach" which is nothing more than an enhanced index. I believe this is the worst move they could make, despite conventional wisdom.

Passive investing is built on the flimsy notion that markets are efficient. In the world of academia there is largely no doubt that markets are efficient. However, the reality is that if markets were in fact perfectly efficient in the real world, no one would be able to consistently beat the market. Every study that is done supposedly proving the merits of a passive investment approach focuses on an industry wide analysis, and claiming that the majority of active funds failed to beat their benchmark. The reality is that there are funds that consistently beat the market over long periods of time, and contrary to what you have heard they are not just lucky.

The notion that investors should not bother searching for these funds is an argument often used by passive investors; it is clever marketing for the index universe but it is simply untrue. Both active and enhanced index investors, agree that index funds have many flaws.

To begin with, the failures of passive investing are that you are buying more and more of a security based on its market cap, meaning you are buying more of a security as it rises in price, how does this make sense?

Forced trading to keep track of an index is an additional detraction for the index crowd, as this results in higher trading costs.

Another challenge is the risk characteristics of index funds, which are taking the full risk embedded in the market and attaining average returns, achieving a low risk adjusted level of return as indicated by the low Sharpe ratios of indexed products.

Active investing done the right way, on the other hand, can steer investors through the waters of the capital markets and arrive at their destinations with more capital than they would have had, had they indexed. This is simply a superior way of investing.

Defining Proper Active Investing

There are seemingly an infinite number of active investing strategies, so how are investors to know which ones to explore further and which ones to throw overboard? In my decades of research on what makes for a successful investor, there is simply no better archetype than Warren Buffett. Following his investment style and process can illuminate what investors should be looking for when analyzing individual securities and even good mutual funds. Warren acts like an owner, looks for companies with strong cash flow, and holds on through the markets ups and downs.

Looking for active mutual funds, one can follow a similar strategy attempting to find those with an active/passive investment strategy. Below are three principles for choosing active funds, this is only a starting point and not an exhaustive list of everything you should be looking for but it provides a good base from which to select an active manager.

  1. Analyze the culture of the firm. Do an extensive look into the culture of the firm you are looking to invest with. Is it independently owned, or not? How much capital do the portfolio managers have in their own funds? What education and experience do the portfolio managers have? Does the firm have high turnover in their strategies?
  2. Assess the TOTAL cost structure. All too often we hear about how low cost funds beat high cost funds. In the isolated variable world of academia this is true every time. But in the real world this may or may not be true. Assess a funds risk structure, expense ratio, turnover, and overall drawdown metrics. All of these will help you to assess what the true cost of this fund may be vs an index. We will look at a few examples below.
  3. Assess the Investment Strategy. Make sure the firm's investment strategy is one you can stick with for the long run. Doing an extensive due diligence results in a firmly planted conviction in a firm, and their investment strategy. This is essential before you choose to invest, but once you do, stay with it for the long run. If the firm has research on their investment strategy explore it further to ensure that the firm's investment strategy aligns with your goals before you invest, and don't buy a hot manager, or select a fund because of strictly performance, there needs to be a multivariate analysis that allows you as an investor to place capital with the firm and the fund for the long run.

Case Study 1: Large Cap Blend

The Mairs & Power Growth Fund (MUTF:MPGFX) is one option for investors looking for a conservative, low cost option for active management. A fund shop that uses a strategic process of assessing companies using Harvard Business School Professor, Michael Porters Five Forces Model. The firm also seeks to take advantage of companies in their own backyard, focusing on Minnesota and the upper Midwest for investment ideas. Living in the community with many of these companies' employees, not to mention quick access to management, make this funds strategy unique. Combine this with a strong internal culture, low costs, and low turnover typically in the single digits, and you have what I would consider an outstanding active investment option for the Large Cap space. The results speak for themselves.

The fund has beaten both the S&P Growth Index and the S&P 500 Index for the past 46 years and beyond. In fact, an investment of $10,000 made in this fund at inception in 1951 would have grown to $4,900,178.97. Vanguard pioneered the first S&P 500 index fund which began trading on 08/31/1976. Had you chosen to put your money in the index vs MPGFX your $10,000 investment would have only grown to $618,707.10, vs MPGFX's ending value of $1,293,251.95, that is more than double the return of the S&P 500.

Case Study 2: International Large Cap Value

There is perhaps no more storied an investment firm, still in existence today, than Tweedy Browne and Co. Founded in 1920, the firm was once Benjamin Grahams broker, as well as Warren Buffett, at the time Buffett was accumulating his control position in Berkshire Hathaway (NYSE:BRK.A). Tweedy Browne's prowess in the mutual fund value investing world is unmatched. The funds communication with shareholders is excellent addressing them as partners and laying out the clear process they go through to analyze a security. The firm provides high level insights in their letters related to value investing, as well as micro level discussions about a particular company in the portfolio.

The firm has engaged in extensive research which backs their view point, which I would recommend as required reading for any investor. No partner has ever left Tweedy Browne except for retirement, reflecting their strong culture and storied history. The partners here invest for the long term, and follow a disciplined Warren Buffett style investment approach. The largest criticism here, is that the fund has not passed on advantages of its size to shareholders with a rather high expense ratio of 1.36% for the Tweedy Browne Global Value Fund (MUTF:TBGVX). But we have to go beyond the mere expense ratio to decipher which investment is truly the most expensive. Tweedy Browne follows a disciplined conservative value investing approach that has served investors well, especially in bear markets.

In their most recent paper Different Perspectives on Investment Performance Global Value Fund, they go through the funds merits for a long term investor, beating the index handsomely after fees, taxes, and other expenses. This is largely due to the funds excellent performance during down markets. Not losing as much as the index is a competitive advantage for an active fund, and a clear reason for why active investing done the right way can lead to serious outperformance for investors.

While Tweedy, Browne has been managing money for private accounts for many decades, the company has only been in the mutual fund business since 1993. Since inception a $10,000 investment in the fund grew to $78,576.35. Compared to the passive investment universe, TBGVX outperforms easily.

Compared to the Vanguard Total International Stock Index (MUTF:VGTSX) from its inception on April 29th 1996, a $10,000 investment in TBGVX would have grown to $52,064.66, vs $23,838.18 for the Total International Stock Index.

Even looking at an enhanced index option, TBGVX continues to outperform. The DFA International Value III fund (MUTF:DFVIX) incepted on 02/02/1995, an investment at inception grew to $37,752.29, vs $65,465.29 for TBGVX, proving once again that active investing done right is the best way for investors to grow wealth.

Case Study 3: Vanguard Wellington

The Vanguard Wellington fund evokes images of a wealthy barons trust fund, it is simple yet elegant. With inception in 1929, a $10,000 investment grew to $9,674,569. Wellington owns a diverse mix of the highest quality stocks and bonds in a traditional 60/40 mix, and it has not only been a compounding machine over the years, it has bested the Vanguard sibling the Balanced Index over every time period. The Vanguard Balanced Index was founded on 11/09/1992, since then a $10,000 investment in the Wellington Fund grew to $87,212.13 vs $64,142.80 for the index. In shorter time periods the fund has continued to best its index sibling over 5 and 10 years. Even better this balanced fund has even beaten the S&P 500 over the past 40 years (1976-2016), with a $10,000 investment growing to $630,726.48 for Wellington, and $618,707.10 for the Vanguard S&P 500 Index fund.


These are three of many examples I could provide for how active investors are creating wealth for clients. The passive investment and evidence based investment camps fail the test of real world data against their academic assumptions. Whether you have a Nobel prize a PhD or whatever else, that is no indicator of success when investing in the real world. Investing, and especially value investing comes down to time tested principles. These principles are what made Warren Buffett wealthy, and they may work for you too, whether you are building a portfolio of your own or looking for active managers that employ these principles. That is why I will forever be a defender of active investing, which done correctly, has proven to be a superior way to invest for the long run.

Disclosure: I am/we are long TBGVX, MPGFX, VWELX.

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.

Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.