The Case For Evidence-Based Investing, Part V: Investment Vs. Speculation

by: EB Investor


There is a great deal of evidence to support the contention that active management is largely a loser's game, but this is not true for all active managers.

In this piece I will review quantitative and qualitative ways to analyze active managers.

I will review how investors can analyze investment managers in order to determine which have skill and which were simply lucky.

Investors' goals are far too important to be left to chance.

I believe that investors might reconsider their faith in professional managers, but I am not ready to damn the entire field. Although it is abundantly clear that the pros do not consistently beat the averages, I must admit that exceptions to the rule of the efficient market exist." Burton Malkiel, A Random Walk Down Wall Street

My views on the role of active management can be summed up by the above quote by Burton Malkiel. I believe so called active investors have a role to play in the portfolio construction process for some investors, providing that a solid case for manager's skill can be made and backed with the requisite data. All portfolio construction decisions should be made with the investor's interests in mind. Without sufficient confidence that an investment manager's results were the result of skill and not luck, wealth managers are in danger of offering sub-optimal advice.

Only when sufficient data can be provided, and confidence of skill established, should an investor or wealth manager consider an active fund. This type of strict data analysis is not perfect, but it increases the chances of making optimal decisions in allocating a portfolio's assets to whatever extent one uses active investment managers. The preponderance of evidence I have presented in this series demonstrates that active management, as it is practiced in today's increasingly complex market environment, has largely been a failure, and the bar for its inclusion in investment portfolios is quite high.

Quantifying Luck vs. Skill in Investment Management

The notion that an investor has the skill to pick a winning manager is just as improbable as that manager beating the index in any given year, because most lack the tools to make these decisions. One such tool is the t-statistic. We can use the t-statistic to decipher a manager's skill or lack there of. We can also use the t-statistic to show how many years we would need as a sample size to determine if a specific manager has skill, or whether their results were simply the result of luck.

The book Investment Performance Measurement has a rather good description of the t-statistic and its usefulness in selecting investment managers:

"We isolate the value added to active management by subtracting the periodic benchmark return from the fund returns. Averaging the value added over a period of time gives us an indication as to the direction and magnitude of the value added. If value added was both positive and large over time, we might take that as an indication of the manager's skill. We can quantify whether or not the value added was significant (or not) by calculating the t-statistic for the value added. The t-statistic is a tool used in the branch of statistics known as inferential statistics. Inferential statistical tests calculate a statistic based on the data that have been collected, where the statistic can be used to infer the strength in the relationship between variables. For example, we are interested in knowing whether or not the value added by a manager is statistically different than zero. To determine this we set up the null hypothesis that the manager has added no value over the period; the alternative hypothesis is that the manager did add value, and we then use the t-statistic to try to prove the null hypothesis false." (p.205)

We can calculate the t-statistic through the following formula:

The author continues by offering an explanation of the interpretation of the t-statistic in making manager selection decisions.

The interpretation of the t-statistic depends on the number of observations used and the significance level selected. The significance level is the tolerance level for accepting that the manager has skill, when in fact he might not. In practice, a significance level of 5% is usually selected and the associated t-statistic required to reject the null hypothesis (that the value added is statistically undifferentiated from zero) is approximately two, depending on the number of observations...The t-statistic works by comparing the value added to that which we might expect to observe given the standard deviation of the value added. If the t-statistic is high enough that it is improbable that we would observe it by chance, we reject the null hypothesis and accept that the manager has added value over the period. If either the fund had outperformed the benchmark to a greater degree over a few short periods of time or we had many more observations of the same relative value added, we might have reached a t-statistic that allowed us to reject the null hypothesis. " (p.206)

Few investment managers would be able to achieve a t-statistic of 2, meaning we have a 95% confidence level that the manager produced the return through skill, rather than luck or pure chance. Even at a t-statistic of 2 there remains a 5% probability that luck explains the results rather than skill. We would thus need a t-statistic of 2.6 or higher to be 99% sure that the manager produced the returns as a result of skill rather than chance. Even in cases where alpha is significant, many times the additional risk taken to pursue the additional return leads to lower t-stats.

Active Management Is a Loser's Game for Most, but Not All

Investment Managers That Test Positive for Skill

“In investment management, the progression is from the innovators to the imitators to the swarming incompetents.” -Bill Ruane

There are investment managers who have tested positive for skill over a long term time frame. There are some investment firms that have a long history of providing investors a great deal of value through a disciplined investment process that keeps costs low, turnover low (often in the single digits), and make investments for years, and in some cases decades. I have only found a handful of firms in the investment universe that are investing this way and test positive for skill (t-statistics above 2.0 for 95% confidence, and 2.6 for 99% confidence). These firms are prudent with investor capital, and often invest large portions of their own net worth along side their clients'.

Capital Group is one firm I have written a great deal about and continue to use to the extent manager due diligence meets the quantitative requirements for skill. They are a unique organization within the world of investment management for those who want an active approach to investing.

“Mr. Buffett’s approach at Berkshire Hathaway has many similarities to how we at Capital Group have built the superior track record of the American Funds― through bottom-up investing, rigorously analyzing companies and building durable portfolios.”

― Tim Armour, Chairman and CEO of Capital Group, February 2017

The partnership of Tweedy Browne & Co, who have produced 534.36% alpha for investors since 1993, is another. A comment in their recent report lays out the argument for the art of real investing in its purest form:

"...we have great admiration for people such as Jack Bogle and Warren Buffett, and perhaps would agree that, in terms of “real” returns, active management is a loser’s game for most, it is not a loser’s game for all. In a recent interview with Bloomberg, Larry Fink, the founder and chairman of BlackRock, expressed a similar sentiment:

I do subscribe to the belief that investing is no different from baseball. Let’s say you have a thousand baseball players. The majority hit .250. We’ll have 45 who hit .300 and we’ll have 10 to 15 who can hit consistently over .300. I don’t believe investing is much different…

The records of many pure adherents to Benjamin Graham’s value based approach over the years are proof of this. At the end of the day, we are comfortable with what we own, the risks we are taking, and the long-term returns we have produced for our shareholders, and this has allowed us to stay the course – which is perhaps the most important thing when it comes to building wealth. While there are no guarantees in the investment business, we remain optimistic and are “tied to the mast,” with over a billion dollars of our own money – that of our current and retired managing directors, employees and their families – invested in portfolios combined with or similar to those that our shareholders own, including over $200 million in our Funds." Partners, Tweedy, Browne & Co.

If an investor is going to engage an active manager, management firms that test positive for skill should be the only active managers that are in an investor's portfolio. Rather than blindly following an index or active approach, following an evidence-based, data driven philosophy to investing is what is most important. Research in the U.S. and U.K. has proven the reason so many investors fail is that, in many cases, they are genuinely unskilled. I believe this is because, in the case of value investing, they have failed to truly grasp the lessons of Benjamin Graham and Warren Buffett. Value investing as it is defined today is not the value investing practiced by Warren Buffett who has held stock in many companies for decades.

This long term approach is followed by only a handful of investment managers today, like a needle in a haystack they elude most investors who fall for the siren's song of short term active management, or the most popular manager holding the hottest stocks. An investors greatest advantage is time, to allow the magic of compounding to work. Too many investors exhibit troubling behavioral habits, supported by the financial media which asks us what are we doing now? The answer almost every time should be--- nothing. Investing is not an area that should take over your life, unless you are a professional.

Quality investments made continuously should be allowed to compound. Investors' tendency to go in and out at the wrong times chasing performance has devastating effects on their ability to invest properly. This is why the individual investor is far better off following the evidence and engaging in a time tested passive approach to manage their assets if they can not do the due diligence to analyze active managers properly. Investors would be wise to follow the lessons of the great father of value investing concerning their behavior:

Active Management for the Ultra-High & High-Net Worth Segment


"There are, of course, some skilled individuals who are highly likely to out-perform the S&P over long stretches. In my lifetime, though, I've identified ' early on ' only ten or so professionals that I expected would accomplish this feat." -Warren Buffett

Many ultra-high & high net worth clients are specifically looking for multiple forms of diversification, including strategy diversification with both passive and active strategies. While I continue to believe that the evidence supports a largely passive core portfolio, ultra-high/high net worth clients may benefit from the variations in styles of these types of disciplined investment managers along with the diversification of asset classes, correlations, and geography provided by passive portfolios. The unique challenges of managing wealth for the ultra-high/high net worth segment are not the same challenges that exist for the mass affluent or the average investor seeking to build wealth.

A core satellite approach that seeks to balance the need for cost and tax efficient strategies with increased exposure to active strategies that offer the potential for outperformance with skilled investment managers, largely through private accounts, is an important decision for the high net worth investor, and should be based on their specific circumstances, values, and goals.

Investors who still want to have some active management in their portfolio, would be wise to seek out firms with statistically significant, persistent skill.

Data should drive these investment decisions, and any investment incorporated into the portfolio should meet these strict standards of excellence through manager due diligence and analysis, especially in situations where private accounts are being used.

In working with a wealth management professional, inquire about the methodology for manager selection. If they do not have one, or if it is too vague to be effective, consider a different wealth management professional.

Turning Active Management into a Winner's Game

Capital Group Chairman Tim Armour wrote an exceptional commentary for CNBC providing his perspective on Warren Buffett's advice that investors should simply own the S&P 500 index and leave active management in the past. Mr. Buffett's advice of passive investing is clearly supported by a great deal of research, much of which I have presented in this series, and Mr. Armour admits "Yes, the average actively managed fund has done worse than the market over meaningful time horizons..." he continues, "but, as Mr. Buffett notes, there are exceptions."

It is these exceptions I want to address. I do believe that active management can be a winner's game for investors when rigorous due diligence is taken into account. Statistical analysis has demonstrated the ability to quantify skill versus luck in selecting investment managers.

Capital Group is one such manager who has been delivering for investors since the 1930s. Their flagship stock fund, Growth Fund of America, has produced cumulative returns of 26,365% since inception, turning a $10,000 investment made at the end of 1973 into $2,646,523 today. This compares to the same investment being made in the S&P 500 being worth a mere $844,296, or 8,343%. Growth Fund of America produced alpha of 18,022%, or $1,802,227 more wealth. One can not attribute such stark outperformance to mere luck. When we test for skill we find that Growth Fund of America tests positive for skill over a long time period. Indeed, many of Capital Group's offerings test positive for skill.

This proves why it is most important for investors to remain open to evidence. Being too tethered to either a passive or active approach to investing creates bias that can have a serious impact on one's investment results or the advice they give to others. Research remains clear that passive investment vehicles, which seek to track a passive benchmark at a low cost, and target the sources of outperformance, should remain the core of an investor's portfolio, but there remains a place for disciplined, low cost, investment managers.

The problem as John Bogle laid out in his book, Clash of the Cultures, is that there is simply too much speculation, and not enough investing for the long run. Far too many mutual funds are gambling with investors' money, hoping to win a game of chance. It is time that investors seeking an active approach to asset management vote with their dollars for investment managers who truly invest money for the long run. Companies like Capital Group and Tweedy Browne have holdings in their portfolios that have been there for decades. Investment managers seek to invest, not speculate in stocks over the short run. It is time investors began rewarding investment firms that put investors first, and seek to create value over years and decades, rather than those that seek short term gains at the expense of long term outcomes.

Can Active Management Become a Winner's Game?

For investors committed to including active management in their portfolios, it is interesting to explore the academic research on what is working in active management. There is a body of research that provides a road map to picking a successful active manager, beyond what we have already reviewed in the luck versus skill analysis previously. It is important to note that you are still analyzing a sliver of the overall fund landscape.

The first screen is for funds that can produce alpha, the second screen is to ensure that the alpha being produced is the result of skill and not luck. Once you have whittled the fund universe down to this select group of managers, we then go further by screening and analyzing a fund and firm's characteristics.

The research clearly defines four characteristics of successful investment managers, which we will use to screen active managers down even further. Doing this type of extensive research and due diligence is essential to making effective investment decisions concerning the allocation of assets.

1. A Long Term Focus That Keeps Turnover Low...Very Low

Funds that consistently turnover their portfolios are speculators, rather than investors. True investors depend on deep fundamental research, and value businesses in whole, purchase businesses at an attractive price and hold for the long run. Warren Buffett is probably the greatest example of this very passive approach to active management. Buffett bought Coca-Cola (NYSE:KO) for example in 1987, and has held it for 30 years. Coke has provided Mr. Buffett with a handsome return over that time period. This explains the problem with active management as it is practiced today, how many funds can you name that are willing to hold a stock for 5 years let alone 10, 20, or 30? I only know of a few firms that take this approach to active management. Most firms have held stocks for as little as less than a year to nearly 2 years, this is in my view pure speculation.

"Covering more than 20 years, the median holding period among mutual funds ranged as low as 0.9 year in the bubble year of 1999, eventually climbing to 1.7 years...Longer holding periods were “unconditionally” associated with better results, the study found, regardless of active share. Yet the only funds to show statistically significant outperformance combined high active share with long holding periods."

Research by Roger Edelen et. al. "Shedding Light on “Invisible” Costs: Trading Costs and Mutual Fund Performance" shows that the effect of turnover is even worse than we thought on investors' wallets. This is because the turnover figure fails to include market microstructure considerations of trading volume and per unit costs. When we adjust for these variables using their proposed method of position adjusted turnover, we find a more accurate effect of turnover on returns.

"...sorting funds on the basis of their aggregate trading-cost estimate yields a clear monotonic pattern of decreasing risk-adjusted performance as fund trading costs increase. The difference in average annual return for funds in the highest and lowest quintile of aggregate trading cost is –1.78 percentage points."

The authors are clear concerning the negative effect of turnover on the portfolio. Investors who are considering an active fund should, according to the literature, give preference to funds with the lowest turnover. Some consider turnover below 50% to be low, I do not. Funds with turnover below 30% are preferred, and funds with turnover in the single digits are ideal. When it comes to turnover the lower the better. I own one active fund that had 1% turnover last year and is routinely in the low single digits. These funds are the ideal.

2. Aligning the Interests of the Fund Manager with the Shareholder

Many mutual fund managers take no positions in the funds they manage. I have to ask, what incentive does the manager then have to produce alpha? This further begs the question what is the link between fund manager ownership and fund performance? Ajay Khorana, Henri Servaes, and Lei Wedge explored this link in their 2007 Journal of Financial Economics paper "Portfolio Manager Ownership & Fund Performance" they found:

"For every basis point of managerial ownership, excess performance of the fund improves by about 3-5 basis points.”

Their research delineates a clear linkage between manager ownership and fund performance. For investors considering active management, the research proves funds with significant manager ownership are preferred over those with lower management ownership.

3. Fund Family Focused on True Long Term Investing

When searching for a fund family for consideration, a strict screen that analyzes qualitative factors is just as important as all of the quantitative analysis. Analyzing a firm for culture, investing philosophy, and most importantly, fund creation strategy, are all integral parts of the decision making process. Fund families that operate an endless number of funds are likely interested in asset gathering and speculation, rather than true investment management. Funds who instead focus on a specific strategy and have a limited number of product offerings tend to perform better.

In the paper "Why Focus? A Study of Intra-Industry Focus Effects," Nicolaj Siggelkow (Wharton) found that U.S. mutual funds managed by firms with a limited set of strategies had higher returns than funds with similar investment objectives that belong to more asset gathering focused fund providers.

"We find that the performance of a mutual fund improves with overall family focus, and in particular with the fund family's degree of focus on that funds category."

Vikrum Nanda (Michigan), Z. Jay Wang, and Lu Zheng explored this question further in their 2003 paper "Family Values and the Star Phenomenon: Strategies of Mutual Fund Families." They found successful fund families with a small number of funds outperformed fund families with larger quantity of funds by 2.5% per year.

We can see from the research that fund size matters, as does the firm's focus on a specific strategy. Fund families with an intense focus and a historical record of staying focused on a specific strategy are preferred to fund families that attempt to offer everything under the sun in an effort to gather as many assets as possible.

4. High Active Share

The active/passive debate and the entire discussion surrounding active management needs to be reframed. Martijn Cremers (Mendoza) and Antti Petajisto explore the spectrum of active management in their 2009 paper, "How Active is your Fund Manager? A New Measure That Predicts Performance." Active and passive are two ends of a spectrum of asset managers. Fund companies like Vanguard are known primarily for their index funds, which are passive. Other fund companies like Dimensional Fund Advisors (DFA) are hybrid managers who take a passive approach to active management through factor bets. Others fall into different quadrants on the graph below.

They found the following in terms of the importance of having high active share:

"Active management, as measured by Active Share, significantly predicts fund performance relative to the benchmark. Funds with the highest Active Share outperform their benchmarks both before and after expenses, while funds with the lowest Active Share underperform after expenses...We also find strong evidence for performance persistence for the funds with the highest Active Share, even after controlling for momentum."

This study clearly shows the importance of high active share when selecting active managers. Those who are looking to implement an active strategy in their portfolios would be well advised, according to the research, to seek out funds with high active share.

In sum, I believe one can definitely put the odds of success in active management in their favor, if they are willing to do the due diligence necessary. I continue to believe that a balanced approach to investment management is warranted, especially for those constructing portfolios for others. Quality solutions in active and passive management exist. Many get caught up in the notion that active funds are all bad, or passive funds are all good; the research simply does not conform to either of these conclusions. The research leaves us with the conclusion that both active and passive management are good for some investors some of the time.

This is especially true when an investor has a specific requirement, such as not owning tobacco stocks or an interest in owning socially responsible stocks. Many religious investors who wish to avoid debt, may want to focus on companies without debt and those companies who do not violate their other moral objections. Quality active management can play a big role in accomplishing their objectives. In all of these discussions on active versus passive, it would seem, based on the research, the key word is balance.


In conclusion, research proves that the majority of active managers are failing at investment management. Their inability to beat the index is attributable to a number of factors. Investors seeking to use active management for a portion of their portfolio, would be wise to perform extensive due diligence of any manager being considered, including quantitative and qualitative testing.

In this series I have made the case for a data driven, evidence-based approach to investment management. I have analyzed volumes of research supporting such an approach to investing, and believe I have provided investors with a more intelligent way to participate in the capital markets. I have sought to prove the merits of Evidence-Based Investing, and why it is a superior long term approach to investing. Basing your investment strategy on centuries of academic and practitioner research and quantitative analysis is far superior to merely speculating in stocks. Investors' goals are far too important to be left to chance.

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.

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.