The Charge, the Facts, the Verdict
Every day there is mounting evidence in the form of publications, television interviews, and new data analysis that is challenging the relevance of active money (AM) management in the years ahead.
The accusations are varied but the common charge is this: over an extended time frame (let’s say greater than 10 years), the vast majority of AM management strategies provide no discernible alpha—the excess returns of a fund relative to the return of a benchmark index. If true, then logic would presume the average long-term investor is better off placing their money into passive investment strategies that mimic an index and provide a better return after accounting for lower management fees and expenses.
However, before we sentence AM management to its demise, it would be prudent to understand the facts.
Without further ado, the case of the Investing Public vs. AM Management.
How do active managers compare against their benchmarks?
Depending on how you look at the data, an argument for AM management can be made. During down markets (usually correlated with increased volatility), there is evidence to support that AM managers, on an above-average basis, tend to outperform their benchmarks (anywhere from 50–65% depending on the asset class and timeframe the analysis encompasses). Recessions lay companies bare and stock pickers can put their analysis to work and discern the best-positioned prospects—essentially, they can help you lose less. While you typically shed value when the overall markets are down, you would be down less than the relative benchmark if your portfolio manager properly analyzes and re-weights your holdings (i.e. reduced Blockbuster’s position in favor of more heavily weighting Netflix shares several years ago).
On the flip slide, during a bull market run, it is quite uncommon for AM management—after accounting for expenses and fees—to beat their relative benchmarks over an extended period of time. In a recent article published by CNBC, Morningstar analyzed the performance of AM managers against 13 asset classes ranging from large/small cap equities, intermediate bonds and emerging markets from 2006–2016. Over that time, there was not one asset class where more than half of AM managers beat their index. The best performance was within the intermediate bond fund class where 39% of AM managers beat their index. The worst was US equity mid blend, where a paltry 6.9% beat their index over those 10 years.
Consider this interpretation: if you, as a long-term investor, believe that the markets are headed for an extended period of retraction/volatility, then perhaps an active management strategy is the way to go. In theory, AM management is better suited to stop the bleeding. But let’s think about that last statement for a moment and then ask ourselves another question. Why are you investing your money in the first place? If you truly believe the market is going down for a period of time then don’t put your money in the market. If you think you can time the market for volatility and toggle between AM vs. passive strategies, then I wish you the best of luck. However, if you are truly a long-term investor (greater than a 10-year horizon) then it shouldn’t matter over the long term. The DJIA has returned an average of 10% per annum over the 20th century and is headed that way for the first two decades of the 21st. We know that on average over the long run AM management struggles to outperform their benchmarks in a rising market.
What are the cost implications of active money management?
Active money is facing tremendous pressure to reduce fees as investors are increasingly focused on absolute performance (return after all expenses) vs. relative performance (return against a benchmark not accounting for all expenses). Without a compelling case to prove alpha long term, AM management has no justification charging higher fees than the passive strategies that outperform them. A major thorn for asset managers is that a large portion of those expense fees is simply to keep compliant with new regulations and complex processing requirements. Asset managers spend huge dollars on their IT and business operations to keep up and that cost is ultimately being passed onto the investor. The kicker in all of this is that the regulation and processing complexities which burden these asset managers are typically born of the bad behavior by none other than the AM managers themselves who incited the regulation (think investing in credit default swaps + Lehman collapse = Dodd-Frank).
Another interesting fact to share is that the average annual returns of the DJIA from the 1950s (19.28%) and 60s (7.78%), when investment products where much simpler (i.e. no collateralized mortgage-backed obligations, collateralized debt obligation, etc.), outperformed the returns of the 90s (18.17%) and 2000s (1.07%). Essentially, AM management has created artificial demand for products that don’t add value to a portfolio and end up ultimately increasing the risk and operational costs to account for them.
Where is the money going?
Undoubtedly AM management represents the bulk of where investment dollars are parked today. According to Morningstar, at the end of 2016, AM management accounted for nearly $9.3 trillion of investable dollars as compared to passive management at around $5.3 trillion. However, while the difference in dollars is clear, what is also clear and perhaps most alarming for AM management is the trend. Active funds have seen over 34 plus consecutive months of outflows dating back to 2014. To put the hemorrhage in perspective, in 2016, AM strategies saw around $300 billion in outflows while passive management saw net inflows of approximately $430 billion. A net difference of over $700 billion.
Further, in a recent CNBC article, 60% of millennials say they believe ETFs will be their primary investment vehicle in the future. Only 38% of Gen Xers and 19% of baby boomers said the same thing. If you are looking to the future, the millennials will be the ones shaping it.
So what’s the verdict—is active management really dying?
I guess that’s up to you, the jury, to decide.
I do know this, while it looks a bit glum for AM management over the foreseeable future there will come a point where AM will settle into a new reality and it will certainly not have the dominance it once enjoyed. I believe survival of the fittest will weed out those AM managers that offer no differentiated value, leaving the investing public with more focused and better-suited options to choose from down the road—a day we should all look forward to.
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