If index investors and other suboptimal buyers are distorting the markets, it should arguably present an opportunity for active managers to exploit. If so, then why have they not done better during the post global financial crisis period? The answer has to do with timing and timeframes.
Put another way, there will come a point when the misvaluations will become so compelling the pendulum will swing back toward active management. This should serve as a clarion call to talented, proven active managers. In 2009, Martijn Cremers and Antti Petajisto, finance professors at Notre Dame and Yale, respectively, published extensive research indicating that active managers whose equity funds had a larger active share (i.e., the absolute sum of portfolio holdings that differed from the benchmark index holdings) delivered the highest and most persistent returns. Similarly, their research showed that active funds with the lowest active share (“closet benchmarkers”) tended to underperform their benchmarks.
Whether it is stocks, bonds or other assets, an active manager with a rigorous top-down and bottom-up investment process and an outlook that vets the potential for a variety of both short- and long-term developments should be able to outperform a benchmark over time, adding value for investors.
Still, the recent statistics do not lie. As a group, many equity managers have underperformed and overcharged for active equity management. It appears too many closet indexers have disguised themselves as active managers, and with little result to show for it.
Nonetheless, I suspect Professors Cremers and Petajisto would find it difficult to explain the magnitude of the exodus from actively managed funds in favor of indexed strategies. Since the global financial crisis, investors have become less confident and less patient with active managers. During this recent period when flows into indexed strategies have been so strong, active managers, who are ostensibly paid to deviate from the indexes, will naturally underperform. For example, in 2012 there was a high correlation among funds that underweighted Apple Inc., the second-largest stock by capitalization in the Standard & Poor's 500, and their underperformance — that is, until the fourth quarter, when Apple dropped 21%. Following the crowd works until it doesn't.
This in turn raises the issue of timeframe. How long should investors tolerate underperformance of their active managers? Remember that behavioral finance has proved that investor impatience can contribute to poor portfolio performance.
Owning a composition of stocks — whether it is the Nifty Fifty, the dot-coms or “the index” — without regard to the expected future marginal returns on invested capital is choosing to wear an investment straitjacket. While passive strategies can protect us from our worst predilections of fear and greed, they can also serve to artificially restrict the free flow of capital into an optimal set of investments and potential returns.
Finally, it is incumbent on the active asset management community to be transparent about the risks of their respective approaches, and to guard against style-invisible drift, particularly as some managers appear prone to masquerade as active managers while they actually have disturbingly low active share.
The capitalistic economies of the developed nations are being tested as a result of persistently high debt levels, low job growth and increasing political dysfunction. Well-functioning capital markets that allocate risk capital efficiently and optimally are our best way out of this troubling triple threat. The community of active investment managers can and should do better. Investors deserve a better option than straitjacket passive strategies, especially in this policy-driven, debt-burdened, modest-growth environment.
Douglas M. Hodge is chief operating officer of Pacific Investment Management Co., Newport Beach, Calif., and a managing director in the Newport Beach office. He also serves on PIMCO's executive committee and on the global executive committee for Allianz Asset Management.