A front-page story in the Sept. 15 Pensions & Investments headlined “Move to passive likely to build still more steam” prognosticates the slow death of active management.
Before we shop for headstones, let's weigh the pros and cons of letting active management die.
The pros: Numerous studies by Standard & Poor's Financial Services LLC, Vanguard Group and Morningstar Inc. appear to prove that the vast majority of active managers fail to outperform passive ones.
The problem is that these studies suffer from peer group classification bias that overstates the failure of active managers, frequently reporting that more than 80% underperform. All peer groups contain funds that don't belong, which causes classification bias.
William F. Sharpe — STANCO 25 professor of finance, emeritus at the Stanford University Graduate School of Business and 1990 laureate of the Nobel Memorial Prize in Economic Sciences — tells us that an unbiased survey should show that about half of the managers underperform, rather than a vast majority. In his famous “The Arithmetic of Active Management,” Financial Analysts Journal, January/February 1991, Mr. Sharpe noted that active managers in aggregate are the market, so collectively they will earn the market return that is the passive benchmark in performance surveys. In other words, active managers will earn the market return on average, so half will earn less and half will earn more. This 50/50 rule applies to any time period, although there will be different winners and losers along the way.
Even if the surveys are accurate and much more than half of active managers underperform their benchmark, that still leaves a group that outperforms. It's just a question of how small this elite group actually is, and whether we can find them in advance. Can we identify skill?
The cons: Meir Statman, the Glenn Klimek professor of finance, Santa Clara University, Santa Clara, Calif., explains in his book, “What Investors Really Want,” that investors want to play the investment game, and they want to win. They believe their investment consultants can identify skillful active managers.
Few asset owners and investment consultants would claim that all active managers are dolts, that none add value. But candid investment consultants acknowledge that finding skill is a challenge, especially when it comes to complicated strategies, like some hedge funds. This challenge could be conquered by contemporary due diligence, although hardly anyone is willing to do the hard work this requires. The search for skill continues to be conducted with the same old tools that have never worked and never will. It's like the allegory of the drunk and the streetlamp: The drunk loses his keys in a park across the street but he looks for them under a nearby streetlamp because it's easier to see.
The old tools are indexes and peer groups. These are awful barometers of success or failure. Indexes don't work because many skillful managers don't live in style boxes, nor do they hug indexes. Peer groups don't work because they are loaded with biases, with classification bias causing the biggest problems. Peer groups of hedge funds are exceptionally silly because hedge funds are unique so, by definition, they can't be grouped together. Hedge fund peer groups epitomize classification bias because the members don't belong together.
Contemporary due diligence: The odds of actually finding skill can be improved with custom benchmarks and scientific peer groups. Custom benchmarks address the make or buy decision. We can replicate (i.e., make) most managers inexpensively with blends of exchange-traded funds long and short, as determined through custom benchmarking approaches like style analysis or factor exposures. Scientific peer groups, or universes, use hypothesis testing to determine if performance in excess of a custom benchmark is statistically significant. The hypothesis “performance is good” is tested by comparing the manager's actual return to the returns on all the portfolios the manager might have held, following his portfolio construction rules and using his eligible stocks; it's a portfolio simulation.
Consolidate the best: Active management doesn't deserve to die. Clients deserve a better chance of finding the good ones. This task is simplified by reducing the number of active managers.
In a June 5 research post, “There are too many active managers,” Towers Watson asserts active managers should be only 30% of all managers rather than the current 80%. This realignment would be more cost effective for investors and would continue to keep markets efficient. In other words, active management should mostly fade away, but not die altogether.
A reduction in the number of active managers will happen naturally if intermediaries — that is, investment consultants and fund-of-funds managers — figure out who's good and who's not. Then Darwinian principles will prevail and only the fittest will survive. Clients hire intermediaries to perform a talent search, but it fails because the processes remain in the dark ages, and include golf (pay to play). Contemporary manager due diligence could change all that and consolidate the active manager pool down to just the most worthy.
We're all hardwired to resist change, so this consolidation requires more than just my voice. It needs and warrants client help. Clients deserve better. n
Ronald J. Surz is president and CEO of PPCA Inc. and president of its target-date solutions division, both based in San Clemente, Calif.
