Does Active Investing Work in the Information Age?
Markus Muhs - May 20, 2019
Marketing from mutual fund companies seems to suggest they can still consistently beat the market, but can they really. Are they really even? Or is it an illusion?
This is my latest blog post delving into the thought process behind my Elementum Growth Portfolio. To read the other posts, go here.
The main impetus behind the EG Portfolio was to further facilitate the shift in my business away from ad hoc mutual fund portfolios, toward more consistently delivered evidence based investing (EBI). EBI essentially means backing every investment decision with empirical evidence, rather than on hunches, hubris, marketing, etc.
The easiest evidence based decision to make when constructing a portfolio is to choose cheaper index funds over more expensive active funds. It's easy to quantify that, all else being equal, an index fund with a 0.1% MER should outperform an active fund at 1.1%. When comparing different index funds there are mostly just objective variables that can easily be compared: cost (MER), liquidity, tracking error, etc, while comparing active funds can be a lot more difficult and subjective.
One piece of evidence that has been pretty reliable is the fact that most active managers have historically underperformed their benchmarks net of fees. According to SPIVA, over 82% of U.S. large-cap equity funds underperformed the S&P 500 over the past 5 years, and this number has only been trending upward over time as markets and the flow of information become ever more efficient.
Think about it: 30 years ago, if a portfolio manager in New York caught wind of some public news about a stock, it's possible that he or she could act on that news before an individual investor in Denver had the chance to pick up the paper or hear about it on a news channel. Back in the day, professionals had more of an edge and had an easier time creating what we in the industry call alpha. Alpha is simply defined as the excess return that an investor can achieve above the benchmark.
Go back to the first half of the 20th century, to Benjamin Graham's era. In his book, The Intelligent Investor (still among my top 5 recommendations for investors new and old), he talks about analyzing stocks and finding those stocks trading well below their intrinsic value, as if there are a whole bunch such gems out there just waiting to be discovered. This may be why deep value investors are having such a hard time of late: those stocks just aren't out there. Flow of information makes them easily discoverable by all, and the efficient markets assign them fairer market value than they would have in the past. Even if it's the tiniest, most unheard of microcap stock trading on the Venture exchange; there's a message board online about it somewhere, or they're discussing it on Twitter. That stock has been discovered.
In short, today it is a lot more challenging for any active manager to beat the index; it's that much harder to find mis-priced investments and act faster than everyone else, or faster than some algorithm.
Marketing from mutual fund companies continues to tell you otherwise and, knowing that their more recent track records don't "walk the talk", they seem to lean pretty heavily on their long term track records.
Something I notice a lot in fund marketing is the historical "mountain chart". A couple years ago a major fund company debuted a fund in Canada based on a very popular long-running U.S.-based fund. Part of their marketing was around how great the lead manager's track record was from when he started managing the fund in the 1980s. The mountain chart, comparing the U.S. fund's track record to the S&P 500, made it look like he massively outperformed, and continues to this day.
I was a bit dubious, so I looked up the U.S. version of the fund and compared it to the S&P 500 and, surprisingly (or unsurprisingly, depending on your level of cynicism) it actually had underperformed over the past 10 years. It's of course hard to see this in the mountain chart. There's a sort of optical illusion caused by the compounding of early outperformance making it appear that the active fund is still outperforming and distancing itself from the benchmark.
To show how such an early outperformance can affect the look of a mountain chart, I ran a little simulation in Excel. First, I looked up actual S&P500 year by year returns for the past 50 years (1969-2018), assembled those numbers in one column, and applied the growth rates to a $1000 investment compounding annually to show what $1000 would have grown to if simply invested in the index. For simplification I'm excluding dividends.
Then, I created a hypothetical "active" investment where I simply gave the hypothetical fund manager the benefit of the doubt and assumed they compounded at a rate 2% higher than the index through to the end of the 20th century. From 2000-onward I then subtracted 1% (fee drag) from each year's return. Here's what I got:
Evidently, the active fund did better over the very long term, after the initial 30 years of outperformance. If you had to choose between the two lines above, I bet the orange line looks a lot more attractive, no? Even from 2000 onward, it visually appears as if the orange line continues to outperform.
At the beginning of the 18 years of underperformance, in 2000, the index investment was at $12,700, while the active investment was at $23K; a $10,300 difference. At the end, despite the active investment compounding at 1% less, the spread between them had increased to $12,400. The mountain chart is an optical illusion which cleverly disguises a fund's underperformance in more recent years, thanks to outperformance in early years.
Below is what the last 20 years of the comparison look like if you started with $1000 in 1999.
Putting all the fund company marketing and trickery aside, there are certain components in my portfolio where I choose to rely on some active management. Indexing is all well and good, and I generally recommend to retail investors that if you don't have the tools to properly filter active managers, or a good advisor who is looking to put your interests first when selecting securities for you instead of selling their parent company's funds, or whatever generates the most commission, then stick to indexing exclusively. Going active should be the exception, not the norm.
Sometimes diversifying by investment styles can have positive effects on an overall portfolio in terms of managing the portfolio's risk, therefore paying for active management can be beneficial, not necessarily in improving absolute returns, but in reducing the portfolio's risk (and maybe in turn giving you the leeway to add risk in other parts of the portfolio).
Just to dispel another area of confusion propagated by the mutual fund industry and their agents: in no way do I mean that active funds tend to be less risky than index funds. I mean that, just as different asset classes combined in a portfolio yield a lower risk portfolio, different investing styles may also have such an effect. Specific investing styles are generally achieved through active management or through some other factor-based strategy. Imperative, of course, is that active/factor funds chosen still have reasonable fees.
Overall, I accept that I could be wrong about the above and am still looking at passive investments first, and only considering active where a good case can be made. Just as I mention in my investing philosophy: only add a security to your portfolio if it meaningfully adds diversification. Low-cost index funds are the portfolio's core; an added active fund needs to be meaningfully different and can't simply be an overpriced closet-indexer.
My Elementum Growth Portfolio is roughly 75% index-based, 25% active currently. If I didn't think that the 25% might actually trend downward in the future, I might write a whole separate blog post on the various qualitative things I look for in an active manager, but some of the basics I go by:
- Low MER active funds have a tendency to outperform higher MER active funds. In addition to the fee alpha, an active manager of a lower fee fund has less of a hurdle to jump and will be less pressured into taking unnecessary risks.
- Fund company ownership is important: privately owned companies are accountable to shareholders with longer-term perspectives (including often their employees/partners themselves, a bonus), while publicly owned companies are accountable to shareholders who are more fixated on quarter by quarter outcomes.
- Good track records are nice on paper, but what sort of process led to that record? If outperformance is unexplainable, or explained purely by fund manager's "skill", how do you know that the fund manager can repeat it in all sorts of different market conditions? Essentially, if you can't figure it out for yourself, then turn away and assume said manager can't repeat their success.
As mentioned at the beginning of this post, it's part of what will become a series of posts, each taking a deeper dive into my style of portfolio management, in the interest of transparency. If it interest you, you can find past and future posts here.
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Markus Muhs, CFP, CIM
Investment Advisor & Portfolio Manager
Images above sourced from Pixabay or created myself using MS Excel and publicly available information.