Devesh and I have an ongoing conversation about the value of active managers. He thoughtfully runs through the arguments – from consistency to tax efficiency – that led him to conclude, “not much value there.” Cool and sensible.
If you want to join the conversation but start with somewhat greater sympathy for the role of active managers, you might consider five arguments.
Measuring an investment by whether it “beats the market” is irrational. It is, nonetheless, the starting point for all criticisms of active management. And, to be clear, those criticisms can get a bit heated. One financial planner wrote to ask whether a piece I’d contributed to on mid-cap funds more reflected the fact that I was “bought off or just stupid.” (Having checked my modest savings account, I concluded that “bought off” couldn’t explain it.)
I’ll repeat the argument I made in “Bright Guys Saying Dumb Things” (2019):
There is no stupider or more destructive obsession in the investing world than this: so how often does your guy beat the market? This is the fantasy football version of investing: we win not by winning but by adding together a bunch of random, unconnected data points and declaring that the person with the biggest piles o’ points won.
Earth to Investors: Fantasy Football is Fantasy. It’s not a model for managing your money. In personal finance, you win if and only if the sum of your resources is equal to or greater than the sum of your needs.
If you beat the market ten years in a row and the sum of your resources is less than the sum of your needs, you lose.
If you trail the market ten years in a row and the sum of your resources is greater than the sum of your needs, you win.
Our guess is that winning requires investments that you understand and can stick with in the long term, ideally calibrated to a calculation of your long-term needs. In my case, for example, I win if my retirement portfolio returns 6% per year. If my 6% returns “trail the market,” I still win. If I “beat the market” but make less than 6%, I lose.
You are much more destructive to your portfolio than your managers are. We panic; we get greedy. We lose focus; we hyper-focus. We pretend we have special insights and, worse yet, act on those delusions. You know all those weird little cloud computing / AI and robotics / disruptive fintech / hemp and pot / obese America / vegan funds and ETFs that have been launched in the last five years? Morningstar “research shows that options for thematic funds—ranging from artificial intelligence to cannabis—have seen a surge in recent years, with $806 billion in assets under management as of the end of 2021” (Morningstar, 3/22). Morningstar tracks the impact of our delusions in their annual “Mind the Gap” studies. The average investor underperforms the funds they’re invested in – active or passive – by 1.75% annually through our ill-timed impulses. The gap is greatest in the sexy sectors and alternative funds (about 4% per year lost) and smallest in boring old allocation funds (0.7% lost).
There is no such thing as “passive investing.” The only truly passive approach to investing would be to assign every person, preferably at birth, fractional ownership of all of the world’s equity, debt, and commodity market. We could call it The One Fund. The total global equity market is about $100 trillion, global debt is $130 trillion and $250 trillion is in real assets.
There would be no other options and you’d sell none of it until you reached your “decumulation date.”
A truly passive portfolio would be 9% US equities, 12.5% international equities, 18% government debt, 9% corporate debt, and 51% real assets.
Just 9% US equities!! Twice as much in God-forsaken foreign stocks? Tons of bonds in a 30-year-old’s portfolio? A toll road in Nepal? (WTF!) You wouldn’t like that, would you? That’s understandable.
Welcome to active management. As an investor, you (or your representative) actively manage your strategic asset allocation (that is, your long-term exposure to stocks, bonds, and so on), your tactical asset allocation (your exposure to them right now, which might vary based on your position on the greed-fear spectrum), and your security selection (Fund A, ETF B, call option C, Stock D). Each of those decisions represents an active bet on your part that one set of options will be more satisfying than another.
And, contrary to the general perception, index funds are not passive portfolios. They represent a series of complex and active decisions, bets, if you will, made by their portfolio managers. The difference is that the portfolio managers reside at MSCI or Standard & Poor’s rather than in the offices of your fund or ETF provider.
By one tally, MSCI calculates 3.5 million potential investible indexes. There are 652 distinct index funds, with expense ratios ranging from 0.0 – 2.01%, tracking US equities alone. They have reported portfolio turnover rates ranging from 0 – 4700%.
But the S&P 500 is …! It’s an actively managed, low turnover fund. The active management occurs at Standard and Poor’s, which updates the fund’s portfolio quarterly. The S&P500 is not a collection of America’s 500 largest stocks. It’s 500 stocks that a committee at S&P has chosen to represent the US market, constrained by a combination of liquidity, profitability, American-ness, and trading rules (which kept Berkshire Hathaway out of the index for decades) and human judgment. Their selection process is opaque and answerable to none. Motley Fool (2019) published a nice walk-through of the process. About 25 stocks per year are booted from the S&P 500, though it’s been as high as 60.
The charm of the best passive funds is that they make predictable mistakes cheaply. The S&P 500 is, predictably and by design, a momentum-driven portfolio. If everyone is rushing to buy Tesla (or, this year, Occidental Petroleum) regardless of the health of its business model or the valuation of its stock, the S&P 500 will rush to buy Tesla. If everyone is dumping Moderna, the S&P 500 will rush to sell Moderna. But, really, that’s about the only sort of mistake the fund will make; it doesn’t pretend to have special insights that other, lesser beings lack. (See, by contrast, Sequoia Fund and their decision to bet 36% of their portfolio on Valeant Pharmaceuticals or Third Avenue Value Fund’s commitment of 40% of their assets around 2010 to Hong Kong property stocks.)
Sensible investors can access an S&P 500 portfolio for between 0 – 61 basis points.
80% of active funds could be liquidated with no loss to anyone except possibly their managers. That’s actually a founding principle of MFO and a carryover from our predecessor, FundAlarm.
Funds can be justified as an investment imperative or a business necessity. By “investment imperative,” I mean that the strategy is really useful, innovative, and rewarding. By “business imperative,” I mean that the fund was launched because the adviser needed a fund like it to “offer a complete suite of investment options” and, hence, to keep investors from taking their money elsewhere. Assuming that an S&P 500 Index fund is a good idea – an assumption I’m happily willing to make – the world needs about three S&P 500 funds. That would be enough to produce a useful downward pressure on expenses. But it has 38 S&P 500 funds, with some offering seven distinct share classes. Thirty-five of those funds, in over 100 share classes, could be liquidated with no loss except to the companies who need them to “keep assets in-house.”
The situation is a lot worse in the realm of active funds. For example, there are 186 separate active funds (some with 16 share classes) investing in US large-cap core stocks, few of which even pretend to add any value for their investors. The five largest active large-cap core funds have correlations to the S&P 500 index of 0.95-0.99. That’s intentional because these funds are business necessities: their imperative is to keep assets in-house, not to do something interesting or distinctive. Put simply, a lot of jobs – and a lot of corporate bonuses – depend on the ability of the managers to hold onto assets. The simplest way to hold onto assets is to avoid getting noticed: never get out-of-step with the index, never act boldly, never take chances. So, they don’t.
So why cheer at all for active funds? At base, I rely on active managers to make prudent risk adjustments on my behalf. There was a time when I thought that checking my investments daily and tweaking them frequently was a good use of my time. I no longer do and, quite likely, I should never have. There are simply too many other things demanding my available brain space – mental bandwidth, so to speak – for me to consistently monitor and adjust market exposure.
Risk management works in the long-term and across market cycles
None of the 50 domestic equity funds and ETFs with the highest 25-year Sharpe ratio are passive products. Of the top 100, only four are passive products. (There are 113 index funds that have been around for more than a quarter-century.)
Shift to a 15-year period, when passive funds and ETFs were much more common and included the major market disruptions of 2007-09, only 14 of the top 50 domestic equity funds and ETFs measured by risk-adjusted returns, were passive. Of the top 100, 17 were passive.
Shift to the Period of the Party, the last ten years in which the most accommodative Fed policy in history created “the market on opioids,” and you still get only 24 passive funds in the top 50 by risk-adjusted returns.
In selecting funds, I’ve looked for several characteristics that allow me to get comfortable with my portfolio and leave it alone, with funds typically remaining there for decades rather than months. Among the characteristics:
- A strategy that I understand well, in preference to algorithms and black boxes.
- A clearly articulated understanding of the manager’s role in controlling risks, in preference to managers who have “pedal to the metal” as their mantra.
- A track record for the manager, rather than just the particular fund, that spans multiple market cycles, in preference to strategies that have proven they work when markets are rising.
- An independent streak, which allows managers to explain why I wouldn’t be better off in a low-cost index fund.
- The ability to invest in more than one asset class, rather than being locked into 80% of the portfolio always in the asset class in the name. That’s a “give them the latitude to zig from time to time” preference.
- Substantial, widespread, and consistent insider investment – by the managers surely, but also by their families, staff, and boards of trustees ideally. One manager admitted, “I hate losing my own money, but it’s deadly if I lose my mother-in-law’s.”
You need to understand what it’s going to take for you to win. That means starting with the “sum of your resources greater than the sum of your needs” calculation, rather than a “beating the market and brag to my brother-in-law” one. (Tools like T. Rowe Price’s Retirement Income Calculator do a phenomenal job of letting you estimate your options and prospects.) From there, determine the long-term strategic allocation you need; how much of your portfolio needs to be exposed to market risks in order for you to have a decent chance of winning? (Our various articles on the stock-light portfolio are a decent part to start.)
Mr. Buffett famously announced that he thinks his wife’s portfolio, as he’s gone, should be 90% Vanguard 500 Index and 10% short-term Treasuries. Uhhh … does anyone else wonder why Warren Buffett’s wife should have any money invested in the stock market? Astrid Menks was born in 1946; she and Mr. Buffett were wed in 2006. At the point of his departure from this realm, she’ll be in her late 70s or 80s and will have … oh, a couple billion in her savings account. One wonders how much capital appreciation she will need in order to comfortably meet her needs.
Think about who, if anyone, is going to try to “tilt” the portfolio to deal with short-term traumas. Then, finally, pick the securities that make it all work. For Devesh, the right answer is a series of indexed products spread across complementary asset classes, and cheers to him for it! For me, it’s a stock-light portfolio of actively managed boutique funds whose managers have a bit of flexibility. For you, it’s quite likely something different from – and, for you, better than – the choices we’ve made. The key is not being trendy, popular or market-beating. The key is reaching the finish line, perhaps bruised but with arms raised in triumph.