Why Active Managers Fail
Excerpt from the book Central Markets, by Robert Lloyd
“The central truth of the investment business
is that investment behavior is driven by career risk. ”
Jeremy Grantham, founder of Grantham, Mayo, & van Otterloo, a Boston-based asset management firm.
Active managers aren't stupid. However, there are numerous academic studies that document their history of underperformance. Most research on the performance and behavior of active managers is derived from studies of open ended public mutual funds, although active managers can be found in hedge funds, private equity funds, pension funds or even individual financial advisers. Mutual funds are typically used to study active managers because they provide researchers with public data on track records, holdings, management, investment process and how they change over time. Additionally, mutual funds typically have professional managers, extensive research staffs and access to the latest investment or trading technology. If anyone can beat benchmarks, this group should be able to do it.
Active management describes a portfolio strategy where the manager picks individual securities like stocks, bonds or commodities. Typically, there is a senior experienced portfolio manager who supervises the overall portfolio strategy and security selection. The lead manager is usually supported by a team of analysts who specialize by sector and do in-depth research on each security held or under consideration for the portfolio.
Passive management, on the other hand, is a portfolio strategy where the fund or portfolio has relatively stable holdings closely tied to a designated benchmark. Without the need for a portfolio manager, analysts, and corresponding support, costs are much lower and performance is easier to monitor. Passive portfolios, commonly called index funds, can be found in mutual funds, exchange-traded-funds, or separately managed portfolio's.
Evidence of underperformance
In 1998, Porter and Trifts documented that a small number of managers are able to outperform the market over long periods of time, but found that there was significant mean reversion after a period of outperformance (Porter, Gary and Jack Trifts, 1998, Financial Services Review, vol. 7, no. 1:57-68). In other words, historical outperformance did not predict subsequent outperformance.
These results were confirmed in 2016 by analysts with S&P Dow Jones (Soe, Aye, and Ryan Poirer, S&P Dow Jones Indices, Dec 2016, “Does Past Performance Matter? The Persistence Scorecard”). Their study examined the persistence of top performance in equity and bond funds by measuring how many funds with top quartile performance over three consecutive 12-month periods retained that top ranking in later years. Out of 631 domestic equity funds with top quartile trailing three-year performance, only 2.85% managed to keep that ranking two years later. Similar poor results were discovered with the fixed income universe. This is an astounding result because of the thousands of hours spent by due diligence teams examining fund historical track records to determine which active managers will outperform in the future. The data indicates past performance is not a prelude to future performance.
Fama and French published one of the most famous studies on active manager performance in 2007 (Fama, Eugene and Kenneth French, 2007, Financial Analysts Journal, vol.63, no. 3 (May/June)). In their study of managers 1984-2006, they reported that mutual fund managers underperformed the market by an amount approximately equal to their expense ratios. Additionally, they concluded that it was nearly impossible to identify managers with superior skill.
Research on managers with good long term track records, when adjusted for style drift, also demonstrate no significant outperformance (Brooks, Leroy, and Gary Porter, 2013, “Investigating Biases in Mutual Fund Alphas”, Working Paper, John Carroll University). For example, managers who say they are value investors, but own growth stocks are drifting outside of their value style discipline to generate outperformance compared to their value style benchmark. When adjusted for this deviation, the manager outperformance is not significant.
One of the most interesting studies on long term performance examined the behavior of superior managers over long periods of time. Reynolds examined 155 funds out of 10,000 that had a ten-year annualized track record of at least one percentage point better than their benchmark, but with lower volatility (Reynolds, Aaron, AAII Journal, July 2011, “The Truth About Top Performing Mutual Fund Managers”). With a filter for positive long-term track records, how did the manager's portfolio behave over shorter time frames during the ten-year period? Approximately 97% of those top managers had at least one three-year period in which they underperformed by one percentage point or more. About half of them lagged their benchmarks by three percentage points and one fifth of them fell five or more percentage points below the benchmark for at least one three-year period. These are the best-of-the-best managers with a proven ability to generate good long term performance, yet they demonstrated fairly long periods of significant underperformance that lasted one to three years.
These studies are not perfect. Academic studies go to great lengths to create broad databases of performance over long periods of time. Missing from this analysis is the recognition that most lead portfolio managers have very short tenures in their positions. A typical ten-year mutual fund track record may include several different lead managers experiencing different market conditions and utilizing different investment strategies.
Another study by Porter and Trifts (Porter, Gary, and Jack Trifts, Financial Analysts Journal 2014, vol. 70, no. 4, “The Career Paths of Mutual Fund Managers: The Role of Merit”) examined the tenure of lead managers. They concluded unsurprisingly that underperforming managers are likely to lose their jobs, but that long tenured managers generally do not outperform the market or their style benchmark, nor do they display consistently superior performance. One of the key takeaways was that constant high turnover among lead managers creates a situation where 55% of the lead managers have less than three years of experience in their jobs.
It is possible for active managers to outperform benchmarks, but the data indicates that the vast majority fail. How can this be when professional managers have the education, tools, and infrastructure to succeed? Most lead managers are MBAs from top schools, hold CFA charters, have access to Bloomberg and Factset terminals, meet with company CEOs and CFOs regularly, read the best Wall Street research, are supported by teams of analysts and are highly compensated. Some academic economists have quipped that so much competition has made the market efficient, therefore there is no chance of beating the competition. However, the answer for this failure is much more complicated.
The conclusion from numerous academic studies is that active management rarely outperforms consistently. Most of the literature has a negative bias, ignoring practical studies like that of Reynolds (2011) for those of purer statistical relevance like Fama and French (2007). Curiously, that has not stopped some professors from trying their hand at active management. Funds run by academics have had mixed success over long periods of time. An example of a fund that unsuccessfully applied academic theories was Long Term Capital Management, which was a spectacular failure.
Why Active Managers Fail
Active management failure has multiple causes that generally fall into three broad categories:
1. Structural – Factors that involve the organizational, legal and practical aspects of money management.
2. Social – Factors that explain the interactions between the active managers and those who employ and supervise them.
3. Behavioral – Factors related to the biases all active managers possess as human beings.
Structural Reasons for Failure
The structural reasons for active manager failure are due to six key issues: the institutionalization of money management, the proliferation of benchmark comparative analysis, central bank market interventions, the shrinking number of the public companies, and pervasive insider trading. Each one of these factors has developed over time to become a major problem for the active manager.
The Institutionalization Of Money Management
Institutional money management is its own worst enemy. Modern institutional money management evolved from fairly simple beginnings in bank trust departments to a vast industry comprised of pension funds, insurance companies, review boards, lawyers, consultants, regulators, risk managers, investment bankers, and mutual fund companies. The objective of this vast infrastructure is good: to preserve and grow the assets under management in order to meet the needs of the beneficiaries. However, the interaction of each participant is driven by the unique needs and behavioral weaknesses of each individual. The action of each separate group to promote and protect themselves creates an environment that dramatically inhibits the long term goal of growing the investable assets they are responsible for. The one thing every player has in common is a desire to keep their job and collect a paycheck.
Pension funds, mutual funds, endowments and insurance companies are similar in that they typically have vast amounts of money to invest. While some manage these assets on their own, many hire outside firms of professional managers commonly called sub-advisers. Sub-advisers usually manage a small piece of a much larger portfolio.
Supervising every public fund and endowment is a board of directors. Board members are typically the nicest and best connected people you will ever meet. However, they are not always industry or finance experts. To compensate for this lack of expertise, most boards hire law firms and consultants to prepare expert opinions on performance, structure, management, benchmarks and other areas of interest. The board members have a fiduciary responsibility to the fund beneficiaries and are subject to lawsuits and embarrassment if they fail. The goal of every board member is to continue serving their board or moving on to a more prestigious and better compensated board position. The board’s primary role is to monitor the CIO and portfolio management team, and replace them if long term goals are not being met.
Director boards hire consultants and risk managers to help prepare independent reports on the managers supervising the investable assets. The consultants may evaluate the CIO or sub-adviser's performance and in many cases provide recommendations for replacement. Depending on the complexity of the portfolio, boards will meet four to eight times per year.
The risk managers and consultants hired to review performance are usually experts in financial analysis with credentials and experience similar to the portfolio managers they review. In addition to analyzing the performance of existing managers, they may also be paid to suggest alternatives or replacements for underperforming managers. As with CIOs, the risk managers and consultants are also familiar with the research on track records and duration of underperformance.
Board members may be familiar with these concepts, but must be ready to answer to the public for fund underperformance and fees paid to managers. The problem of carrying an underperforming manager becomes an image problem. For example, how long should an underperforming manager be retained, all the while charging fees? Even if the rational decision is to retain the underperforming manager, both the CIO and board members are pressured to change managers to fulfill the expectation that they are performing their due diligence function and acting as responsible fiduciaries. Risk managers and consultants contribute to this problem because they see themselves as catalysts for change. The pressure for change, though irrational, is very strong.
The Problem With Benchmarks
Benchmarks, modern portfolio theory, and factor analysis have transformed performance measurement and supervision. Increased computing power and the internet have put powerful financial tools into the hands of most investors. Portfolio performance can be tracked and analyzed on a daily, and in some cases, a second by second basis. This has not led to an improvement in active manager performance, however. Ease of measurement increases the desire to change managers when performance lags. It also generates constant calls to the active manager to explain performance drift from benchmarks, when all finance professionals know that over shorter time periods portfolio and market movements become random and difficult to explain. Part of the problem is the construction of the benchmarks themselves.
The first benchmarks of stock market performance were created by Charles Dow in 1896 to help sell his newspaper, the Wall Street Journal. Today we know these as the Dow Jones Industrial Average (DJIA) and the Dow Jones Transport Average (DJTA). These indexes are price weighted, meaning if you owned one share of a basket of stocks, the average was simply an average of the stock prices. In this type of benchmark, the stock with the highest price is weighted the most.
While price and market-cap benchmarks are widely followed by the investing public, the S&P 500 took on an especially important role in academic research during the 1960s and 1970s. In the early 1960s, the Capital Asset Pricing Model (CAPM) was introduced by several researchers working independently. William Sharpe generally gets credit for trying to publish the idea first in 1961. In economics, as in many parts of life, there is resistance to change and new ideas. Sharpe's paper on CAPM was initially rejected by the Journal of Finance as being irrelevant. His experience was similar to that of Harry Markowitz, who had trouble with his PhD thesis committee because they didn't think a paper on portfolio construction was a topic for economics. Ironically, William Sharpe, Harry Markowitz, and Merton Miller would later share the 1990 Nobel Prize in Economics for their contributions to the field of economics.
Sharpe's theories laid the foundation for modern portfolio theory. The key insight behind the CAPM concept was that security risk could be broken down into two components: systemic and non-systemic risk. Systemic risk was correlated with changes in the broad market. Non-systemic risk was that which could not be explained by broad market movements.
The theories of Sharpe and Markowitz revolutionized portfolio management and became the building blocks of modern financial economics. In 1988, Sharpe applied his CAPM concept to the analysis of mutual fund portfolios to determine manager skill. This formula and the concepts behind it dominate modern performance analysis to this day (Sharpe, William F. (December 1988), "Determining a Fund’s Effective Asset Mix". Investment Management Review: 59–69).
There was one problem, however. When tested with real world data, the CAPM theories were found to be weak and in some cases conflicting. Remember, economics is not a science like chemistry where the periodic table of elements is considered settled science, no questions asked. Economics is the study of human behavior in the markets, and humans do not always behave rationally or consistently. More importantly, theories modeling behavior are attempts to generalize complex behavior between multiple players, constraints and incentives.
In 2004, Fama and French wrote an article examining CAPM that concluded that the failure of the theory in most empirical tests invalidates most applications of the model (Fama, Eugene F; French, Kenneth R (Summer 2004). "The Capital Asset Pricing Model: Theory and Evidence" Journal of Economic Perspectives. 18 (3): 25–46) . Despite this startling conclusion, modern portfolio theory constitutes the basis of financial education and permeates the risk reports managers and consultants use to review active managers today. Not only are active managers contending with benchmarks that are not efficient portfolios, but those same flawed benchmarks are key factors used in performance analysis based on theories that apparently don't work well in the real world. Amazing.
In recent years, new techniques such as factor analysis and contribution/attribution reports have become popular. Factor analysis attempts to measure performance by determining the macroeconomic factors driving portfolio performance. Typical factors might be growth, value, oil prices, interest rates, currencies, Fed policy changes, security valuations, or any other variables relevant to the active manager's style. Factor analysis tend to be of limited use, however, as it tends to reveal what the portfolio manager already knows. For example, a portfolio overweight energy will have a high factor exposure to oil prices, a self-evident conclusion.
Regulation Full Disclosure (Reg FD)
The passage of Reg FD in 2000 dramatically changed the world of fundamental investors, they just never noticed. Under this SEC regulation, companies were required to fully disclose material non-public information in a uniform and simultaneous manner to improve market fairness and limit insider trading. Most companies immediately began limiting disclosure of important information to press releases or other broad public forums. As the legal departments gained more control over company communications, the leakage of important company data points to analysts and fund managers gradually declined.
At the same time this regulatory change occurred, technology that could read press releases, headlines, and analyze earnings reports quickly became widespread in the market. To a certain extent, fundamental analysis was automated resulting in the near instantaneous reaction to company specific news. The market now moves quickly on all news items, eliminating time for a thoughtful analysis and portfolio change. In today’s rapid market, many believe the reaction to the news is usually more important the news item itself.
All finance students will recognize this as a dramatic increase in market efficiency as described under Fama’s Efficient Market Theory. Eugene Fama won a Nobel prize in economics for his theory that all relevant public information is included in the price of a security. As market efficiency increases, the value of research based on public sources of data decreases.
Central Bank Market Interventions
Central bank policy creates structural problems for active managers. Both here and abroad, central banks have regularly intervened in the stock and bond markets for national policy purposes. The central banks believe that trading bonds and stocks on the open market will add or subtract liquidity to accomplish their monetary policy goals.
In the United States, the Federal Reserve has focused its intervention on Treasury and mortgage bonds. Switzerland, on the other hand, has chosen to invest heavily in US stocks as a method for weakening their currency. As of June 2017, the Swiss central bank held $84 billion in US stocks with major holdings in Apple, Microsoft and Amazon. This made the Swiss central bank one of the largest actively managed US equity portfolios in the world.
Japan's central bank also owns stocks. Through their index ETF purchases, the Bank of Japan became a top-10 holder in 90% of large Japanese companies. This activity took place regardless of the value or growth characteristics of each security.
Constant central bank intervention distorts the market's ability to function normally. If stocks and bonds rise due to central bank intervention, there is little room for active managers to reward good companies by buying their securities and selling those of poor companies. Because of this, weak companies waste precious capital on business models that should be restructured or eliminated. This type of intervention negates the benefits of market capitalism and concentrates wealth in financial centers. Additionally, because financial securities are typically owned by the wealthy, the positive wealth effect is focused on those in society who least need it.
Finally, the ease with which profits are made from securities trading and financial engineering creates a huge disincentive for companies to invest in productive capital investment. Instead of building plants and factories, companies are buying back their own stock and paying special dividends with operating free cash flow. Shareholders are delighted with this situation because stock prices rise. However, when companies don't invest in plant and equipment, the infrastructure for growth is not put into place. Policies utilizing the wealth-effect theory to stimulate short term growth strongly discourage long term investments.
Central banks have evolved from providing liquidity in times of crisis to facilitating government policy objectives supporting growth and employment. In general, the financial community has supported this intervention because the resulting higher asset prices generate higher revenue for most entities that charge fees based on assets under management. The problem for active managers is that they tend to be experts on economics and companies, not governments and the market impact of policy changes. With a distorted economic and market cycle, there is greatly reduced opportunity for active managers. This results in the ongoing reports that indicate active managers are not able to keep up with constantly rising benchmarks.
The Disappearing Public Company
Another structural problem hindering active managers is the declining number of public companies. In 1996 there were 7,322 public companies; in 2017 there were 3,671 (The Economist, April 2017, Schumpter, Why the decline in the number of listed American firms matters). The universe of public companies continues to shrink. This trend is driven by three key factors. First, the 2002 Sarbanes-Oxley Act tightened disclosure rules and criminalized acts that misled investors. Passed in the shadow of the 2001 bear market, this law was designed to correct problems created during the late 1990s. Most company CEOs hate this law. One way to avoid it is to remain a private company.
Second, the growth in private market liquidity created an alternative for many company founders and small companies that could only sell their companies by going public. As private equity investment assets grew, many large companies opted to remain private that in other times would have sold an initial public offering (IPO).
Third, continued merger & acquisition activity between public and private companies has also reduced the broad spectrum of stocks available to trade and invest. One byproduct of this trend is that the benchmarks continue to get more concentrated into fewer stocks as companies merge.
Pervasive Insider Trading
It seems unbelievable in this age of minimal electronic privacy, aggressive prosecutions and heavy handed regulation that insider trading would take place. Yet, there is strong evidence that insider trading is widespread in the financial market place. This behavior occurs despite clear rules promulgated by the Securities and Exchange Commission (SEC) and Commodities Futures Trading Commission (CFTC) to prohibit insider trading.
Since the 1930s, specific rules such as SEC rule 10b-5 prohibit insider trading of stocks. They have been published and understood by the investing community for decades. The SEC clearly defines insider trading:
Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information.
In 2010, the CFTC was given broad powers from the Dodd-Frank Financial Reform statute regarding fraud prevention. Based on the SEC's precedent, the commission is now enforcing rules similar to that of SEC rule 10b-5. It is now illegal for most people to trade commodities, futures, stocks or bonds using inside information.
There are two groups not covered by the SEC and CFTC insider trading rules. The first one is obvious: investors and traders not present or active in U.S. jurisdictions are not covered by the law. To the extent insider information helps them in overseas markets, this informational advantage is not illegal under U.S. laws. The second group is less obvious: the U.S. Congress and their staffers. Incredibly, Congress exempted themselves from insider trading laws under the logic that separation of powers between the Executive, Judicial and Legislative branches of government prevent the law from applying to Congress.
Studies of Congressman's trading data reveal a remarkable ability to beat the market. Ziobrowski (2011) found that from 1985 through 2001, members of the U.S. House of Representatives executed 16,000 common stock transactions, generating approximately 6% annual excess returns over the broad equity benchmark return (Ziobrowski, Alan, James Boyd, Ping Cheng and Bridgette Ziobrowski, Business and Politics, Volume 13 Issue 1, April 2011, Abnormal Returns From the Common Stock Investments of Members of the U.S. House of Representatives). A similar study of the Senate found even better relative performance. It is highly unlikely skill or luck played a role in this group's ability to invest so wisely. There is also evidence that politically connected corporate insiders executed trades 30 days in advance of bailout announcements during the 2008 Financial Crisis (Jagolinzer, Alan, David Larcker, Gaizka Ormazabal, Daniel Taylor, September 8, 2016, Political Connections and the Informativeness of Insider Trades, Rock Center for Corporate Governance at Stanford University Working Paper No. 222). In case you are wondering, there are over 2700 congressman and staffers exempt from insider trading laws in our country.
In 2010 and 2012, the Federal Reserve was caught leaking confidential FOMC meeting notes to the public (Reuters, January 15, 2016, Fed was worried 2010 leak amounted to “insider trading”: transcripts). Many in the Fed were shocked to discover that this behavior was criminalized by Dodd-Frank. Investigations are ongoing at this time. Based on the Fed's desire to influence markets as part of their monetary policy, knowledge of future Fed actions has become extremely valuable to those who get the word and trade early.
The worst insider trading scandal began in 2009 with a crackdown by federal prosecutors and the FBI on industry consultants (Edde, Julie, Nishant Kumar and Suzy Waite, Bloomberg News, February 27, 2018, Investors Are Paying $1300 Per Hour for 'Expert' Chats). 95 people were convicted, among them fund managers, analysts, and employees at public companies working part time as consultants for expert networks. These networks charge investors a fee to discuss industry or company issues with experienced insiders. The problem arises when the topic crosses the poorly defined threshold of “material non-public” information. While the individuals who broke the law were rigorously prosecuted, the firms that sponsor these expert networks tweaked their compliance systems and continued providing experts to “inform” and “educate” investors.
Finally, on Wall Street there is evidence that central brokers gather information by executing informed trades, then leak that information to their best clients. Informed trades are defined as large blocks of stock traded by hedge funds or activist investors. Di Maggio (2017) examined trade level data to show that after large informed trades, a significantly higher volume of other institutional investors executed similar trades through the same broker, allowing them to capture higher returns in the first few days after the initial trade. In contrast, they found that when the informed asset manager was affiliated with the broker, such imitation did not occur (Di Maggio, Marco, Francesco Franzoni, Amir Kermani, Carlo Sommavilla, The Relevance of Broker Networks for Information Diffusion in the Stock Market, Swiss Finance Institute Research Paper No. 16-63, Harvard Business School Working Paper).
Similarly, the clients of a broker employed by activist investors tended to execute their stock trades just before the filing of news on the same stock. This evidence suggests that an important source of alpha for fund managers is the access to better connections rather than superior skill. The bottom line here is that information about large trades leak into the market to benefit the best clients of a central broker.
It is time consuming and difficult to identify and prosecute insider trading. While the authorities try to keep up, the tremendous complexity of markets and relationship networks make it unlikely regulations will easily deter this behavior. Insider trading inhibits the performance of law-abiding active managers.
Social reasons for failure
The social structure of the money management industry is a major contributor to active manager failure. Despite the different environments where active management is practiced, organizational politics plays a massive role hindering the ability of the active manager to deliver good performance. This topic in money management is seldom considered seriously, although some risk managers and consultants believe bigger teams and more oversight are positive attributes when selecting a manager. Nothing could be further from the truth. In particular, team structure, firm politics, career trajectory, conformance pressure and business responsibilities contribute to an active manager's inability to deliver good performance. Additionally, as the industry consolidates, opportunities for employment, professional development and leadership experience have declined.
Most investment teams consist of one lead portfolio manager surrounded be a group of junior managers and analysts. The senior manager may be someone with five to ten years of experience.
Team structure ideally allows the senior manager to supervise the basic research process, leaving the details to the analysts. This will free the portfolio manager for other responsibilities such as marketing, board meetings and management meetings. The problem with this arrangement is that the senior portfolio manager probably was promoted for his ability to analyze companies and pick securities in one particular area. As a supervisor, he must now impose his own investment process on sectors he is not familiar with and work with analysts that may lack talent.
Naturally, this creates friction with the analysts, who are themselves juniors learning the business, but also because they know their narrow sector better than the boss. While tracking portfolio performance is fairly straightforward, analyzing analyst contribution to performance is difficult. While ultimate performance responsibility resides with the lead manager, analysts play a critical role in security selection, for better or worse. Team structure is critical factor for active manager success.
The inability to isolate investment skill among analysts and managers is one of the key reasons firm politics play an important role in the promotion of individuals to positions of leadership. You would think the large money managers would have a program and process for identifying talent, but sadly this is not the case. In most large firms, the analyst pool is the first place to look for investment talent. As with any hire, upper management is looking for highly educated, articulate, credentialed team players to lead fund management teams.
Identifying a verifiable track record of investment outperformance is nearly impossible, however. Hiring someone from outside may bring a track record, but can be expensive and controversial if non-compete agreements are involved. Ultimately, the CIO must make a decision on selecting a lead manager without clear evidence of ability. This situation contributes significantly to a sink-or-swim attitude regarding new managers, despite the knowledge that a manager's ability may take time to manifest itself. Most new managers are learning the complex lessons of leadership on the fly.
The personalities of senior managers can also affect politics within the firm. Let's face it, if the CIO and a fund manager hate each other, it is only a matter of time before the lead manager is replaced, regardless of track record and pedigree. This brings up the role of career risk for active managers. Lead managers get compensated based on performance and tenure. So, the best paid active managers are those with the longest tenures and best track records. However, long tenures and great track records rarely run together based on the evidence of active manager underperformance reviewed earlier.
Active managers worry about career risk. They are shrewd enough to realize that investors and upper management want outperformance, not underperformance. Underperformance results in the active manager getting terminated. This means the active manager's incentives are different than that of his investors. While risk managers, consultants and investors want a style-pure fund manager with high active share, the active manager has a strong incentive to closet benchmark his portfolio. A style-pure fund is one that consistently applies a value or growth investment process to security selection. Active share is a measure of portfolio benchmark overlap. Portfolios with high active share possess little overlap with their benchmarks, allowing the active manager a chance to significantly outperform or underperform the benchmark.
From the perspective of the active manager, high active share is undesirable because it increases the probability of a career-ending period of portfolio underperformance. It is no accident that managers with long track records have delivered uninspiring performance. The brave active managers that took risk and dramatically outperformed their benchmarks only to predictably underperform later lost their jobs. Jeremy Grantham explains:
“The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business, we are all agents, managing other peoples' money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority 'go with the flow', either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest.”
This is what Porter and Trifts (2014) discovered while examining the tenure of lead managers. They explained that underperforming managers are likely to loose their jobs, but that long tenured managers generally do not outperform the market or their style benchmark, nor do they display consistently superior performance. What Porter and Trifts did not uncover was that the managers with long track records were not managing for outperformance, but for tenure, compensation and career longevity. Consistent average performance by the long tenured manager is not by accident, but rather by design.
Pressure To Conform
Money management firms also create cultures that pressure active managers to conform to peer group and benchmark holdings. There are several reasons for this. First, while firms with large assets under management (AUM) tolerate average performance, significant underperformance may risk loss of investors and the associated fee revenue. One way to prevent this is to develop techniques for replicating benchmark holdings to minimize portfolio drift while leaving the active manager flexibility to add some positive alpha with the remainder of the portfolio. Strongin, Petsch, and Sharenow (2000) presented one such process suggesting that at a minimum, a certain amount of benchmark hugging was required for the active manager to outperform over long periods of time.
The goal of this technique is to help the active manager avoid missing a large benchmark move by owning the critical components of the benchmark. For most market-cap weighted benchmarks, this means permanent positions in those stocks that make up the heaviest weights in the index. Based on the recent report from S&P Dow Jones4 on poor sustainability of manager outperformance, this lesson has not been adopted widely.
The second source of pressure for conformity comes from within the investment department itself. CIOs sometimes press active managers to share their investment outlook, best ideas or trading strategies internally. This creates an environment where new ideas can be heavily critiqued or front-run by other teams. There is a significant amount of resentment and envy when one manager or team is successful while others lag in performance. Successful managers are encouraged to help other teams, even at the expense of their own portfolio. After all, they all work for the same firm, right? The requirement to share and defend ideas among your peers can be exhausting. It is emotionally easier to own securities that are not controversial and approved by internal consensus thinking.
The third source of conforming pressure originates from the security holdings of style peer groups. Just as S&P has created a benchmark of the 500 largest companies, there are benchmarks based on what various style groups own. For example, Lipper and Morningstar both have indexes based on what growth and value funds own in aggregate. These sometimes resemble, but don't perfectly mirror, the common rules-based style benchmarks created by Russell Investments and Standard and Poor's.
There is a difference between what the Russell 1000 Growth benchmark holds and what the Large Cap Growth managers own collectively. Both holding lists can be used to judge active managers willingness to deviate from the crowd to create reward and risk for the fund management company. There are peer group and benchmark holding lists for every style and asset class you can think of: equities, bonds, currencies, alternatives, international, and emerging markets.
The final social factor inhibiting active managers are mundane business responsibilities. Every lead manager with a team must, at a minimum, supervise research, review, hire and fire team members, present to boards, report progress to the CIO, answer compliance questions and participate in the marketing effort. Marketing and raising money can be extremely time consuming. For those of you who have worked in the field, you know that client interactions, letters, emails, reports, and meetings can consume enormous amounts of time. If the active manager is unlucky, he may also get tasked with managing the research budget, laying out office space, or negotiating the cost of new computers.
Managers with extremely good and bad performance records also have additional duties. The successful manager will be called on extensively to raise money by giving additional presentations, appearing on television, writing articles and traveling with the marketing force. Conversely, the failing manager will be spending a lot of time with the CIO and board members explaining bad performance and what is being done to fix it. Either way, the fund investors lose as the lead manager gets distracted from the primary job of managing money.
There is a line of thought that it is no use complaining about all these restrictions placed on active managers, because all managers face the same the same issues and constraints. In this sense, the constraints among active managers are certainly fair and equitable. However, if most active managers can't consistently beat their benchmarks, then the fairness-of-constraints argument is irrelevant because of the cost effective alternatives to active management. Rational investors will logically pursue an index investing strategy. In fact, this is what has happened over the last decade as billions of dollars have left active management for passive management strategies.
Behavioral reasons for failure
Behavioral flaws affect all types of active managers. Whether they use fundamentals, valuation, quantitative measures or technical signals, all active managers are subject to the cognitive flaws of human nature. Behavioral finance examines persistent biases that exist and distort our investment decision making processes. The major ones affecting active managers are anchoring, confirmation bias, gambler's fallacy, overconfidence, herding behavior, endowment effect, and the hot-hand bias.
For decades, investors have tried to create mechanical systems that overcome the weaknesses of humans making trading decisions. However, behavioral flaws in investing can never be eliminated because a person in authority is ultimately required to make a decision to hire-and-fire a manager or change a strategy. Additionally, the institutional money management world is full of people, not machines deciding strategy, allocations and investment goals. Individual human biases and mass psychology will always be a factor in investing.
For an investor subject to the anchoring bias, irrelevant statistics, prices or ratios become important drivers in making short term decisions. Quantitative trading strategies advertise their ability to manage money by using proprietary methods based on advanced statistical analysis. By examining historical data and market prices, a mathematical model is used to create trades. Clearly, this strategy relies heavily on historical data, discourages human interaction and benefits from the tendency of history to repeat itself.
Unfortunately, financial markets and current events are highly variable and the relationships between historical and future events are constantly changing. Another logical flaw with the quantitative approach is that a computer model analyzing prices is unemotional, while historical prices themselves are a reflection of the emotions and decisions of other traders and investors. Because computers are programmed by humans and use as their inputs market prices, they themselves are particularly vulnerable to the anchoring bias.
An example of this bias is the situation where a security that has fallen from one price level to another. Investors expecting a reversion to the old price level may buy the security hoping prices go back up to their old levels. The original price level is the anchoring point for this bias. Conversely, in technical analysis, trends in prices are particularly attractive. Rising prices are expected to continue rising because the most recent history of prices shows exactly that. In both of these cases, the anchoring bias is to the recent price and it's influence on the investors expectation of future prices.
For value investors, valuation ratios are important screening and investing tools. However, most investors agree that these tools are informative, but poor timing tools for investment. The investor with an anchoring bias believes the valuation will revert to an older level, whether it be higher or lower.
Investors with confirmation bias seek out information that confirms an existing opinion or belief. Facts that contradict this belief are filtered out or ignored. This bias overlaps with the overconfidence bias, a state of mind where the individual is firmly convinced that a strongly held belief is correct, regardless of whether it is true or false. The strength of belief may be based on research that confirms an idea, or ignorance of data the refutes the idea as valid.
Investors are faced with numerous conflicting opinions and data. The fact that economic data itself is noisy and difficult to interpret aggravates these biases. Those with the confirmation and overconfidence bias find plenty of data to justify retaining a position. One glaring example of confirmation and overconfidence bias is the continued use of modern portfolio theory to evaluate active managers. Despite the demonstrated inability of the theory to work empirically, risk managers and consultants rely heavily on the output of CAPM models and benchmark comparisons to evaluate performance.
The gambler's fallacy affects those investors who believe the frequency of a recent pattern indicates a change is imminent. For example, if an event happens more often than normal, then someone subject to the gambler's fallacy would expect those events to become rarer in the future. Similarly, if an even happens less frequently, this bias would lead one to think the event frequency will increase soon. At the core of this bias is the confusion of randomness with cause-and-effect relationships. Economic data is littered with randomness and unstable concepts that are difficult to understand and predict.
Herding behavior is quite obvious in the financial marketplace in both manager and security selection. In the securities markets, herding most obviously occurs at extremes of optimism and despair. Markets that are overly optimistic for extended periods of time typically evolve into bubbles. Speculative bubbles, while not clearly defined, are built around a common belief that asset prices can only go up. This becomes self-evident as popular securities keep rising, enriching those on the right side of the market. One of the defining characteristics of a bubble is that it is not sustainable. However, while it is inflating, investors come to believe that profits can best be made by buying and holding the rising asset. It feels comfortable because many other people are doing the same thing.
Of all the behavioral biases, this one is the easiest to understand because we see that same behavior affecting fashion, politics, education, and entertainment. Conversely, an extreme of despair creates a herding behavior to sell, frequently well below what would be considered fair valuation. Many people are familiar with the bubble and collapse of technology stocks in 2000-2002 or the housing bubble of 2007. These are cautionary tales for long term investors. The successful active manager is aware of the tendency for the crowds to go to extremes and tries to take advantage of it. However, the typical active manager is just as much a victim of bubbles and collapses as the retail investor. You see, if the active manager resists following a speculative bubble, he is guaranteed to underperform his benchmarks and peer groups. Because this is fatal for the manager's career, most active managers fully participate in the pop and drop of a bubble episode. As one manager once quipped, stocks in a bubble are the ones I need to hold to keep my job.
This is what happened to the growth managers during the technology bubble of 2000 and the value managers during the housing bubble of 2007. Benchmark aware active managers cannot protect their clients during periods of extreme herding. This behavioral bias is the primary reason predictions of active management coming back into style are never realized. The managers that resisted investing in bubble securities were fired during the bubble inflation, while the bubble chasers were promoted and rewarded.
Hot Hand Bias
Manager selection can also be affected by the hot-hand bias. Active managers can become extremely popular, gathering assets after a recent string of strong returns or an good market call. Some investors will chase relative performance by investing only with managers that have done well recently. Based on the data reviewed in the last section, you can imagine how poorly this strategy works in practice over long time horizons. Investors wind up leaving managers during their slumps instead of waiting for performance to improve. By investing with a different active manager with better recent performance, investors follow the new manager into their inevitable period of weakness.
Chasing performance is perhaps the greatest behavioral bias affecting institutional investing. Sadly, the money management industry's structure reinforces this behavior. Consultants and risk managers are in the business of replacing underperforming managers with those who have better “recent” track records. That is how they earn their fee. It may take years before this type of bad decision is realized, if recognized at all.
The endowment bias affects those investors who can't let go of investments they already own. Due to familiarity, sloth, or tax reasons, many winning investments are held well beyond maturity. While professional investors love to say they cut losers and let winners run, the reluctance to take profits and move on creates a situation where profits don't get maximized or may become losses. While minimizing taxes is a worthwhile goal, including tax implications when making an investment decision usually leads to a poor outcome. Taxes can become one more constraint on the active manager's decision process. This bias is further reinforced by the psychological requirement to stay fully invested. Faced with bad investment choices and no opportunity to hold cash, the active manager may opt to not trade and hold existing securities.
The active manager faces severe structural, social and behavioral challenges when it comes to beating benchmarks. The evidence on performance indicates very few can overcome these obstacles and those that do can only do so for short periods of time. Some in the analyst community point out that the current rush to indexing strategies is a speculative bubble2. However, the movement from active managers to index strategies is a rational decision by investors trying to manage their portfolios in an efficient and cost effective manner. For equities, where this trend is more advanced, the overall level of aggregate equity exposure has risen slightly over the last few years, while the cash flow movement is clearly from active to passive index strategies.
Change Is Resisted
Consultants and financial advisers continue to recommend active strategies for a variety of reasons. Consultants get paid for reviewing and recommending changes to portfolios that sub-advise to active managers. Once an index strategy is employed, there is very little need for extensive analysis or change. For a consultant, no portfolio changes means no need for a consultant.
Financial advisers also have a self-interest in utilizing active managers for their portfolios. In many cases, large brokerage firms get paid by the mutual fund companies for access to their brokers. Additionally, mutual fund firms are expected to support advisers in the field with training, seminars, and entertainment.
Active managers provide boards, consultants and advisers a convenient scapegoat when things go bad. Instead of losing a valuable client, changing active managers can be way to “fix” things by moving to a manager with a new or better story. Despite the unfavorable research on active strategies, consultants and risk managers will continue to recommend active managers. Their pay depends on it. As Upton Sinclair famously wrote:
“It is difficult to get a man to understand something,
when his salary depends on his not understanding it.”
Robert Lloyd, CFA
Thank you for reading this essay on why active managers fail. If you would like to discuss the practical implications of this research on portfolio management, please reach out to me at email@example.com.
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Robert Lloyd, CFA® is President, Chief Investment Officer and founder of Lloyds Intrepid LLC, and author of the book Central Markets.
With over 28 years of experience in the financial industry, he has held positions as a trader, analyst, portfolio manager, and wealth manager while working at Invesco, CCM Opportunistic Advisors, and Merrill Lynch. At Invesco, he was lead portfolio manager of the AIM Summit and AIM Constellation Funds, managing approximately $5 billion. In another life, Rob served in the U.S. Navy for 8 years as a Naval Flight Officer flying in the S-3B Viking. For a complete resumé, visit his profile at LinkedIn.
Rob holds a B.B.A. in Management Information Systems from the University of Notre Dame and an M.B.A. from the University of Chicago.
Rob is a Chartered Financial Analyst.
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