(MoneyWatch) We saw Tuesday that-- that rising stock correlations meant they couldn't beat the market -- doesn't hold up to the light of day any more than the other excuses offered. Today, I wanted to dive a little deeper into why active management doesn't work.
The reasons active managers fail are simple:
- The markets, while not perfectly efficient, are highly efficient in setting prices.
- The vast majority of trading is done by institutional investors. Thus, it's hard to imagine a large enough group of victims that are going to be exploited -- for some managers to outperform others must underperform.
- Their costs are much higher -- what John Bogle called the "cost matters hypothesis."
I'm never surprised when active managers come up with excuses for their failure. After all, they fail so persistently that they have to keep coming up with them -- their livelihood depends on keeping hope alive. However, I have to admit I was amazed when I read the one provided by the MFS family of mutual funds in a November 2012 paper, "Correlation, Idiosyncrasy and Cyclicality." The authors blamed the failure of active management on "active managers contending with forces outside of their skill set" (Emphasis mine.) They went on to explain: "Waves of macroeconomic volatility overwhelmed fundamental assessments."
The authors provided a laundry list of issues that caused active managers to fail badly and persistently over the past few years, with 2011 being the worst in decades. The list included:
- Europe's persistent debt crisis
- Decelerating growth in China
- The end of the US business cycle's "Great Moderation"
- The onset of new and higher regulations and taxes
- Private and public sector deleveraging
All these factors, they said, made discounting and rating corporate cash flows even more problematic than usual. Well, if it ever was easy, why would we mere mortal individuals need to pay high fees to these supposed superstars? And second, isn't it when economic conditions are difficult that these active managers are supposed to protect us by using their superior skills?
It gets better. The explanation for the failure of active managers was that it was the market (not active managers) that was stupid: "The market has not differentiated between good stocks and bad." Who do they think is setting the prices of stocks? It's not individual investors who account for a very small percent of trading. And it's certainly not the index funds who basically accept the prices set by the active traders. It's the very people (active managers) they say have mispriced stocks.
The authors also argued that high correlations were to blame. But as we have shown, it's the dispersion of returns that matters, not correlations. And there's always a wide dispersion between the best- and worst-performing stocks, providing active managers with plenty of opportunity to outperform. They just persistently fail to do so.
There was another "gem" in the paper. "All passive strategies are virtually guaranteed to underperform their benchmarks, at least by the extent of their fees." While that's basically true, falling fund costs, securities lending and patient trading make it possible for funds to fully cover their costs, or at least come very close.
More importantly, as William Sharpe explained in his famous paper, "The Arithmetic of Active Management," in aggregate active funds must earn the same gross return as passive funds. In other words, the same math applies to active funds. The only difference is that in aggregate their underperformance will be much greater because they have much higher expense ratios, much higher trading costs and much greater tax inefficiency (for taxable accounts). Conveniently, the authors forgot to mention that.
The authors go on to state: "Despite any persistent fiscal uncertainty or economic volatility, capital will seek to exploit such mispricings. Given that companies exist in the real world, superior businesses with superior value propositions will prosper; the chaff will be blown away."
The problem with the statement is that there's no evidence anywhere you look, no matter the asset class, that even if such mispricings occur, that active managers can exploit them sufficiently to overcome the hurdle of their much higher expenses -- though they need you to believe they do.
They state: "Skillful active management affords the opportunity for outsized gains and minimized losses that in the long run can generate meaningful alpha." That's not quite right. It's true that active management may be able to generate meaningful alpha. Unfortunately the evidence demonstrates that for investors the far greater likelihood, especially after taxes, is that it will generate negative alpha. Thus, it's a game better off not played.
Image courtesy of Flickr user 401(K) 2013