Why Hasn’t Active Investing Outperformed Passive Investing in Recent Years?
Over the last several months, I’ve explored why active investing has been unable to outperform passive investing in recent years. My series is called Alpha Wounds, and so far the issues covered are the unintended consequences of benchmarks on active management, the poor measurement techniques of investment industry adjuncts, and the lack of diversity in the human resources portfolio. In this week’s CFA Institute Financial NewsBrief, we decided to ask our readers their explanation for the lack of active management outperformance.
Rare for our polls, we included a large number of options to try and capture a wide swathe of opinions. The options provided appear to have successfully reflected the broad range of views, as 90% of the 743 respondents selected one of the specific choices rather than “other.” Because it is difficult to know the precise reason for choosing the “other” category, it makes sense to recalculate the percentages without including “other.” These modified results are the ones listed in parentheses below. Note: We did receive one e-mailed response from a reader who opted for “other.” The reader explained, “I marked ‘other’ [because] the market is illogical, so trying to apply logic is bound to fail.”
Why has active investing been unable to outperform passive investing in recent years?
Active Managers Can Do Nothing to Outperform
About 24% (27%) of respondents believe the reason for active management’s underperformance is the deleterious effects of high fees on net performance. This is not surprising given the large number of studies highlighting this fact. Many asset management firms are, in fact, trying to reduce their expenses to mitigate this alpha drag. Another 15% (16.5%) believe that individual investment managers cannot compete with the wisdom of financial markets. Combined this means that about 40% (43.5%) believe that no matter what active managers do, they cannot beat passive investment strategies.
Active Managers Can Do Something to Outperform
Of the remaining five options, 10% (10.8%) believe that the concentration of top stocks in indices detracts from the success of active managers. For those not familiar with the argument, it recognizes that indices have built in momentum effects because many of them are market capitalization weighted. Indices are effectively “must buy” lists of securities that create demand — not because of fundamentals — but because passive strategists must buy the securities in order to closely track their index. Controlling for these momentum effects is outside the specific capabilities of active managers as security prices advance. When indices fall, however, active managers not invested intimately with the securities in the index should be able to avoid some of the downside.
What hope do active managers have of beating passive strategies? Together the four remaining options provide some insight. Most importantly, according to 18% (20.2%) of respondents, active managers should minimize their use of benchmarking, style boxes, and tracking error, which lead to a sameness of results. Next, 13% (14.7%) believe that active managers are guilty of short-termism and need to change their investment time horizon and lower turnover. Incidentally, lowering turnover reduces trading costs and will reduce the expense ratio of active funds. Increasing diversity of opinion in active management is believed by about one in 20 respondents (5.5%) to be critical for improving success. Lastly, approximately 5% (5.2%) of those polled think that active managers should improve their due diligence to better compete with passive strategies.
Active vs. Passive Tug-of-War
Taken together, the above four tactics, all well within the purview of active management, represent about 46% of total responses, as compared with the roughly 44% of responses from those who believe active strategies can never beat passive ones. This result indicates a tug-of-war between camps, and to my mind, reflects the conversation occurring in the financial community in the long-running active vs. passive debate.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.