Practical analysis for investment professionals
01 October 2015

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?

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.

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor and the CEO of Active Investment Management (AIM) Consulting. Voss also sub-contracts for the well known firm, Focus Consulting Group. Previously, he was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. Voss holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason@jasonapollovoss.com

14 thoughts on “Why Hasn’t Active Investing Outperformed Passive Investing in Recent Years?”

  1. Irwin Stein says:

    What passes for active investing is not always active. Statistics often include mutual funds which are often restricted to specific sectors and always encouraged to be 100% invested. A true active investor will take profits, stop- out losses and sit in cash when appropriate. A passive investor is at the whim of the markets which is never intelligent investing and guarantees losses when the market turns down. Passive investing uses past performance which makes an enormous presumption that the US markets will repeat what they have done in the past. In the past, there was no market in China to collapse and cause a 1000 point drop in the DJIA. Globalization of the markets requires an eyes-open approach to investing.

    1. Hello Irwin,

      Thank you for your comments, and for starting the conversation. It sounds as if you may be interested in my ongoing series entitled Alpha Wounds. Each article takes one problem that I believe is leading active managers to underperform passive managers. The first article, in particular, where I criticize benchmarking, style boxes, and tracking error seems in alignment with your comment above. You may find it here:

      Yours, in service,

      Jason

  2. So half think that Active can’t ever beat Passive and half think Active that high-fees / index-hugging / etc are characteristics that drag Active down.

    Rather a damning piece of navel gazing 😉

    1. Hello Shane,

      I like the commentary; thanks for sharing.

      Yours, in service,

      Jason

      1. If you accept guest posts, let me know 🙂

        1. Hello Shane,

          We do accept guest posts that we feel meet our publication’s criteria. Most specifically, are a majority of readers better off having read the piece than not?

          [The rest of the reply was handled via private e-mail.]

          Yours, in service,

          Jason

  3. Angelo Calvello says:

    Have you considered whether the difficulty in beating one’s benchmark is because we, as an industry, all tend to use the same data (price, economic, financial) and quantitative methods to try extract insights from these data?

    1. Hello Angelo,

      I am so glad that you mentioned this, and indeed, I have considered such things. Take a look at my book The Intuitive Investor, in which I discuss the importance of creativity, at length. Also see an abridged version in my post Skills That Separate You as an Investment Manager: Creativity https://blogs.cfainstitute.org/investor/2014/05/13/skills-that-separate-you-as-an-investment-manager-creativity/ Also, the finishing touches are being put on a monograph for members entitled, “The Investment Idea Generation Guide.” I authored this work to break managers out of their normal comfort zones.

      You won’t be surprised, given this lineup, that in a future Alpha Wounds piece I will be addressing issues hinted at in your comment. Thank you, again.

      Yours, in service,

      Jason

      1. Angelo Calvello says:

        Jason,
        I’ve been exploring the topic of same data/same methods. See: http://www.ai-cio.com/Blog/The-Doctor-Is-In/Investing-Is-One-Big-Data-Problem/
        I look forward to your comments.
        Angelo

  4. Steve Bridge says:

    Great article, Jason. Bit of ‘the emperor has no clothes’ situation, eh?

    My comments relate to actively-managed mutual funds.

    You say this is a recent phenomenon, but I think it goes back farther than that. I have read from various sources that active management has lagged passive management since the beginning of time.

    This topic is so important for retail investors, but while so many people’s livelihoods depend on the myth that active outperforms and while advisors don’t have a fiduciary standard, this dirty little secret will continue to be swept quietly under the rug.

    Thanks for bringing this into the open.

    Steve

    1. Hello Steve,

      The active vs. passive debate is a perennial one and only in the last 15 years has it become heated. Current research makes the argument that active managers of yesteryear, when evaluated with current thought about what properly constitutes quality management, do not outperform benchmarks. I would consider this spurious research. Why? Because the active managers of yesteryear had no opportunity to try and satisfy the criteria.

      Though I believe sports analogies are overused, I am going to rely on one here. Sports records of bygone eras ought not to be usurped by current era players. Why? Rules change. For example, in baseball the height of the pitchers mound is different than it was in the past. So this effects all pitching and hitting records. Another important factor – I believe also germane to the active vs. passive debate – is that in sports the pay is so much higher now than it was, say, 100 years ago. This has created a class of individuals interested in maximum performance, and leagues interested in the best players from around the world. Does this change in incentives affect records of the past? No, it shouldn’t in my opinion.

      For apples to be compared to apples the criteria for success in place in the past needs to be respected. Research that uses current preferred methodologies is interesting, but I think that is about all it is.

      Last, I am only about 40% of the way through an extended discussion about this topic, which I am referring to as “Alpha Wounds.” I believe our entire industry is culpable for the current state of affairs in the active vs. passive debate and I am trying to spark a conversation. Thanks for participating in it.

      Yours, in service,

      Jason

  5. Joseph V. Bocchino, MD says:

    Do all 743 respondents hold the CFA?

    1. Hello Joseph,

      Likely not. These polls are asked of the readership of our Newsbrief product and subscriptions are free, and open to the general public. Also, the polls are not in adherence to statistics. For example, it is possible to vote more than once, and the samples are not random. However, we think they are an interesting gauge of sentiment.

      Yours, in service,

      Jason

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