Seven Reasons Active Management Underperformed in 2015
In 2015, most investment managers produced mild single-digit to mid-teens losses. Some of them were research-intensive managers with long histories of good results. They confronted a world where the vast majority of securities and commodities fell, but they should have done better. That includes having some of their money in the minority of stocks that did rise.
I believe conditions fundamentally changed.
The first time I had to confront making bad decisions was at the racetrack, when I didn’t cash my winning tickets. In many ways, that is when I started to learn valuable thought patterns that I later applied to investing.
In roughly the half hour between the losing race and the next one, I would hurriedly review all of my calculations and visual inputs. I divided these into categories.
In the first category were the questions: Did I miss changes or underestimate the importance of track or equipment changes? For example, I usually noted that my horses had changes of equipment or jockeys or trainers — but I also asked, “Were they equipped with blinders to keep them running straight and not distracted by other horses?”
Too often, I did not look at these changes on all competitors, which meant that I missed a poorly performing animal prior to the race that became easier to ride and guide to the finish line. This applies directly to investing. Too often, investors don’t fully appreciate the changes in management of competing companies or portfolio managers.
The biggest category was the expected winning time of the race. Often, if the race is slow, almost any horse can win. Similarly, in a low-performing market, any investment that has a slight advantage does win.
My mistake was to look at the recent track record for the race and guess which horse could run at that speed or better. In the market, all too often investors look for an investment that can be spectacularly better than average.
One also needs to look to the risks undertaken when finding such a vehicle or horse. Most of the time, a spectacular win will start with a chorus of disbelief, which could be correct.
By far the biggest hurdle to handicapping or investing is recognizing when basic conditions have changed, be they rule changes, unexpected weather, personal issues of the professionals, or any number of other fluctuations.
From an investment viewpoint, I believe 2015 experienced such cumulative changes that made many of our old approaches less useful.
The following is a list of important differences in 2015:
- The reduction of position capital at trading desks of major institutions and investment banks under the restraints of the Volcker Rule. Liquidity was available, but at a price and time of the liquidity provider’s choosing. This led to a significant level of intraday volatility, which played into the hands of the high-frequency traders and other algorithm users picking off large-scale movements. Bottom line: Trading has become more difficult and expensive in terms of full execution costs. What used to be only an equity market problem is very much a factor in trading in US government paper and is starting to be an issue for investment grade trading.
- The central banks’ manipulation of internal interest rates has morphed into manipulation of foreign exchange rates, which are impacted by non-price-sensitive flows into and out of the market, the values of global securities, and a range of commodities.
- Big data comes to the biggest markets in a big way. US-based managers feel comfortable having their US offices managing non-US securities. Similarly, global portfolios of US securities are being effectively managed in distant offices of foreign investors. The instant availability of full information about a security means that there is less opportunity to strip or dump into a market. The passage of “FD” (full disclosure, as mandated by the SEC) means the investment/trading value of published information has declined. As more institutions utilize secondary and tertiary research, their value becomes discounted.
- “TINA” (There Is No Alternative) is not the only alternative. The global investing public has increased its stake in money market funds and other repositories of low returns in order to gain the currently unused ability to rapidly reinvest. Some are using long or short positions in index exchange-traded funds (ETFs) or index funds. (I prefer the latter.)
- A growing recognition that much of government-produced data needs to be questioned. In one of his first acts, the new president of Argentina, Mauricio Macri, sought to overhaul Indec’s tabulation of data. Another example is Li Keqiang, now the premier of China, acknowledging that GDP figures were “man-made,” meaning they are unreliable.One can take the position that one of the reasons the US Federal Reserve has had such off-the-mark forecasts is bad data. I asked Bill Dudley, president of the New York Federal Reserve Bank and a permanent voting member of the Federal Open Market Committee (FOMC), what additional data he would like. Bill, who is a veteran number-crunching economist with Goldman Sachs, stated he would like to know more about the rapidly expanding student debt. He is right. Student debt accounts for the largest amount of consumer debt, greater than residential mortgages.
- Increasingly, many of the major economies are being driven by the service sector and not manufacturing, but most government and central banks tools are designed to spur a declining manufacturing sector. In the United States, it is important to focus on how US auto sales are returning to previous heights with a smaller population. What should be noted is that in 2015, US-branded cars are filling less than half the demand. This is important because to an increasing extent, a car or light truck is an electronic platform on rubber wheels. This signals that the auto market (and, for that matter, almost all markets) has changed and our governments have not kept up.
- Target date funds (TDFs) are being questioned due to their exposure to bonds in a somewhat rising interest rate environment. This could be quite harmful to those who are about to retire when much higher interest rates and lower bond prices are occurring. (Editor’s note: TDFs also vary widely in their risk allocations. Salil Mehta, CFA, explains.)
Don’t Bet on Favorites Most of the Time
I learned at the track that normal favorites win only about one third of the time. Betting odds get beaten down by players pouring in the winning dollars when they do win and not paying for the two thirds of the time they don’t win.
That is why my bet for 2016 is for a big year up. A recent Wall Street Journal article bore the headline, “Drab Outlook for Markets.” If the article is correct, my clients don’t stand to lose a lot. But if I am correct, 2016 will be anything but drab, with a reasonably good chance of a better than average result.
Perhaps some of the poorly performing managers could produce great results in their recovery.
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