The Active Equity Renaissance: Rejecting a Broken 1970s Model

Categories: Behavioral Finance, Economics, Equity Investments, Guide, Portfolio Management

Launching the Active Equity Renaissance: A Broken 1970s Model

Co-authored by Jason Voss, CFA


The average active equity mutual fund underperforms its benchmark.

This statement sparks little controversy and can be applied to active equity hedge funds as well.

The story gets worse when the results are AUM-weighted. Collectively, active equity delivers no value to its investors and, in fact, extracts value from them.

In our highly competitive markets, what industry can survive if it fails to deliver value to its customers? The consequences of these competitive forces are clear as money flows out of active and into passive equity funds. Passive investing is being touted as the superior alternative, and who can argue?

As an active equity industry, we have to ask ourselves how we descended into such a sorry state. The conventional explanation is that portfolio managers and their investment teams lack stock-picking skill. But as is often the case, the answer is not so simple.

A more careful analysis indicates that investment teams, buy-side analysts in particular, are not the problem. Instead, the fund distribution system is what’s at fault.

So rather than loudly denouncing the lack of stock-picking skills, those in the distribution system have some soul searching to do. As Pogo used to say: “We have met the enemy and he is us.”

Buy-Side Analysts Are Superior Stock Pickers

There is considerable research showing that buy-side analysts are superior stock pickers. I conducted a study that supports this conclusion.


Active Equity Fund Best Ideas: Top 20 Relative-Weight Stocks*

Active Equity Fund Best Ideas: Top 20 Relative-Weight Stocks

* Based on single variable, subsequent gross fund alpha regressions estimated using a data set of 44 million stock-month US active equity mutual fund holdings from January 2001 to September 2014. Source: Lipper and Morningstar


The top 20 relative-weight holdings generate fund alpha, while the low-ranked holdings destroy it. So any restriction imposed on a fund that mandates holding anything other than the best idea stocks negatively affects a fund’s alpha. If enough mandates are added, a potential positive alpha is transformed into an actual negative alpha.

The fund distribution system is full of such restrictions: Fund managers are required to hold many stocks for diversification purposes, manage to low volatility and drawdown, avoid tracking error and style drift, grow large, and impose sector-weighting constraints.

In essence, the distribution system is a closet indexer manufacturing juggernaut.

To be clear, we are talking about those who run the distribution system, both inside and outside the fund. The internal sales and marketing teams work hand in glove with the external platforms — broker-dealers, registered investment advisers (RIAs), and institutional investors — imposing value-destroying restrictions on investment teams.

The “pot of gold” generated by an analyst’s investment decisions — somewhere around a 4% average alpha based on several studies — is eaten up by fund fees and the external restrictions placed on the fund.

In the end, the fund itself captures the entire potential alpha and then some by growing too large, ultimately turning itself into a closet indexer. None of the alpha is delivered outside the fund, and worse, additional value is extracted from investors.

Fixing a Broken Investment Management Model

A system that encourages closet indexing while delivering negative value to investors is clearly broken. So what is to be done?

Investment teams, particularly buy-side analysts, need to be elevated to a starring role since they deliver the most value to investors. Funds need to be rewarded for consistently pursuing a narrowly defined strategy, taking only high-conviction positions.

Participants in the distribution system need to avoid imposing restrictions that impede the successful pursuit of an equity strategy. More specifically, asset bloat, benchmark tracking, and over-diversification need to be discouraged. Why? Because these are the precursors to closet indexing.

To resurrect the industry, an important first step is to move away from the discredited 1970s modern portfolio theory (MPT). Not only is the evidence overwhelmingly against this model, but MPT provides the theoretical justification for many of the value-destroying restrictions foisted upon funds.

The new market paradigm will most likely arise from behavioral finance. The discipline is already transforming the advisory business. Major players — Merrill Lynch and Morningstar, among others — have established behavioral finance units and are disseminating the resulting research throughout the adviser community.

This is an important value add in the competition with robo-advisers. The mechanical solution offers little help in steering investors away from value-destroying emotional errors. Studies reveal that focusing on minimizing emotional investing can enhance returns by 2%–4%.

Some financial advisers now think of themselves as behavioral advisers. A recent sign of this industry trend: the Behavioral Financial Advisor certification and designation.

Can a “Behavioral Financial Analyst” be far behind? Behaviorally based objective measures will begin to replace the metrics currently used to analyze investments. Several of these measures — asset bloat, benchmark tracking, and over-diversification — are more predictive of fund underperformance. That is, objective behavioral measures are predictive, while the traditional measures targeting past performance are not.

A Robust Debate

Future posts in this series will provide suggestions on how the system might be fixed. The goal is not to present final solutions, but to spark a robust debate around the many challenges facing a broken industry.

Imagine a world in which only the lowest-cost index funds along with truly active, alpha-generating funds exist, without a closet indexer in sight.

Together let’s launch the active equity renaissance!

At the 70th CFA Institute Annual Conference, which will be held 21–24 May 2017, C. Thomas Howard will discuss ways that active equity mutual funds can be evaluated through behavioral concepts during his presentation, “The Behavioral Financial Analyst.”

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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.

Image credit: ©Getty Images/duncanecampbell

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42 comments on “The Active Equity Renaissance: Rejecting a Broken 1970s Model

  1. Pingback: Tim's Top Links - 3/14/17 | Mullooly Asset Management
  2. Uwe Schillhorn said:

    I am not so sure about the relevance of the conclusion that any restriction imposed on a fund that mandates holding anything other than the best idea stocks negatively affects a fund’s alpha. Restrictions regarding TE and active sector weights could in theory constrain the PM to include active bets outside the top 20. But the article does not show that it actually does. It is as plausible that the PMs simply have too many low conviction active bets instead of concentrating on what they know most about. There are other methods of neutralizing unwanted factor exposures than forcing low conviction bets into the portfolio.

    • Tom Howard said:

      Thanks for your comment Uwe.

      The bottom line is investing in other than the top 20 relative weight stocks hurts performance regardless of why other low conviction stocks are held. There is considerable research supporting this point, as we reference in the post.

  3. frederic smoak said:

    The indices are appropriate for pension funds and other unlimited life investors, but less so for individuals. In a market that has declined by 50% twice within the last 20 years, risk is as important a variable. Or, as I tell my clients, will you feel your portfolio is a success if you beat the indices, but end up eating dog food?

    Since the math of gains & losses works against investors. managing risk is the name of the game.

    • Tom Howard said:

      Thanks for your comment Frederic.
      InI our next post we will discuss the Cult of Emotion and its pervasive impact on the investment industry. Your comments are straight from the cult handbook: ” I know you are afraid and you should be afraid and I will not invest you in anything that stires up your fears.”

      Long term holding of stocks has generated the best returns available even including the drawdowns you mention. As advisors we need to press this message with our clients to the greatest extent possible in order to generate the greatest long horizon wealth.

      It is the difference between catering to client emotions and mitigating them.

    • Hello Frederic,

      Thank you for your comment. Also in a future post, Part 4, we discuss different ways of evaluating risk than the standard methods prescribed by Modern Portfolio Theory.

      Yours, in service,

      Jason

  4. Ahmed said:

    Why insist on the notion that the system is broken when the managers themselves are the ones at fault?
    I believe the real problem out there is the severe lack of talent.
    In my experience, imposed restrictions are generally more flexible than the way you view them. Managers may communicate their ideas to their clients and obtain consent to make some exceptions, relax some rules, etc. But only the best managers actually do that. It takes talent, confidence and loyalty. Sadly, around 80% of active managers generate negative alpha like they don’t care.
    RIP Ab Nicholas thank you for your never-ending determination.

    • Tom Howard said:

      Thanks for the comment Ahmed.

      There is much evidence that buy-side analysts are superior stock pickers which we reference in the article. There is also considerable evidence that the constraints imposed on funds are the root cause of underperformance.

      Not sure what else to say.

      • Ahmed said:

        Constraints never get in the way of a truly capable manager. That’s what I’ve always known. Significant active decisions that bypass constraints are not uncommon. To my mind, this flexibility (that is part of the nature of active management) is not reflected in your article. You view the system as a non-compromising dictator with a harmful regime.

    • Hello Ahmed,

      Thank you for taking the time to share your thoughts. I disagree with you that managers themselves are solely at fault. The industry has changed over the past 50 years and many participants have shaped those changes. Yes, the active management community has played its part. See my Enterprising Investor series entitled, Alpha Wounds, for some of my criticism for the active management community. Other participants include asset owners and consultants, too.

      Regardless of where the fault lies, the point is that our end clients are not getting ideal results. To the degree that these issues are not issues of talent, but are issues of incorrect structures, we should strive to fix them. Tom’s research, along with that of others, suggests that research analysts and portfolio managers are actually good at security selection, but that portfolio-level decisions serve as a drag on returns. These constraints have been put in place in a tug of war between the asset managers, consultants, and asset owners.

      Last, is there any evidence that consultants who want very constrained strategies so that they can properly execute their asset allocation strategies are adding alpha for the client, and that clients over time are achieving their goals? I think there is poor to no evidence that this additional layer adds value for end clients. This is an area of research that needs to be undertaken, in my opinion.

      Yours, in service,

      Jason

      • Ahmed said:

        In my experience, consultants and asset owners don’t seem to mind our very large active weights so long as the results are good. We fulfill our promise to create the win-win and collect our performance bonuses and cute trophies and the system never shows the slightest signs of being broken.
        Active managers are the centerpiece of this design and they bear most (if not all) of the responsibility. In case of failure, I would blame them and no one else.

        • Tom Howard said:

          Ahmed-

          Not sure what you are looking at, but my firm AthenaInvest runs into contraints all of the time and we have evidence that these hurt returns. We choose to not abide by these constraints and as a result have been able to outperform over longer investment horizons.

          But we are barred from many, many platforms as a result. Particularly in the 401k space which will be the last bastion for closet indexers.

          Ahmed, where is it that you offer your products in which the constraints are non-binding? We would love to be in that space!

          I do agree that active managers must be held accountable for superior returns when constraints are removed. That is the world we are striving to resurrect.

  5. I’m kind of puzzled about the cracks about MPT being

    1) discredited, and
    2) from the 1970s

    Is it possible the authors were referring not to MPT but to CAPM? Even CAPM isn’t from the 1970s (it’s from the 1960s), but it’s closer and it is largely debunked.

    If the authors really meant MPT, I’d like citations for when it was discredited, because I seem to have missed them. Are there CFA publications on this? Seems like they would be worth publicizing.

    Any time you use an efficient frontier you’re using MPT. If you’re concerned about portfolios being too diversified, MPT doesn’t prevent you from concentrating your portfolio – so long as you don’t use constraints, the farthest point to the right on the efficient frontier is either a single security or a very concentrated portfolio.

    I realize this isn’t the FAJ, but still, I am surprised to read this post in a CFA Institute blog.

    • Tom Howard said:

      Thanks for your comment Tom.

      As we will discuss in an upcoming post, the three MPT pillars (efficient frontier, CAPM, and EHF) have all failed empirically (starting in the late 70’s and early 80’s) and so MPT is a discredited paradigm.

      Sadly, my former academic world continues to teach this model, as does the CFA, simply because “if we did not teach MPT what would we teach?”

      The next paradigm will emerge from Behavioral Finance, which is sweeping across the investment industry. Investor Behavior will be the lens through which advisors and analysts will view the world abound them.

      A new set of behaviorally based, objective tools will emerge for analyzing investment decisions.

      • I want to point out [and here I am wearing my ‘representative of CFA Institute’ hat] that CFA Institute teaches many things other than MPT, including APT, financial statement analysis, valuation, arbitrage, and so forth. We believe that the goal of the CFA program is to provide a modern financial professional with tools, yes, but also an understanding of jargon that they may encounter when in finance. Not all of our candidates and members have business or finance backgrounds when they come to the CFA program. Consequently, our role is to educate about many things.

        Yours, in service,

        Jason

        • Jason, what tool other than MPT does CFAI offer to answer the questions

          What is the expected return on a portfolio?
          What is the expected risk of a portfolio?

          To me, it seems pretty clear Tom Howard is confusing MPT with CAPM in this post and his comments.

          • Tom Howard said:

            Tom, as I studied modern portfolio theory in the PHD program in the 1970s, the three pillars were Capital Asset Pricing Model, Efficient Market Hypothesis, and the efficient frontier. Evidence since then has destroyed each of these pillars and in turn MPT.

            As Behavioral Finance sweeps across the investment industry, objective behavioral measures will arise for analyzing investments and managing portfolios. We will discuss some of these in future posts.

          • Hi Tom,

            What is the context of your question, within the curriculum for the CFA program itself, or within our tens of thousands of pieces of content in the archive dating back to the 1940s?

            If you are talking about within the CFA program I am uncertain because my role at CFA Institute is not to work on the curriculum. So you would need to address your question to a member of that team. If, on the other hand, you are referring to the vast content archive, there are multiple examples of us covering this issue. For example, Andrew Lo’s Adaptive Market Hypothesis and our coverage of the issue comes to mind. Another is the work of Gregg Davies, that we have also featured in which he recasts a theory within a behavioral finance framework.

            Also, Tom, you seem to be reliant on theory in order to think you need to be a successful investor. Valuation is also a means of attaining expected returns on a portfolio. Value each security with an embedded assumption about future growth rates, and weight accordingly. Also, do you believe that an evaluation of risk should be boiled down to one number? If so, then I think that figure obscures risk as much as it reveals. We will be covering in a future edition of this series some alternative ways of thinking about risk.

            In concluding this comment, I believe the most important thing about MPT is the idea that different risks should be priced differently. The idea is more important that the specific implementation.

            Yours, in service,

            Jason

      • Tom,

        How did the efficient frontier “fail?” It is a tool for rational decision making under uncertainty.

        What do you mean by “pillar?” MPT neither depends on CAPM nor implies CAPM’s validity.

        I can’t comment on “EHF” because I’m not familiar with it. Did you mean “EMH?” MPT does not depend on EMH either.

        Markowitz 1959 is replete with all kinds of caveats people often don’t remember: It allows for using asymetric risk measures. It calls for an experienced practitioner to use judgment when applying MPT. It even has the seeds of behavioral finance. Daniel Kahneman actually credits Markowitz for giving him the idea of loss aversion (see Prospect Theory: An Analysis of Decision under Risk, by Kahneman and Tversky)

        • Tom Howard said:

          Tom, the efficient frontier failed in 1981 when Robert Shiller determined that volatility was the result of emotions and not changes in fundamentals. Since then many studies have tried to overturn his result to no avail. This means that the efficient frontier is a trade-off of long-term returns relative to short-term emotions. So for this reason I have abandoned the efficient frontier for building portfolios. It turns out that volatility is a measure of emotion and not a measure of risk. We will address this topic in more detail in a future post.

        • Hi Craig,

          Again, thank you for the links. Even if the efficient frontier were incontrovertibly proven empirically it still does not get rid of the ‘ex ante’ or ‘a priori’ problem. In fact, it actually demands another layer of estimation to the problem of anticipating the future correctly. Also, there is nothing about the efficient frontier that tells you the correct time frame for which you should model your portfolio. Some suggest using ‘unbiased estimators,’ meaning if you have a 37-month investment time horizon then you should use 37 month data to build your estimates. But the efficient frontier still requires choices to be made by people, and at least to me personally as a former investment manager, actually adds to my estimation problem, rather than subtracting from it.

          With smiles,

          Jason

    • Some people consider CAPM to be one of the outcomes of MPT.

      Harry Markowitz delivered this rebuke of CAPM in 2005: http://www.q-group.org/wp-content/uploads/2014/01/Markowitz2.pdf .

      Could it be that CAPM is a tautology? “Given that all investors have the same views and preferences, all investors would hold the market portfolio.”

      But then of course, you knew that equilibrium cannot actually exist in a capital market because trading would cease — refer to http://alex2.umd.edu/wermers/ftpsite/FAME/grossman_stiglitz_(1980).pdf

      • Hello Craig,

        Thank you for your comments and especially your links.

        In general, I think the ‘market portfolio’ is easier to imagine conceptually – race your mind to the idea of infinity – than it is to buy in reality. There are so many markets, both public and private, and so many asset classes, including things like leisure time, art collections, mid-century modern furniture, and so forth, that it is very difficult to ‘buy’ the market portfolio.

        Yours, in service,

        Jason

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  9. The new investment frontier is the use of strategies using low expense ETF products representing proven underlying CAPM risk premium factors ( hundreds of stocks ) combined with tactical allocation variables for optimal alpha production and risk management. The ability to move to “defensive” asset classes during higher risk environments through predetermined, objective tactical instruction, circumvents the fund distribution “restrictions” mentioned. The strategy can be offered within “motifs” and managed by one or two persons, cutting out the large retail fund management structure and administrative and staff requirements, offering a more direct and efficient route for the investor to access.

    • Tom Howard said:

      James-

      You are heading in the right direction by capturing a small portion of potential active management benefits.

      If you do not mind, I provide a few additional thoughts.

      The 100’s of identified anomalies (what you call factors and I call behavioral price distortions) can be thought as ingredients used by active managers for building successful stock picking strategies. By using narrow ETFs you are essentially serving the ingredients to investors but not the strategy.

      Using a culinary metaphor, you are serving up the ingredients, say flour, milk, and sugar, without the recipe executed by a skilled chef. The chef combines the ingredients to deliver a soufflé instead. Most agree that eating a soufflé is preferred to consuming raw ingredients!

      So it is with best idea stock pickers. A recipe in the hands of a skilled chef adds value beyond the individual ingredients, just like a strategy in the hands of a skilled active manager adds value beyond anomalies. Investing in narrow, factor ETFs delivers only a portion of the potential benefit of active equity. There is considerable evidence supporting this contention.

      Some additional comments:
      • The factors you mention are not factors at all but rather are factor proxies. The actual factors are the unobservable drivers of investor buy and sell decisions. The goal is to identify measurable and persistent proxies for these factors which can be used to build superior portfolios.
      • The truth is that we do not know what anomalies are capturing, risk or opportunity.
      • CAPM predicts beta is the only factor priced by the market, so the very existence of so many anomalies soundly rejects the model. Anomalies are not part of CAPM but its destroyer.
      • You mention timing ETF investments. Of course there is little evidence managers can successfully short-term time. In fact, a recent article “Abusing ETFs” presents evidence that those who invest in ETFs, as compared to a corresponding mutual fund, actually do worse. The authors contend that this is the result of the narrowness of the EFTs purchased and the lack of timing skill. Myopic Loss Aversion lurks around every corner and it seems investing in easily traded ETFs exacerbates this most common of cognitive errors.

  10. John B. said:

    Mr. Howard mentions that: “Collectively, active equity delivers no value to its investors and, in fact, extracts value from them.”

    Of course *taken collectively* this must be the case, by simple arithmetic, since active managers can make profits only at the expense of other active managers, right? I guess that I had presumed that this was widely accepted in accordance with Sharpe’s work on the subject (“The Arithmetic of Active Management,” 1991 and “The Arithmetic of Investment Expenses,” 2013).

    Pedersen (“Sharpening the Arithmetic of Active Management,” 2016) adds a small glimmer of hope that *taken collectively* active management can add value, but he doesn’t propose that this will be much help to investors, as identification of outperforming managers in advance is next to impossible.

    • Hello John,

      Actually, this is an oft repeated fiction. Tom addressed this very well in my interview with him last year. Here is the link: https://blogs.cfainstitute.org/investor/2016/07/26/is-active-management-dead-not-even-close/

      I reproduce my question and his answer below for convenience:

      “CFA Institute: Talk to me about the additional fiction that active management is a zero-sum game.

      “A strongly held belief within the investment industry is that stock picking across active equity funds must be a zero-sum game. Such an assertion is true for the stock market as a whole, as stock picking must have as many losers as winners. But this does not have to be the case in every market segment.

      “The US stock market has a current total market value exceeding $38 trillion. Active US equity mutual funds hold $3.6 trillion, about 9% of all equities. So it is entirely possible for the average stock held by funds to outperform at the expense of the other 91% of the equity universe.

      “Arguing that stock picking among equity funds must be a zero-sum game is akin to arguing it is impossible to drown in a lake of average depth of three feet. That lake may have pockets 20 feet or more deep. Both represent indefensible statements.

      “In particular, this study estimates that the average stock held by active equity mutual funds earns an alpha of 1.3%, confirming that mutual funds do earn superior returns. Indeed, this must be the case in order for equity funds to cover their fees and, in turn, earn a near-zero collective alpha.”

      Yours, in service,

      Jason

      • John B said:

        Hi, Jason:

        Thanks for your reply.

        No offense, but we’ll have to agree to disagree on this one. 🙂

        Let’s look at your example. In your example (as I understand it), 91% of invested funds are passively managed. 9% of invested funds are in active management. Is that correct?

        If it is, then one might write an equation giving the total return of the market portfolio as a weighted sum of the passive and active segments:

        Market Return = ( 0.91 * Passive Return ) + ( 0.09 * Active Return )

        Okay so far?

        But now, if we can presume that passive investors hold the market portfolio, we realize that the Passive Return must be equal to the Market Return. So our equation becomes:

        Market Return – ( 0.91 * Market Return ) = 0.09 * Active Return

        or

        0.09 * Market Return = 0.09 * Active Return

        thus,

        Active Return = Market Return

        But this is before costs.

        After costs of active management, the Active Return must be less than the Market Return.

        Hope this helps to explain Dr. Sharpe’s math.

        John

        • Hi John,

          If I agreed with your assumptions then your math would hold. Those assumptions: a) People can buy the ‘Market’ portfolio, and b) that every active manager holds a subset of the Market portfolio as their portfolios.

          Regarding your first assumption, how can an investor invest in a single passive product that includes claims on the performance of, yes, the S&P 500, but also silver, molybdenum, lumber, art, every option, a 2020 maturity bond from Slovenia, et. al.? Not only that, but the ‘Market’ portfolio is not just the public assets. For if it is to lay claim to ‘Market’ (with your capital ‘M,’ not small ‘m’) then it must include every private asset, too. So my collection of mid-century modern furniture needs to be in there, too. How does an individual investor get to buy a claim on my coffee table in a single product?

          Regarding your second assumption, since I am guessing your answer to the first question is that there is no such investible Market, then all an active manager has to do is to hold assets not in your proxy for the Market. That is, she just needs to have assets different than the market, little ‘m.’ One way of doing this, that is quite obvious is to hold the S&P 500 plus one other asset.

          Yours, in service,

          Jason

  11. The primary problem with asset management – both active and passive – is that most ‘asset managers’ are actually asset gatherers. It is abundantly clear, not least from the track record and shareholders letters from and interviews with Warren Buffett, that size of assets under management and subsequent investment returns are in most cases negatively correlated. Very few investment strategies scale, notably ‘value’ – and as Research Affiliates recently pointed out, despite being the best performing long-only equity investing strategy over the long term, ‘value’ is also the strategy most likely to get an adviser fired by his client for short term underperformance. When investors come to appreciate that size is the enemy of performance, the active industry will shrink back to a more appropriate level of AUM. I say when, but I really mean “If”. Many funds are aggressively sold more than they are voluntarily bought.

    • Hello Tim,

      To me you have hit the nail on the head! I raise this very point in my article last year entitled, “Alpha Wounds: Benchmark Tail Wags the Portfolio Management Dog.” In particular, my words under the heading, “A Brief History of the Benchmark.” Few take the road less traveled to gain AUM: earning them through performance. Most take the road very well traveled: convincing through marketing.

      Yours, in service,

      Jason

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