10
The End of Active Investing?

While China's stock market continues to be dominated by retail investors, most other markets are now overwhelmingly dominated by professionals—all with superb information, powerful computers, Bloomberg terminals, and Internet access to an enormous flow of information. And each active manager has the same big problem: all the other experts have the same wonderful resources, too. As a result, after costs of operations and fees, most professionals fall short of the market over the long term—and most of the few who did not fall short in the past 15 years will fall short in the next 15. Active investing rose to fame 60 years ago, had a wonderful run, but just may have seen its era ending in recent years.

Since index funds deliver the market rate of return through a widely diversified portfolio with no more than the market level of risk, the only justification for actively managed funds must be either more returns or less risk—or both. That justification is increasingly recognized as the investment world's version of the triumph of hope over experience.

During the 1960s and 1970s, most actively managed “performance” funds were able—more years than not and almost always over longer periods—to produce superior returns. Clients loved it. And, as money poured in and fees were raised, investment managers prospered. If nothing had changed over the past half-century, active investing would still be triumphantly successful.

But things have changed. New investment companies were created, prospered, and expanded rapidly. Established ones reorganized and then prospered too. Darwinian evolution drove inferior institutional managers out of the market and strong firms made themselves even stronger. As the competitive norm rose higher during the 1980s and 1990s, the capabilities required for even moderate success continued to rise. Today, actively managed funds are not beating the market. The market is beating them. And the long-term trend for active management is grim.

The seriously distorted conventional data on the performance of active managers are now being corrected by adding back into the record the results of funds that, because they performed so poorly, had been closed or merged into other funds and then deleted from the conventional records. This corrected data has important messages for investors.

Actively Deficient

Three points are crucial. Over 10 years, 83% of active mutual funds in the US fail to match their chosen benchmarks; 40% stumble so badly that they were terminated before the 10-year period was completed and 64% of funds drift away from their originally declared style of investing. These seriously disappointing records would not be at all acceptable if produced by any other industry. And while these are US statistics, since international institutions dominate all stock markets, they are all moving in a similar direction (Table 10.1).

The forces of change causing these shabby results for active managers are numerous and undeniably powerful. Over 50 years, trading volume on the New York Stock Exchange has increased 5000 times—from 3 million shares a day to over 5 billion (while trading in derivatives has gone from zero to now exceed the stock market in value). Investment research has increased substantially. Today's leading securities firms have as many as 600 company analysts, industry analysts, market analysts, commodities and foreign exchange experts, economists, demographers, and political analysts located in offices in major cities all over the world. The number of Chartered Financial Analysts is up from zero to 135,000, with another 200,000 studying for the CFA exams.

Instant communication of all sorts of information via 325,000 Bloomberg terminals, the Internet, and blast faxes ensure that all investors worldwide have immediate, equal access to a global cornucopia of information, analysis, and insight. With SEC Regulation FD (for “fair disclosure”), any investment information made available to any investor must be simultaneously made available to all investors. This eliminates what was once the “secret sauce” of active investors: getting the “first call” with new information, insights, or judgments.

The number of professionals engaged in price discovery has, over half a century, exploded from an estimated 5,000 to over 1,000,000. Hedge funds, the most intensive and price-sensitive market participants, have proliferated and now execute nearly half of all buying and selling. Algorithmic trading, computer models, and early versions of artificial intelligence are all increasingly powerful factors. As a result, institutional investors have collectively created a global expert information network that produces the world's largest and most effective continuous prediction market.

The only way for active investors to outperform is to discover and exploit pricing errors by other expert professionals, all having the same information at the same time with the same computers and teams of experts having much the same talent and drive. The difficulty of sustaining a significant competitive advantage at price discovery continues to increase.

Standing Out?

Curiously, the most powerful force for change has gone largely unnoticed. In the US, institutional trading has gone steadily upwards over the same half century from a market share of 9% to 20% to 50% to 80% and now over 90%.

While institutional trading volumes may have advanced in an almost straight line, the difficulty of achieving superior performance when selling only to, or buying only from, near-equal competitors—all active participants in the same giant, swift, global information network—has been accelerating. The difficulty of outperforming the expert pricing consensus which is the market has been accelerating up an exponential “power law” curve.

Like the Doppler effect on an approaching train's whistle, the impact of professionals increasingly trading only with other professionals—all nearly equally well armed and equally well-informed—has made and will make it increasingly hard for them to outperform the market they and their peers collectively dominate as the corrected data on funds now shows.

Surely, some active managers with unusual skills or practices will outperform, but they will not be competing directly with the many conventional active managers. These active managers will have developed and focused on a market segment with fewer competitors and will excel in it. Nor will future “winners” be easy to identify in advance.

When price volatility or a bull market in small company stocks or a bear market in large capitalization stocks develops, we can be sure stories will appear claiming that “active is back,” filled with admiring interviews of the new heroes of the sector. Their case will require focusing on the lucky winners while ignoring the equally unlucky losers in the wide dispersion of results so predictably caused by the statistical “law of small numbers.”

Even as evidence piles up that forceful changes are closing in and threaten to confound more and more active managers, most investors still will not recognize the reality—or will say they don't. But as Winston Churchill once said: “We must look at the facts because the facts are looking at us.” Like climate change and other complex systemic changes, the evidence needs careful analysis to separate long-term secular trends from medium-term cyclical fluctuations around those secular trends—and both of these from meaningless short-term, random statistical “noise.”

Sorting out the profound from the probable—and both of these from the ephemeral—will be sufficiently difficult for most clients that clever sellers will be able to find and merchandise highly selective, semi-plausible supportive “evidence.” We've seen this movie before in the way Big Tobacco cast doubt over the evidence that smoking causes cancer or the oil industry raised doubts about climate change.

The Good Old Days

Active managers had their halcyon days in the 1960s, when they did less than 10% of the trading in the US and were almost always competing at price discovery with amateur individual investors with little or no research or investment expertise who averaged just one trade a year, and who bought or sold for reasons outside the market: to invest a bonus or inheritance received or to raise money to buy a home or pay college fees for their children.

Back then, most institutional investors were the trust divisions of regional banks buying blue-chip “dividend” stocks held over the long term to avoid taxes and bond portfolios with laddered maturities. They were not challenging competition.

In those days, it was not unusual for active managers to beat the market by 200–300 basis points each year. Would investors mind paying 1% of assets to get double or triple that much in higher returns? Of course not.

Then, in the 1980s and 1990s, interest rates declined from 12% to 4% as the Fed, having broken inflationary expectations by pushing interest rates to record levels, let them normalize. Stock and bond prices began a long upward surge, with annual returns to investors of 10%, 12%, and 14%. Would investors mind paying 100 basis points while getting such splendid returns? No!

But today, if stock market returns over the next several years average only 6–7% and bond returns only 2–3% (as the consensus expects), will investor clients still be happy to pay over 100 basis point in fees (and nearly as much in operating costs) when most active managers continue to underperform their own benchmarks? Index funds repeatedly and predictably produce market-matching returns with no more than market-matching risk and charge less than 10 basis points. Will investors be willing to pay 90–120 basis points more to get active management when it typically produces less than market rates of return with both more risk and more uncertainty?

Before answering that pair of central questions, readers may want to consider four phases in the history over the past half century of active investment management.

• Phase One (1960–1980): active managers compete principally against individuals and conservative mutual funds and trust institutions. Results: 200–300 basis points of superior performance are common. Index funds get no attention.
• Phase Two (1980–2000): active managers ride a strong bull market, which pleases clients greatly, but can only achieve enough incremental performance to offset their costs and fees. Index funds get some attention.
• Phase Three (2000–2010): active managers no longer earn back all their operating costs and fees. Index funds experience increasing interest and demand. Switching from active management to indexing increases from a low base level.
• Phase Four (2010–): increasing numbers of active managers—particularly larger firms that must invest mostly in large capitalization, widely owned stocks covered by many analysts and mostly correctly priced—underperform an almost completely professionalized market, with prospective returns averaging only 7%. Objective observers conclude that fees and other costs can no longer be dismissed as “inconsequential.” Demand for low-cost indexing steadily accelerates.

Active investment managers and their clients had little or no difficulty with each other during Phases One and Phase Two. Even in Phase Three, memories of better times in the past blended with understandable hopes for a return to past years' favorable experiences—without insisting on any explanation of how that might actually be achieved. Investors waited patiently, hoping for better returns.

Phase Four is different. Clients are inevitably learning that the key question is not, “Can we find an investment firm of super-bright, hard-working, skillful managers who will work hard for us?” The obvious, but useless, answer to that question is Yes! But that is not the right question. The crucial question is, “Can we find significantly more skillful, more hard-working, more creative active managers?” Alas, the answer to that question for most investors is clear: No.

Poor Value

The fees conventionally described as “only 1%” of assets are better seen for what they really are in a 7% return market—15% of returns. Worse, try taking incremental fees as a percentage of incremental returns—both versus indexing. When you do, incremental fees for active investment management are now actually over 100%—a price-to-value ratio seldom seen and rarely substantial.

Dismal reality will not confront all active managers equally nor simultaneously. Managers least at risk will be those delivering the best results or having the best client relationships or the least demanding clients—or both. Also, managers with clearly differentiated capabilities in advanced mathematics or clearly longer fundamental research time horizons will be under less pressure.

The greatest pressure will be on large, conventionally active managers of portfolios necessarily dominated by the same large stocks that are most widely owned and most carefully priced by the professional consensus. Meanwhile, the “vice of destiny” will continue to squeeze in on layer after layer of full-fee active managers.

Historically, most products and services that have commanded prices that produce unusually high profit margins in free, open, and competitive markets have been unable to sustain their exceptional profitability. So far, the business of active investing has been remarkably successful—for the active managers. But the remarkable success of the business; as distinct from the profession, continues to attract more and better competitors, information, and technologies. This makes superior returns ever harder to achieve. And, in a lower rate of return market, this problem is increasingly visible to growing numbers of clients.

As the negative evidence continues to accumulate and the forces driving active investing's underperformance continue to be better understood, increasing numbers of clients will realize that in toe-to-toe competition versus near-equal competitors, most active managers will not and cannot recover the costs and fees they charge.

As indexing repeatedly earns higher returns at lower cost and with less risk and less uncertainty, the world of active management will be taken down, firm by firm, from its once dominant and exalted position. The painful process will be seen in retrospect as the inevitable result of the increasingly visible impact of external and internal forces of change. As T.S. Eliot wrote in 1925: “This is the way the world ends. Not with a bang but a whimper.”