Too Many Maybes

The SPIVA U.S. Scorecard results are out and as is usually the case, active managers had a difficult time keeping up with their respective benchmarks.

Before we examine some of the results, it’s worth mentioning that SPIVA accounts for the entire opportunity set, which eliminates survivorship bias. Being that 23% of domestic equity funds were merged or liquidated over the last five years, this is something worth pointing out.

Over the last year, 65.34% of large-cap managers underperformed their benchmark. As the period increases, the odds of victory become even less likely. During the previous five and ten years, 80.8% and 79.59% have failed to beat their benchmark.

It’s difficult to draw conclusions from large-cap managers alone as such a heavily traded market offers little in the way of alpha. Perhaps lesser fished areas like small-cap stocks are more conducive to active management. Here’s SPIVA:

It is commonly believed that active management works best in inefficient markets, such as small-cap or emerging markets. This argument is disputed by the findings of this SPIVA report. The majority of small-cap active managers consistently underperformed the benchmark in both the 10-year period and each rolling five-year period since 2002

Then they bust the myth that high-yield bonds offer a better opportunity for active management.

The high-yield bond market is often considered to be best accessed via active investing, as passive vehicles have structural constraints that limit their ability to deal with credit risk. Nevertheless, the 10-year results for the actively managed high-yield fund category show that over 90% of the funds underperformed the broadbased benchmark.

I believe the days of superstar stock pickers is a thing of the past. For many of these professionals, career risk is too large a hurdle to overcome. Straying too far from the index keeps their returns looking a lot like it and fees generally eat up any alpha they might earn. Aside from career risk, here are a few other risk factors to consider that can negatively affect a portfolio manager.

  1. Maybe they get divorced
  2. Maybe they lose a key analyst
  3. Maybe they go through a bad stretch and start second guessing themselves
  4. Maybe they leave for another company.
  5. Maybe they want to spend more time with their kids.

This is just too many maybes and why I believe that if you’re going to deviate from the index, it’s important to do so in a systematic way. With quantitative strategies, you understand there will be times when it falls out of favor, in fact you sign up for that ahead of time. However, if a stock picker hits a rough patch, you don’t know they will ever regain the ability it appeared they once had. Furthermore, it can be difficult to ascertain what caused them to outperform in the first place; that whole thing about distinguishing luck from skill.

When considering active strategies, it’s important for us that we’re not relying on anyone’s intuition, expertise, or mental or emotional well being. We don’t want our PMs speaking with management, doing channel checks or backing out the cash. We want them to follow their models with as little interference as humanly possible.

Lest anyone think I’m an index zealot, I’m a big believer in active management, so long as it’s done systematically and in a cost effective way.