In the past few years, active managers have weathered an onslaught of criticism from passive management proponents, especially as low-cost ETFs continue to gain market share.
August's market correction provided an opportunity for active managers to argue why being able to react to markets is still valuable. But at least one wealth advisor would like to stir the pot, claiming research his firm has done questions if any skill in active exists.
"The stock market is the single largest gambling casino on this planet," Mark Hebner, the founder and president of Index Fund Advisors, says in response to evaluating the active management strategy.
"So part of what is going on that contributes to investors' poor returns, relative to market returns, is varying degrees of the allure, and the extreme situation: the addiction of gambling."
In a recent interview with Money Management Executive, Hebner points to findings from his firm that he says proves that active advocates are not only misleading investors with the traditional active management strategy, but the industry and media outlets are playing into the trap as well.
In data collected from looking at the returns of 2,076 fund managers from 1975 to 2006, IFA researchers concluded that 99.4% of fund managers lack "genuine stock-picking ability," while 0.6% were "just lucky" at attaining positive returns. This data alone, Hebner says, should warrant an ideological shift.
What are some of the misconceptions surrounding active management?
As it turns out, the investors are rarely - if they're concluding there was skill - doing a proper analysis. But, what is a proper analysis?
One thing might be controlling the excess returns that the manager earns for a chance outcome. Academics are fond of saying lately that managers do well because of luck and not because of skill.
I think that's a little bit of an eye opener for most investors because it never occurred to them I think, that in many cases their manager who had these excess returns on some benchmark in the past, was just lucky like a lottery winner or like a casino winner.
That is sort of a light bulb moment for many investors. Then it gets them thinking about the next stage of that logic, which is, how would I sort out who was lucky and who I concluded had a skill, such that in the future they would be expected to continue to beat the market? And so one of the questions I like to start off with for investors is basically, how long of a track record - or a statistical record - is needed for you to draw the conclusion that your manager actually has skill as opposed to just being lucky?
Well, as it turns out, there are two key numbers in determining that sample size, or let's call it track record. Number one is the excess return over an appropriate benchmark. Now, let me tell you why this is a problem. There are multiple regressions - that's what's used by a statistician to compare one data set to another.
How would you explain this to managers that believe there is more to beating the market than just luck?
Usually what happens in our industry is managers are selecting benchmarks and then style drifting from that benchmark. When their style variance, if you will -let's say they're a large growth manager and they start buying large value stocks - when their style variance is in favor, such as value stocks do better than growth stocks, then all of a sudden they look like a stock market guru.
But in fact, it was just a random outcome and it was an improper benchmarking of the manager because if you could buy value stocks very cheaply in an index fund, like a Dimensional Value Fund, or a Vanguard Value Fund, or an iShare Value Fund, then you shouldn't have to pay an active manager let's say, 1%, or 1.2%, I think is the current average to allocate a portion of your assets to value stocks instead of growth stocks.
You could just have a portfolio, let's say, that's 80% growth and 20% value and just buy them both in an index fund.
What would this mean for the average investor?
Well, first we want to know how much excess return the manager earns relative to an appropriate benchmark. Let's just say for argument sake that's 2%. As it turns out that's a pretty reasonable number. When we looked at all of the mutual funds in the Morningstar database, there's about 300 of them, that survived over 20 years and had over 90% of their assets in U.S. stocks, the average fund that had an alpha, which was about one third of them, of 2.15%.
But here's the next number that I've never seen in the press: the volatility or the deviation of that alpha from its average. It turns out that the average fund with a positive alpha has a deviation of that alpha of about 8%. So what that says is they don't get 2% every year. Two percent alpha with an 8% standard deviation required 64 years' worth of data before you would conclude that you could anticipate getting that excess alpha in the future; otherwise you would attribute the excess return to skill versus luck.
Investors solely rely on some intuition or gut feel and in the market that is the worst thing investors can do. There's a whole science area now called behavioral finance around that very point that basically we are hardwired to be bad investors. The main reason is returns are positively correlated to risk.
And what does an investor want - low risk, high return, not high risk, high return. And even worse than that is you're hearing about DraftKings now - the [online gambling] football scandal that's happening - they're claiming it's a gamble. Well the stock market is the single largest gambling casino on this planet and so part of what is going on that contributes to investors' poor returns, relative to market returns, is varying degrees of the allure and in the extreme situation; the addiction of gambling.
You're saying active managers are deceptively viewed as skilled investors?
I am saying that because we have a free and open market that stocks are traded on, and in essence what's happening when we close the market each day is we have collected the information, the wisdom and the forecast of approximately 10 million investors trading 10 billion shares nearly every day.
The result of that process is a highly efficient gathering of that information and an imbedding of it into prices so that at the end of the day the price agreed upon - in fact at each moment in time it's not just the end of the day, but that's the number we usually hear about - by these millions of traders is the single best estimate of the fair market value of all the world's securities?
For an active manager to beat the market they must identify those securities - stocks or bonds - that are either overpriced or underpriced. The over-priced we want to sell and the underpriced we want to buy.
Their mission is to discover these, but pray tell me how could it be that one individual or even a committee of 10 has more knowledge, information, wisdom and forecasting ability than 10 million?
That in short is known as the efficient market hypothesis, and it explains why stocks and bonds are fairly priced all of the time so that there are not mispricing opportunities for active investors to exploit on a consistent basis.
Why then do you consider passive investing a better model?
Passive performance is not indicative of future results, in short because no active manager has a 64-year return - and that's the average excess return with the volatility involved.
Investors' returns are not the result of speculation. Basically people think, "I'm going to bet on this stock and get a 40% return." They're thinking those returns are tied to a speculative activity, but in fact the returns of the market are risk, compensation, not due to speculation.
Risk compensation now opens a whole new can of worms - what amount of risk is right for each investor, and then secondly, which types of risk are right? It turns out there are lots of different types of risk.
This can be most easily categorized as different indexes; large company indexes, small company indexes, value company indexes or growth company indexes.
Once you've looked at the history of indexes and their returns and their risks, then portfolios of those indexes need to be assembled in a way that at each point of risk you have the best estimate of the optimal blend of indexes.
By the way, it's no wonder investors do so poorly. This is not easy for investors to reverse a thought pattern that Wall Street has embedded in their brains. And CNBC and Fox Business amplify the whole idea that, "We have lots of news for you to trade on today." As it turns out, that information is embedded within literally nanoseconds with high-frequency trading.
But on the passive side investors have to determine what I call their risk capacity and do what they have to do to look at the various dimensions of capacity for investors. Then they have to match that capacity up with a risk exposure in the form of a portfolio of indexes.
As it turns out, there are substantial differences in different index returns over time, but essentially the 2013 Nobel Prize in economics was awarded to Eugene Fama for his work in trying to identify the sources of returns in the market. As it turns out, small companies have had higher returns than large companies - about 3% a year. Value companies have had higher returns than growth companies at about 5% per year.
Now those numbers aren't the same every year. There is also a variation in those, just like the active manager's alpha, and investors have to be patient - in other words investors in passive investing need a long enough sample size to achieve what we call the expected returns.
How do you educate the average investor on active and passive investing?
This is so hard to get people to reverse their thinking on this. From speculation to education is what we like to say, but we have got to figure out a way for you to get away from the speculative activity.
There is a whole gamblers' anonymous out there to treat gamblers, and that's why the intro to my book, Index Funds: The 12-step Program for Active Investors, is in fact a 12-step recovery plan for active investors.
It is a program that is both educational and emotional and right off the bat, those are two pretty scary words for people to confront and pass that hurdle (a hurdle of education and the hurdle of emotion control) and so it is a difficult idea and process, but what's the reward at the end of this?
Well it is capturing market returns, and market returns have been very good if you captured them.
On average stocks get 10% a year, bonds the average has been over long periods of time about 4% a year, and there's enormous opportunity.
