FINDING THE PROVERBIAL NEEDLE IN A HAYSTACK: THE CASE FOR ACTIVE MANAGEMENT
Victor von Reiche
The underperformance of the average institutional fund manager is well publicised and has resulted in significant capital flowing into exchange traded funds (ETFs), which look to mimic or track an index, instead of trying to outperform it.
This has impacted active management across a broad range of asset classes, geographies and underlying strategies; so much so that independent investment research firm Morningstar estimates that 2019 marks the year in which the divide is crossed. As things stood at the end of 2018, based on data from the United States (US), equity strategies which passively tracked indices held 48% of assets. If the current trend holds, passively tracked indices will top 50% or more than actively managed funds for the first time.
Adding further pressure are the low fees being charged by providers of these strategies, which have amassed significant scale given continued inflows. The underperformance of average active fund managers has lead Jack Bogle, the Vanguard founder and pioneer of index investing, to famously remark that a better alternative to trying to find a needle in a haystack was to simply to buy the haystack.
Perhaps one the most significant and least understood reasons for active management’s underperformance in recent years has been poor portfolio diversification. The market doesn’t compensate investors with higher-than-expected returns for taking risks that are easily diversified away. Portfolios which are well diversified have a lower risk of suffering significant drawdowns which make it difficult to recoup underperformance for active managers. Unfortunately, the evidence is that the average investor - while being risk averse - doesn’t act that way. In a triumph of hope over wisdom and experience, investors fail to diversify.
Hendrik Bessembinder, a finance professor at Arizona State University, contributed to our understanding of the risky nature of individual stocks with his January 2017 study: “Do Stocks Outperform Treasury Bills?” The question posed in the title of this paper seems nonsensical at first. The fact that stock markets at index level provide long-term returns that exceed the returns to low risk investments, such as government obligations, has been extensively documented, for the US stock market as well as for many other countries. His study which covered the period 1926 through 2016 and included all common stocks listed on the main US exchanges looked at the underlying attribution of returns at stock level. After analysing the lifetime returns of 25 967 common stocks, he determined that 4% of total stocks generated all of the US$34.8 trillion in wealth created for shareholders by the stock market. Even more striking, a mere 50 stocks accounted for well over one-third of that amount, while 96% of all stocks collectively performed no better than risk-free one-month Treasury bills. The fact that the overall stock market generates long-term returns, while the majority of individual stocks fail to even match Treasury bills, can be attributed to the fact that the distribution of individual stock returns is positively skewed. Simply put, large positive returns to a few stocks offset the modest or negative returns to more typical stocks.
Bessembinder concluded that his results help to understand why active strategies, which tend to be poorly diversified, most often lead to underperformance. Bessembinder added this observation: “The results here focus attention on the fact that poorly diversified portfolios may underperform because they omit the relatively few stocks that generate large positive returns. Underperformance is typically attributed to transaction costs, fees, and/or behavioural biases that amount to a sort of negative skill. The results here show that underperformance can be anticipated more often than not for active managers with poorly diversified portfolios, even in the absence of costs, fees, or perverse skill.”
A study by Longboard Asset Management, entitled “The Capitalism Distribution”, which covered the period 1983 through 2006 on the Russell 3000 Index, broadly came to a similar conclusion. The authors found that while the Russell 3000 Index provided an annualized return of 12.8% over that period that:
- The mean annualized return was just 5.1%.
- 39% of stocks lost money (before considering inflation) during the period
- 19% of stocks lost at least 75% of their value (before considering inflation).
- 64% of stocks underperformed the Russell 3000 Index.
- 25% of stocks were responsible for all the market’s gains.
Investors picking stocks had almost a two-in-five chance of losing money, an almost a one-in-five chance of losing at least 75% of their investment (again even before considering inflation) and slightly more than a one-in-three chance of picking a stock that outperformed the index. The reason for the strong index performance of the Russell 3000 lies in its construction methodology, which is market-capitalization weighted. This means successful companies with rising stock prices receive larger weightings in the index.
Compounding the problem of poorly diversified portfolios is the fact that most investors are below average stock pickers, who are negatively influenced by cognitive and emotional bias. The sheer quantum of research work from behavioural economists such as Dan Ariely, Richard Thaler and Daniel Kahneman bears testament to the increasing recognition being paid to this important field. Cognitive bias generally involves decision making based on established concepts, which may or may not be accurate, or mental accounting. Emotional biases typically occur spontaneously based on the personal feelings of an individual at the time a decision is made. Well known examples of cognitive bias includes: confirmation and hindsight bias, bandwagon effect (groupthink) and anchoring (relying too heavily on immediate past events). Emotional bias typically manifests through investor overconfidence, familiarity bias and buyer’s remorse. A further headwind (or opportunity) facing the industry is the increased use of artificial intelligence (AI), machine learning and big data analytics, which has seen a seismic shift in assets away from traditional asset managers towards passive and quantitative strategies.
Citadel’s flagship global equity solution, Global Greats, is therefore instructive in this regard as an actively managed solution. The portfolio has an excellent long-term record and has outperformed its benchmark meaningfully since its inception in 2012. Worth noting is the role the quantitative screening process has played in finding potential new investment ideas. This process essentially highlights attractive opportunities from a valuation and business attribution perspective and adds breadth to analysis. By employing a fundamentals-driven quantitative approach, combined with human oversight, behavioural bias is reduced and the investment process is enhanced thanks to a more effective screening of promising investments, an example of the synergistic benefit of combining complimentary processes.
The past three years offer some insight into the value of this process and active management approach. With technology stocks receiving a lot of investor attention it has, in fact, been the industrial sector that has accounted for more than half of the portfolio’s outperformance against its benchmark and placed it in the top 5% of its global peers, despite the fact that the portfolio and benchmark industrial weights were similar. What explains the outperformance is stock selection. Within the industrial sector the bulk of positive attribution has come from three stocks which collectively represent less than 0.5% of the benchmark weight, a result which is consistent with Hendrik Bessembinder’s findings. This is perhaps also illustrative of the potential opportunities for active management in future. As more money flows to passive strategies that are market-capitalisation weighted, so too will more of these opportunities become available to those investors who cast their nets wide enough.
From an active management perspective, portfolio diversification is a necessary precondition for diversifying single stock specific risk and for exposing the portfolio to positive skew. Diversification in this sense should be multi-faceted and take into consideration geographical and sector exposure, economic drivers, interest rate sensitivity, currency exposure and company lifecycle assessment. Our actively managed funds are benchmark aware which ensures diversification across many of these risk factors-this will continue to play an important part of our risk management process.
We believe that active management will continue to play an important role in managing clients’ wealth. In this regard the philosophy and process which an active manager employs to find exceptional long-term opportunities is and will continue to be critical; this is especially true given the evidence that a narrow subset of stocks drive long-term performance. The ability to adapt to industry and technological changes will also be vital.