http://thereformedbroker.com/2015/02/17 ... rmanently/As you are likely well aware by now, 2014 was the worst year for actively managed mutual fund performance in three decades. Less than 20% of stock-picking managers were able to exceed the returns of their benchmarks last year and, in some categories, the number was closer to 10%. How on earth could things have gotten so bad?
More importantly, is it secular or cyclical? Permanent or fixable? There is some evidence that last year was an anomaly and some evidence that the decline of active management is inexorable. Below, I will solve the mystery behind how this happened and I’ll let you decide whether or not things will change.
Why Active Management Fell Off a Cliff
Why Active Management Fell Off a Cliff
Re: Why Active Management Fell Off a Cliff
Thanks, Richard. I believe the equally-talented manager theory is only part of the story. There is more. There is Dunn's Law and momentum. Dunn's law says when an asset class does well, an index fund in that asset class will usually outperform actively managed funds. Note there is nothing scientific about Dunn's law. It was created by Steven Dunn, a friend of Wm Bernstein's. Dunn's law probably gets fulfilled due to initial performance from an asset class, large caps in this case, and then it's driven higher by momentum from naive investors jumping on index funds. We also saw this phenomenon in the late 90's too. So, we have a combination of new investors getting into indexing--check out the forum for verification--and we have the style purity of index funds like the the S&P500.
The purity aspect is this: An index fund is pure to the asset class, plus it's full strength, no cash balance waiting to invest. The purity hypothesis was introduced in a paper by William Thatcher in 1999.
http://www.iinews.com/site/pdfs/JOI_fal ... ammond.pdf
Active management does not use pure asset classes. They normally take an asset class like large blend and tweak it with selected stocks outside the index in the hopes of beating the benchmark. This sometimes does work when a different asset class is doing well, but it only works for those managers who made the right guesses. It does not work for most any manager when the index is surging.
Paul
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The purity aspect is this: An index fund is pure to the asset class, plus it's full strength, no cash balance waiting to invest. The purity hypothesis was introduced in a paper by William Thatcher in 1999.
http://www.iinews.com/site/pdfs/JOI_fal ... ammond.pdf
Active management does not use pure asset classes. They normally take an asset class like large blend and tweak it with selected stocks outside the index in the hopes of beating the benchmark. This sometimes does work when a different asset class is doing well, but it only works for those managers who made the right guesses. It does not work for most any manager when the index is surging.
Paul
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When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.
Re: Why Active Management Fell Off a Cliff
the linked article wrote:...the “Paradox of Skill” theory that Michael Mauboussin has written at length about – wherein it is only relative skill, not absolute skill, that matters.
At the time Buffett wrote this, ERISA was just coming into being, prior to enactment and subsequent revisions and clarifications the standards for institutional investment were considerably different, what someone with a fiduciary responsible could invest in without also putting themselves at risk of being liable for being somehow irresponsible was different. In the newer editions of "Stocks For The Long Run" Jeremy Siegel suggests this might be part of the explanation for the unusual surge in smaller cap stocks that occurred in the late 1970's early 1980's.Warren Buffett in 1975 letter to Katherine Graham wrote: https://www.scribd.com/doc/160301289/Wa ... ham-Letter
...in no case were the superior records I have observed based upon institutional skills which could be maintained despite changes in the faces. Rather, the good results have been accomplished by a single individual or, at most, a few, working in fairly specialized areas in which the great bulk of investment money simply had no interest. It has been very difficult to out-think the pack on General Motors, IBM, Sears, etc. Rather, the unusual records - and there have been a few that have been maintained - have been achieved by those who have worked relatively neglected fields in which competition was light. * ...
* Your win-loss percentage in tennis will not be determined by the absolute level of ability that you possess. Rather, it will be determined by your ability to select inferior opponents. If you select with care it will be quite easy to attain a winning percentage higher than, say, Cliff Richey while he is playing on the tour. Application of this principle is the key element in bridge, poker, or investments. Harder to apply in the latter, however - it is easier to identify a couple of palookas at the bridge table.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
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Re: Why Active Management Fell Off a Cliff
Well written article. Should mentioned that it analyzes ideas from Larry's new book.
A couple of passages made me curious:
This is because, with all the unskilled investors departing, pros will be left to square off against only other pros. The lack of retail punters and their harvestable mistakes cuts off one of the most reliable historical sources of alpha for sharp-eyed managers.
and
Minus the exploitable accidents of large numbers of mom and pop investors, there’s simply less alpha to go around. The low hanging fruit has left and gone to Valley Forge, PA. In the absence of so many unskilled players, the field has become much more brutal, much more difficult to best.
Can someone expound on what these mean?
It seems to be saying that with all the cash flowing into index funds, there are fewer individual investors "speculating" on individual stocks such as Apple and Tesla?
Somehow clever managers can do well when the market is populated mainly by day traders but not so well when the large majority are simply in index funds?
A couple of passages made me curious:
This is because, with all the unskilled investors departing, pros will be left to square off against only other pros. The lack of retail punters and their harvestable mistakes cuts off one of the most reliable historical sources of alpha for sharp-eyed managers.
and
Minus the exploitable accidents of large numbers of mom and pop investors, there’s simply less alpha to go around. The low hanging fruit has left and gone to Valley Forge, PA. In the absence of so many unskilled players, the field has become much more brutal, much more difficult to best.
Can someone expound on what these mean?
It seems to be saying that with all the cash flowing into index funds, there are fewer individual investors "speculating" on individual stocks such as Apple and Tesla?
Somehow clever managers can do well when the market is populated mainly by day traders but not so well when the large majority are simply in index funds?
Attempted new signature...
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Re: Why Active Management Fell Off a Cliff
Minus the exploitable accidents of large numbers of mom and pop investors, there’s simply less alpha to go around. The low hanging fruit has left and gone to Valley Forge, PA. In the absence of so many unskilled players, the field has become much more brutal, much more difficult to best.
40 or 50 years ago the collective market volume action was dominated by individual investors, mostly mom and pop types who invested in individual stocks when they got a bonus or had excess cash and got a "hot tip." As a group they were financially unsophisticated and a market dominated by them developed large areas of inefficiency. Early along there was a lot of low hanging fruit for people like Ben Graham and later Warren Buffett to harvest. Graham initially would refrain from buying small cap stocks unless they were selling for less than book value, had positive earnings, good management, and PE ratios of less than 10. No such stocks are currently available in the US market now because unlike the past, 90% of all stock sales and buys are controlled by full time professionals, actively managed mutual funds, financial firms, hedge funds, etc.. They would buy such firms instantly if they became available and drive up their prices until they were no longer compelling buys. That means that whenever a trade is done now there is very likely a full time professional on both sides of that trade, one who believes the stock's prospects are going down, the other who believes they are going up. Hence the market price tends to be an efficient price or at least more efficient than a mom and pop set price. The low hanging fruit is gone and the market has become increasingly more efficient due to the dominance of these professionals. As a corollary, as the market gets more efficient by these professionals, it becomes ironically more and more difficult for them to find and exploit inefficiency in asset pricing.The Wizard wrote:
Can someone expound on what these mean?
It seems to be saying that with all the cash flowing into index funds, there are fewer individual investors "speculating" on individual stocks such as Apple and Tesla?
Somehow clever managers can do well when the market is populated mainly by day traders but not so well when the large majority are simply in index funds?
As for your second question about index funds dominating the market action, that is simply incorrect. Although cash flows are heading out of active management and into index funds, the majority of market action is still run by active management. There will always be many whose goal is to outperform the market and a large well organized industry to cater to them. These active investors make the market more efficient and set better asset prices. The great thing about index funds is that you get to harvest these benefits, to go along for the ride essentially without paying for it, a 0.05% annual charge in the case of VTI.
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Re: Why Active Management Fell Off a Cliff
Short answer, the market has gotten more efficient over time and continues to do so. First the stock pickers had trouble, then the fund managers, and nowadays even the hedge funds are having trouble generating alpha. The only way to beat the index nowadays is to find some really obscure or really complicated investments and develop knowledge about them that no one else has. Given how much information is available now that's becoming virtually impossible to do with any consistency.
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Re: Why Active Management Fell Off a Cliff
My question would be when was active management ever 1. Consistently on top of the cliff and 2. NOT fallen off the cliff?
Back to Jensen's published article in the late 60's looking back at fund returns from the 30's to the 60's he should that the funds that did the best in one period underperformed In the next. DFA did a similar study. Mr. Bogle did the same analysis in his 1990's and 10 yr. anniversary edition of "Common Sense". Vanguard has done the same papers, etc...
I think the only thing that has been consistently shown among active funds are: 1. It is unlikely to outperform and 2. If it does outperform it will soon underperform in the next time series.
So again I ask: When was active management a winner's game ESPECIALLY in the ex ante world we live in?
Good luck.
Back to Jensen's published article in the late 60's looking back at fund returns from the 30's to the 60's he should that the funds that did the best in one period underperformed In the next. DFA did a similar study. Mr. Bogle did the same analysis in his 1990's and 10 yr. anniversary edition of "Common Sense". Vanguard has done the same papers, etc...
I think the only thing that has been consistently shown among active funds are: 1. It is unlikely to outperform and 2. If it does outperform it will soon underperform in the next time series.
So again I ask: When was active management a winner's game ESPECIALLY in the ex ante world we live in?
Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” |
-Jack Bogle