Passive vs Active Management: Efficiency Over Skill

Author: Ryan Kimes, CFP®

Alpha is a statistical financial metric that measures the excess performance of an investment or portfolio relative to a benchmark such as the S&P 500. Although it is possible for investment managers to outperform relative benchmarks (positive alpha), investment underperformance (negative alpha) tends to be more probable after fees and trading expenses are taken into account. Considering empirical studies by Harbon, Roberts, and Rowley 2016, consistent net outperformance is rare, not necessarily due to lack of manager skill, but as a consequence of added expenses born by active trading,

In fact, according to Vanguard calculations using data from Morningstar Inc., over the past 20 years, less than 25% of actively managed U.S equity mutual funds outperformed their relative benchmarks. Consistent underperformance of actively managed funds were found across all asset classes across numerous countries, market segments, and time periods. Studies that conclude the scarcity of persistently outperforming, professionally managed funds include: Sharpe 1966, Jensen 1968, Carhart 1997 (risk-adjusted), Fama and French 2010, and Harbon, Roberts, and Rowley 2016.

Why does this occur? The poor performance of these funds can be understood in the concept of the zero-sum game found in financial markets. According to Sharpe 1991, the zero-sum game explains that within capital markets, the holdings and transactions of all participants aggregates into the market as a whole. For every winner, there is a loser. For every loser, there is a winner. Essentially, for every dollar of outperformance earned by a manager or individual, there is an equally lost dollar to underperformance. Therefore, it is reasonable to suggest that the probability of any given transaction leading to outperformance is 50%. This outperformance probability is considered before expenses and taxes are ever accounted for.

In reality, investors must pay costs associated with participating in the market. These include management expenses, administrative costs, broker/dealer bid-ask spreads, commissions, and of course, taxes. These cost variables will have a significant reduction to an investor’s net return over the long-term. Consequently, the potential for an investor’s outperformance in this zero-sum game becomes increasingly improbable, even with professional active management.

Further, the average return of a relative asset classes’ benchmark (such as the S&P 500) does not equate to the average return realized by an investor investing in that asset class or fund. Undisciplined investors are influenced by emotional decisions when it comes to initial investment timing and tolerance to return variability. Consequently, investors spend too much time and cost succumbing to internal biases that reduce the amount of time their investment is invested, increasing transaction costs, taxes, and introducing the risk of detrimental investment timing.

Market Participant Returns After Adjusting For Costs

 Vanguard

Vanguard

As investors focus too heavily on security or fund selection (bottom-up investing), they make poor investment decisions that hinder the realized return of their investments. Consider that a mutual fund’s exceptional performance would likely attract additional investors, consequently increasing the demand of the underlying securities within that actively managed mutual fund’s portfolio. This increased demand may inflate the value of the underlying assets, potentially making the security overvalued, thus reducing the probability of the fund’s future outperformance. Remember, past performance is not indicative of future results. The figure below illustrates this concept by measuring the difference (green) in average returns of investors (light blue) in various mutual fund classes to the actual returns of those mutual funds (blue).

Investor returns versus fund returns: Ten years ended December 31, 2015

 Vanguard

Vanguard

So what should investors do? Rather than focus on fund or security selection, investors should place a greater emphasis on asset allocation. Also known as “top-down” investing, asset allocation begins with analyzing a client’s financial goals and constraints, then creating a mix of assets (such as stocks and bonds) that best suits the client’s needs. Rather than buying funds with the most attractive returns, an investor focused on asset allocation would place a greater emphasis on maintaining a targeted mix of stocks to bonds, regardless of the characteristics of the underlying securities’ firm. As any individual stock or bond increases and decreases in value, its overall percentage weight within the portfolio will change. Periodically, trades are then placed to readjust, or rebalance, the investments within the portfolio to their original percentage weights. This is done to maintain the volatility-to-return characteristics of the portfolio, rather than actively trade the holdings to produce excess return relative to the stock or bond benchmark. Here, the investor realizes value in maintaining a portfolio that will have an acceptable level of variability and return expectations, while also eliminating as much for-certain expenses as possible.

The Mixture of Assets Defines the Spectrum of Returns

 Vanguard

Vanguard

Security market pricing is highly efficient, meaning excess return from underpriced securities is becoming increasingly improbable. With that said, it is often in the best interest of investors to work with advisors that focus on efficient asset allocation, rather than costly active management. Evidently, logical investment advisors should recommend portfolios that shy-away from for-certain expense ratios or active advisory fees in exchange low-cost asset-exposure alternatives.