During the past five years, we have witnessed a dramatic shift in the way that investors are accessing the capital markets. The proliferation of Exchange Traded Funds (ETFs) and similar products has provided new avenues through which investors can gain exposure to equities, bonds, commodities and a host of other assets. The growth of such products, which usually track a passive market index, has largely come at the expense of actively managed mutual funds. In fact, since 2009, investors have pulled nearly $500 billion from active U.S. equity mutual funds and invested a similar amount into passive ETFs.
In light of this trend, many of our clients are asking whether they should abandon their actively managed equity strategies in favor of lower cost products that simply track the market. At Monticello, we believe that indexing is an excellent strategy for most investors. It’s no secret that the majority of actively managed equity funds trail their respective benchmarks because of a combination of high fees and trading costs. And the picture is even worse for taxable investors. The fact is that the choice of whether to invest in equities and how much is far more important than the choice of whether to invest actively or passively. This is because beta tends to dominate total returns, especially over the long-term. However, for the patient, long-term oriented investor, the rewards of a successful active management program can be substantial, as small incremental returns can lead to significant wealth creation over time.
Over the past decade, academics have spent considerable time on the issue of active management. Two professors affiliated with Yale University, Martijn Cremers and Antti Petajisto, seem to have made the most progress on understanding why certain active managers outperform. They concluded that investment managers who have the highest Active Share, defined as the percentage of a portfolio that does not replicate an index, have the greatest probability of outperforming the index. This makes intuitive sense as well: the best way to outperform the index is to not be the index.
The problem for investors is that concentration produces a much higher tracking error (i.e. deviation from the benchmark). A low tracking error can often mean closet indexing and a high tracking error, although greatly increasing the odds of market beating outperformance over the long-term, can try the patience of investors in the short-term.
This is a subject that we’ve spent a considerable amount of time researching at Monticello and the end result is somewhat surprising. For the 25-year period ending December 31, 2014, there have only been 70 mutual funds in the Morningstar U.S. Large Cap category that have beaten the S&P 500 Index. These 70 funds have beaten the index by approximately 1% on average. However, the average fund in this select group only outperformed the index about 60% of the time on a rolling five-year basis. That’s right, the 70 funds that outperformed the index for the lengthy time period of twenty-five years spent 40% of all rolling five-year periods underperforming.
We performed another study which looks at actual active managers our clients have employed during the past twenty years. We identified seven highly pedigreed firms that substantially outperformed the S&P 500. Over the 20-year period, ending December 31, 2014, these firms earned on average, an 11.6% per annum return, outperforming the index return of 9.9% by 170 basis points per year. If an investor placed $10 million in the S&P 500 Index on January 1st, 1995, the investment would have grown to $66 million by the end of 2014. On the other hand, if the investor placed the capital with the seven firms we studied, the initial $10 million investment would have grown to $89 million on average. Obviously, that’s a pretty big difference and probably worth fighting for.
However, the seven active firms spent considerable time underperforming over short to intermediate periods. In fact, they only outperformed on average in 76% of the rolling five-year time periods, underperforming in almost one-quarter of the five-year periods. So, in order to generate 1.7% of outperformance over two decades, mostly by concentrating and not replicating the index, investors had to underperform for a number of five-year periods. For many equity investors that’s tough to stomach, hence the attraction of indexing.
Source: Morningstar and Monticello Associates
It is this factor that makes active management emotionally difficult for investors, as they hate to tolerate underperformance. In this case underperformance happens for a specific reason: portfolios are designed to own higher quality assets than the index by concentrating their bets. It is this strategy that has the best chance to outperform over the longer term. However, it can prove frustrating to investors as performance can lag, leading to termination right before a sustained period of outperformance.
The key lesson from these studies is that patience is an absolutely essential ingredient for success with active management. Investors must be willing and able to tolerate underperformance, often for long periods of time, in order to reap the rewards of active management. This is easier said than done, and investors would be far better off sticking with a plain vanilla index fund than abandoning an underperforming active manager at exactly the wrong time. As a result, active management certainly isn’t for everyone, but when applied successfully it can lead to substantial long-term rewards for the patient investor.