Active Portfolio Management
(Updated August 2020)
Traditional portfolio management strategies, the type most advisors recommend, strive to add value through market timing and security selection. This active portfolio management process operates under the assumption that markets are inefficient and that teams of full-time skilled professionals should be able to consistently “Beat the Market”. Active portfolio managers rely on company meetings, news and announcements, detailed analyses, unpublished research and the insights of highly paid research analysts and traders who have access to piles of in-depth reports advising them on which stocks to buy or sell, and industries to overweight, under-weight, or avoid altogether.
Passive Portfolio Management
For passive and index fund portfolio managers like Cardiff Park Advisors, the burden of creating returns is removed from the research process and returned to the responsibility of the market, which sets prices to compensate investors for the risks they bear. Investors compete with each other to find the most attractive returns. This competition drives prices to fair value, ensuring that companies must offer returns in line with their perceived risk. When markets work properly, no investor can expect greater returns without bearing greater risk.
Passive portfolio management acknowledges that returns come from risk, and at least some risk is essential for long-term gain, but that not all risks carry a reliable reward. Rather than trying to out-research other market participants, passively managed index fund investors look to asset class diversification to manage uncertainty and to position portfolios for long-term growth.
For passive and index fund portfolio managers, the idea is to hold as many stocks in as many industries and as many countries as reasonably possible. Transaction expenses, taxes and tracking error, the byproducts of portfolio management, are the unavoidable costs of asset allocation. The passive and index fund portfolio management process offers a way to invest that reduces these and other costs that penalize long-term expected returns.
For passively managed index fund portfolio managers like Cardiff Park Advisors, the objective is to devise appropriate long-term strategies that will move investors towards their financial goals with the least amount of risk. These strategies do not fight the capital markets with the goal of trying to beat them so much as they intelligently ride with them.
Active vs Passive Portfolio Management: Which is Better?
For active portfolio managers the central questions are whether information is already incorporated into market prices and is there a way to accurately predict when to buy and sell assets to produce better returns from short-term market predictions. Unfortunately, skill in evaluating the business prospects of a firm or the outlook for an industry may not be sufficient for successful trading. To construct a market beating portfolio, active managers must identify miss-priced securities. They must have accurate information that other investors don’t know about yet. To profit from this insight, other investors must then act upon this information, causing the mis-pricing to be corrected. In a world where information is rapidly distributed, and use of insider information is illegal, identifying miss-priced securities is a tall order. Gaining an advantage over other investors in a competitive market place is challenging. To be successful, active managers must regularly find miss-priced securities and anticipate when unusually high or low returns might begin or end. The failure of active management to outperform the market would provide solid evidence that capital markets are functioning efficiently.
Passive Portfolio Management: Everyone has an Opinion and Misconceptions Abound
Novice and experienced investors, when first introduced to passive management tend to dismiss it. How can a strategy to buy and hold every stock deliver higher-returns than only selecting the best stocks to invest in? You would think that some companies with better prospects than others would be more profitable investments. Shouldn’t analysis by skilled researchers deliver superior results? Embraced by many of the world’s largest investors passive investing has overcome enormous skepticism. In the 70’s researchers armed with powerful computers began assembling a detailed history of security prices and tested assumptions that had never been thoroughly evaluated before. The superiority of active management was one of the assumptions that researchers tested for.
Actively Managed Stock Funds Underperform
Audited by professional accountants and publicly available for all to see, mutual fund returns are a good source of data on the effectiveness of active manager efforts. For the five-year period ending December 31, 2010 Standard & Poors (S&P) reports that only 37% of actively managed large cap core funds outperformed the S&P 500 Index on an annual basis. Results were even less favorable for non-US markets. Just 18% of international funds and 10% of emerging markets funds beat their benchmarks. It’s often said that foreign stock markets contain more pricing errors than the US market; supposedly giving clever stock pickers plenty of opportunity for beating the market. The performance data published by S&P suggests in reality this is more often fiction than fact.
Actively Managed Bond Funds Underperform
Fixed income (bond) markets pose even more of a challenge: for the same five-year period, Standard & Poors found that only 25% of short-term government funds were outperformers, only 14% of general municipal debt funds were outperformers, and the number of outperformers dropped to 8% for high-yield bond funds and only 3% for short-term investment grade bond funds.
Actively Managed Stock and Bond Mutual Fund Winners Don’t Repeat
Consistent superiority has been even a tougher challenge for active fund managers: Few bond funds consistently repeat top-half or top-quartile performance within their category. And over the five years ending September 2010, Standard & Poors reported that only 4.10% of large-cap funds, 3.80% of mid-cap funds, and 4.60% of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. If 4.1% of the funds were able to beat the market consistently isn’t that evidence that a minority of active managers are genuinely skilled? Not necessarily. According to Standard and Poors a random outcome would give you a rate of 6.25%. In other words, the number of actively managed mutual funds outperforming the market is no greater than one would expect by chance.
Actively Managed Mutual Funds Underperform in Bear Markets too.
Some people falsely believe that during a bear market active management has a distinct performance advantage based on its ability to quickly shift into cash or defensive securities. Again, nothing could be further from the truth. Standard and Poors found that a majority of active funds underperformed their indices in the negative markets of 2008. Over the five-year market cycle from 2004 to 2008, the S&P 500 Large Cap stock index outperformed 71.9% of actively managed US large cap funds, the S&P Mid Cap 400 outperformed 79.1% of mid cap funds, and the S&P Small Cap 600 outperformed 85.5% of small cap funds. These results are similar to that of the previous five-year cycle from 1999 to 2003. According to the S&P report the story was similar for foreign equity funds, with the majority of actively managed non-U.S. equity funds underperforming benchmarks over the five-year market cycle from 2004 to 2008. What about bond funds? Benchmark indices outperformed a majority of actively managed fixed income (bond) funds over the 2004 to 2008 horizon as well. Five-year benchmark shortfalls ranged from 2%-3% per annum for municipal bond funds to 1%-5% per annum for investment grade bond funds.
Why Should Outperforming an Index be so Difficult?
The investment industry attracts bright, highly trained, and hardworking people. So why can’t they outperform an index? Maybe high management fees are to blame with fund companies more concerned about increasing their profits rather than improving investment results. This criticism is valid, but it misses the point. The insinuation is that managers could easily outperform their benchmark if they weren’t so greedy. If this were true, major pension funds, who negotiate low fees would show better performance results. But even among these sophisticated investors, the record of active management compared to passive strategies is unimpressive.
Internally, active managers often explain their mediocre performance by pointing to their size. They are unable to fully implement their research ideas because as they execute their transactions, stock prices tend to move away from them. Treynor (1994) points out that bid-ask spreads and prices pressures from the adversarial nature of the trading process give rise to implementation shortfall.
What else might explain the failure of active managers to perform better? Just as aluminum, gas, or timber prices rapidly incorporate new economic developments, so do financial asset prices. At any given moment, stock and bond prices represents the best estimate of their fair value by investors. Do some companies have better a outlook due to brand name recognition, superior technology, unique selling position, or financial strength? Absolutely! But this optimism is reflected in higher stock price relative to other companies as prices adjust to new information. And since news is unpredictable so are stock prices. The failure of active management to perform better is solid evidence that capital markets are functioning efficiently.
The Academic Case Against Active Portfolio Management
Dozens of academic studies over the years have examined how efficient the markets are by looking at the performance of professional money managers. The studies discussed below dating back to the late 1960’s present evidence that out-competing the market is difficult to do on a consistent basis.
Luck Not Skill
In 1969, Michael Jensen of Harvard Business School wrote a paper published by the Journal of Finance in which he developed a risk adjusted measure of portfolio performance based on the theory of the pricing of capital assets by Sharpe (1964). The measure now known as “Jensen’s Alpha” estimates how much of a manager’s skill to pick stocks or time markets contributes to a fund’s return. Jensen applied the measure to estimate the forecasting ability of 115 mutual fund managers between 1945 and 1964. He questioned their ability to earn returns which are better than would be expected given the level of risk in each of the portfolios. Jensen found that the sample underperformed a buy-and-hold strategy (1945-1964), and individual performance was no better than what could be predicted by random chance (in other words, it was luck, not better stock picking).
Winners Don’t Repeat
Several later studies found evidence of persistence among winners; funds with unusually high returns tended to have high returns in the following periods. This result is repeatedly cited as confirmation that some managers are more skilled than others. One exhaustive study (Carhart, University of Chicago dissertation, 1997) specifically addressed survivorship bias and distinguished skill from simple momentum effects. Carhart showed that persistence was determined mainly by short-lived momentum in a fund’s underlying securities. Mangers don’t effectively exploit momentum to enhance returns. Rather, Carhart’s research demonstrated that some of the stocks that manager’s own by chance develop upward momentum. When the momentum on those stocks’ decays, so does the superior performance of the manager. The bottom line to Carhart’s research is that Investors cannot identity superior managers by looking at past returns.
Carhart found that an equal-weighted portfolio of 1,892 funds existing at any point in time between 1961 and 1993 underperformed the market by 1.8% per year after adjusting for common factors in returns. Think about that. The universe of actively managed funds available to investors over that long period of time produced a collective annual shortfall of nearly 2%. Short and long-term capital gains, which are less an issue for passive investors, further erode the returns of the active investor.
The Failure of Track Record Investing
Track record investors rely on historical data to predict future success. Based on a track record, they may place their faith in a fund, an adviser, a private investment newsletter, or Morningstar ratings. When active fund managers point to charts and graphs that demonstrate the market-beating performance of specific funds, they implicitly suggest that track records work. Most investors fail to recognize that these charts have nothing at all to say about how a fund will perform next week, much less next year. What the charts do demonstrate is how certain asset classes performed in the past. Passive investors would have reaped the same gains at much lower expense. The same holds true for track records of active investment advisors. The best can only be identified after the fact, and only then when performance can be shown to be related to skill and not random luck.
Even when an active fund manager does have a record of out-performance, it can change overnight. An adviser’s track record may be related to a particular skill or investment style or, more likely, to fortuitous asset class selection. This point was born out by a 1992 study of the Forbes Honor Roll. John Bogle examined the performance of 15 to 30 mutual funds annually named to the Honor Roll between 1974 and 1990. He found that subsequent to being selected, these funds tied the performance of the average stock fund, and significantly underperformed the market after accounting for all costs. Luck, not skill, is what lands funds on honor rolls.
Despite the obvious flaws in track record investing, millions of investors rely on Morningstar track record ratings to guide fund selection. Funds that perform well receive five stars; those that do poorly get one star. Because funds are a reflection of their stock holdings and asset classes, a sector that falls out of favor can knock a fund from five stars to one very quickly. The average five-star rating only stays in place for about eight months. Investors face a dilemma: chase the rating, or stick with the fund that has been downgraded. Ultimately, a five-star rating is simply a way of saying “this fund has performed well in the past.” It is not a predictor of the future.
The Odds of Successful Market Timing are Low
Market timers move money in and out of the market in attempt to profit from short-term events or sit out downturns. Some use historical trends and data to time their moves, while others rely on advisors or their own hunches. For the average investor, market timing is a terrible strategy. It takes nerves of steel to buy into a market that seems to have no bottom. But market timers must act when pessimism is greatest—something they can only sense but never truly know. Likewise, when markets begin to climb, market timers must decide when to get back in. Swift upturns can just as easily revert to steep setbacks, and the wrong entry point can be disastrous.
Passive investors reject market-timing strategies in favor of a buy-and-hold strategy that keeps money invested during good times and bad. For over more than a century of measurable financial history, the markets have rewarded investors with long-term gains in value, despite wars, economic, social and political turmoil, and natural disasters.
Survivorship Bias Inflates Past Performance Records
A 1998 study looking back at two decades of mutual fund performance (Arnott, Berkin and Ye, 2000) demonstrated that on whole, actively managed funds underperformed the Vanguard 500 (an index fund) by 2% annually over 20 years. Over 15 years the performance record compared to Vanguard was -3.73%, and at 10 years, it was -3.18%. The results are actually worse than that, as this study failed to take survivorship bias into account. This means that the funds that simply failed and disappeared completely weren’t accounted for. Results were even worse when capital gains and dividends taxes were included. In this study, just one in ten mutual funds outpaced the S&P 500. A large body of research suggests that the under-performance of actively managed funds is between 1.5% and 2% annually when comparing the same asset classes and mix.
Active Small Cap Managers Fail to Outperform their Benchmarks
Investors often argue that small cap stocks are more inefficiently priced than large cap stocks, so that the pricing errors can be more easily be exploited. This suggests there should be evidence of persistence among small cap portfolio managers. However, no real evidence of reliable positive persistence exists among small cap managers according to studies by Davis (2001) and Quigley and Sinquefield (2000). When pursuing the small cap premium passive portfolio management is clearly the way to go.
Active Bond Funds Cost Society $1.4 Billion Annually
In a well-constructed study Marlena Lee (2009) examined the role of luck in the performance of actively managed US bond funds from 1991 to 2008. At the end of 2008, there were 1,476 actively managed bond mutual funds in the US, with total net assets of $158 billion. Lee (2009) studied the performance of these professional bond managers. In aggregate, Lee found that bond funds underperformed, by an amount roughly equal to their fees. Additionally, good past performance did not predict good future performance. According to Lee, the top decile of funds sorted on abnormal results in the previous three years had insignificant alphas in the following six months. In contrast, the poor performance of the biggest loser persisted for several years.
These results show that investors cannot expect to profit from investing in actively managed bond funds with good past performance, and they may be able to protect themselves by avoiding actively managed bond funds with poor past performance (Lee, 2009). Collectively, investors in active bond funds lost about 90 basis points per year, or about $1.4 billion in 2008, in under-performance. This under-performance was primarily driven by fees thereby negating the argument that higher fees associated with active management reward investors with above average returns.
Active Management Accelerates Taxation
With active trading, portfolio turnover is a given. For instance, the average turnover rate for US large caps was 79% in 2009. This is not good news for investors who hold funds in taxable accounts—and taxable accounts hold nearly two-thirds of all mutual fund assets. Turnover accelerates taxation, costing fund holders 1% to 2% annually in estimated capital gains taxes. According to a 1993 study by Arnott and Jeffrey, even modest turnover of 10% can reduce returns by a full percentage point. To achieve 6% after-tax growth, an active fund would have to outperform its passive counterpart by anywhere from 70 basis points (for a portfolio with 5% turnover) to 278 basis points (for a portfolio with 50% turnover).
The Advantages of Passive Investing
Index Mutual Funds and ETFs Perform Better
Unlike index mutual fund and ETF investors, active investors pay heavily to participate in actively managed funds which is a direct expense to performance. Fees and expenses vary from fund to fund but can take a huge bite out of returns. Some costs such as portfolio management and administrative fees, trading commissions, and ongoing 12b-1 fees intended to cover fund marketing and advertising expenses are hidden or obscured by the fine print in the back of prospectuses. Even small differences in fees can translate into large differences in returns over time.
For example, if you invested $10,000 in a fund with a 10% annual return before expenses and annual operating expenses of 1.5%, after 30 years you would have about $115,582. But if the fund had expenses of 0.2%, you would end up with $165,223, a 43% difference. Bottom line, high investment costs, the byproduct of active portfolio management are as much a threat to investment returns as inflation and taxes. The main point is that any portfolio with fewer costs has a higher expected return. And because this is true, actively managed mutual funds would need to deliver the impossible and outperform the market every year just to break even with their lower-cost passively managed index fund and ETF counterparts. When adjusted for common risk factors index mutual funds and ETFs consistently produce rates of return exceeding active managers by close to 1.5 percent.
Index Mutual funds and ETFs are Tax Efficient
Index mutual funds and ETFs trade only when necessary (since passive managers aren’t active traders), whereas actively managed mutual funds typically have a turnover rate of close to 100%, and often significantly more. Index funds allow investors to defer realization of capital gains or avoid them entirely if shares are later passed to heirs. To the extent that the long-term upward trend in stock prices continues, active trading from one security to another entails realizing capital gains that are subject to tax. Taxes are a critically important issue because realization of capital gains significantly reduce net returns. Index mutual funds and ETF investing tends to minimize capital gain taxes because they do not trade from security to security.
Index Mutual funds and ETFs are Predictable.
When you buy an actively managed fund, you can never be sure how it will perform relative to its peers. When you buy an index fund you can be reasonably confident that it will track its index and that it is likely to outperform the average active manager. Moreover, index funds are always fully invested. Be skeptical of the active manager who claims that his or her fund will move into or out of cash at the correct times. Research shows unambiguously that market timing does not work. With index funds, you know exactly what you are getting. The passive investment process is straightforward. Broad diversification and low costs due to low turnover and low management fees reduce risk and provide long-term insurmountable return advantages for the passive investment process over any form of active management.
Index Mutual Funds and ETFs are less Risky
Conventional investing wisdom holds that the safest portfolios are highly diversified and spread across a large number of securities. However, the growth of passive investing has motivated an increasing number of active mutual fund managers to shun diversification and focus on portfolios of fewer stocks. Part of the idea is to differentiate themselves from the low-cost index tracking mutual funds and exchange-traded funds. The number of active U.S. stock funds holding fewer than 35 stocks has nearly doubled since the start of 2009, while the assets under management in such funds have almost tripled, standing at around $161 billion at the end of October, 2019 according to Morningstar Direct. Yet the broad performance of these concentrated bets hasn’t been great. Since the start of 2009, equity portfolios with fewer than 35 stockholdings have lagged behind both the S&P 500 and their more diversified peers. Even more highly concentrated portfolios—those holding 20 stocks or fewer—have underperformed by a wider margin, returning 133 percentage points less on average than the total return of the S&P 500, according to Morningstar Direct data. Index Mutual funds and ETFs eliminate manager risk, or the risk of investing in an actively managed fund only to see the manager underperform the benchmark index.
The main message of the performance studies and the other research is that it is very difficult to beat the market by collecting and evaluating information or trying to time the market. The average mutual fund fails to outperform a style adjusted passive benchmark. There is little evidence of persistence in good performance when returns are adjusted for common risk factors and the effects of momentum. Some active managers may be more talented than others, but the reward for their effort isn’t large enough to cover the higher costs of the active management process.
Learn More About Us
Cardiff Park Advisors is located in San Marcos, 25 miles north of San Diego. We work with clients throughout the United States. We welcome the opportunity to discuss your financial goals and how we can help you reach them. You may reach us by emailing our principal at email@example.com or calling our office at 760-635-7526.
For more information about Cardiff Park Advisors please review our brochure at https://adviserinfo.sec.gov/firm/summary/126752 or visit www.cardiffpark.com