Advisors constantly debate passive versus active management styles. The passive camp argues that active managers fail to add value, so why pay the added fee? The active camp counters by arguing that active managers outperform over longer periods, thus adding value and justifying additional expense. Ultimately, the debate degenerates into a race to the bottom – lower fees. And in the absence of value, fees matter.
Regrettably, this argument leaves professional advisors focused on cutting fees in order to win business. This is a foolish strategy. Providing professional advisory services to retail investors is a critical job and an important function in our capitalist society. Advisors should be well-compensated for their effort, which requires a high level of responsibility and brings with it the associated stresses of working in an increasingly complicated capital marketplace.
However, we are writing about a more nuanced issue. We believe many professional investment managers claiming to be “active” managers are in fact active in name only. What do we mean by this? Active managers tend to trade often, resulting in unusually high portfolio turnover, yet they generally barely manage to track a benchmark index and are effectively “closet indexers.”
There are three types of investment managers:
- Passive managers seek to match a benchmark index
- Active managers buy and sell securities in an attempt to perform above a selected benchmark index
- Actively managed managers attempt to obtain information advantages over other market participants and use that to influence the investment outcome
Actively managed is a subset of Active management and relatively uncommon.
Activity in itself does not make a manager active. In our view, to “actively” manage investments, a manager must engage in the following:
- Concentrate on relatively few holdings
- Participate in quarterly earnings communications
- Frequently speak one-on-one with senior management
- Regularly query other institutional holders of the security
- Willingly communicate with directors when shareholder value is threatened
From our research perspective, owning a company’s equity or debt involves a huge commitment of analytical resources. Public companies report earnings quarterly. Each earnings release involves an initial press release (an 8-K filing), followed by an investor conference call (typically an hour in length). The call generates a corresponding transcription document. Next comes the company’s SEC form 10-Q or 10-K (quarterly/annual) filing, which includes detailed financial statement updates. Filing footnotes provide granular detail of a company’s financial, strategic, operational, and legal condition – often running 100 pages or more. The final and most important step in an actively managed investment is the follow up call with management. This is where unscripted dialogue occurs, where analysts have an opportunity to press management on specific strategic and operational issues. Our experience over many years indicates roughly 25 man-hours are required to rigorously complete the review of a single company.
Companies report earnings four times per year, thus analysts commit approximately 100 hours annually to actively evaluate each company. This is exclusive of extraneous communication an analyst should have with other institutional owners to compare notes and seek a thorough understanding of investment merits and shortcomings of the company. In sum, assuming a 2,000-hour work year, an analyst could theoretically manage 20 companies.
The average domestic equity fund holds roughly 120 companies. Many funds hold 250 or more with some holding over 1,000!
While a firm employing dozens of analysts could theoretically provide comprehensive analytical coverage, our experience leads us to conclude otherwise. We find relatively few analysts committing the necessary time to conduct rigorous fundamental research. We think many securities are selected based on screens or quantitative research that only superficially probes fundamental issues impacting price and value.
We arrive at our conclusion from two vantage points. First, we speak directly with analysts whose funds own large stakes in companies under our review. It’s rare to speak with an analyst who is thoroughly versed in the fundamental details of a company. For example, we recently called an analyst whose firm owns over 5% of the company’s equity (a notably large ownership for a fund which must file form 13-G). During our call, we mentioned the company had switched its reporting currency from US to Canadian dollars on January 1st, a significant corporate election. He responded, “They did?” which surprised us, since it was mid-July.
You may think this is an exceptional example; surely this is a one-off case? Yet we find the incidence of under-informed analysts to be surprisingly high.
Our second vantage point comes from speaking with company management. We are frequently told by CEOs and CFOs that we are among the most informed investors with whom they have spoken. This surprises us given the thousands of analysts working for large firms with greater resources at their disposal. Our first-hand experience leads us to believe much of Wall Street’s analytical work is superficial at best and frequently incomplete or factually incorrect.
A recent Wall Street sell-side firm’s research report (whose name we shall not mention) covered a company of which we are very well informed. The analyst misstated a critically important number – shares outstanding. When we called this to the analyst attention, he ignored our correction and stuck with the wrong number!
We raise this issue to expose Wall Street research and research analysts claiming to provide rigorous analysis and insights. We conclude that many active managers in fact have no “information advantage” when selecting securities. We believe most “active” fund managers simply hope to match or modestly outperform their benchmark. In many cases, they have little prospect for meaningful outperformance over time; they aren’t structured or organized to do so.
Actively managed investment managers generally have low levels of trading activity because they buy and manage an investment while the investment thesis develops. Further, when an actively managed investment isn’t working out as expected, it’s incumbent on the active manager to press the board of directors for change, often leading to shareholder recommendations for new senior management, a shift in business strategy, retention of outside advisors to solicit a sale of operating divisions or the entire company, a review of compensation and incentive plans, or a shareholder proxy contest to replace impotent directors. This is how we define “actively managing” investments.
Few active managers share our perspective on active management, with many preferring instead to be active with short-term buying and selling in a desperate effort to match their benchmark every 90 days.
Generating outsized investment returns requires a manager to think and act differently. If they don’t, then their results will be the same as others, just average. Many investors assume high activity levels are synonymous with deep thinking and concentration. We believe the opposite is the case. Actively managing investments requires a thoughtful and disciplined approach to synthesize information into meaningful investment decisions and actions. There are no activity constraints associated with successful management, only carefully thought out and executed investment strategies.