A myth has become mainstream thinking right before our eyes. Financial professionals often state, “You can’t outperform the market, so don’t bother trying, simply index.” Index investing is by definition accepting and setting the expectation of an average result.
Investment managers can either manage a portfolio actively, making investment buy and sell decisions, or alternatively, buy and sell the identical holdings of an index, thus managing in a passive manner.
Many of the most vocal proponents of index (read passive) investing are those who stand to benefit the most – those selling index investment strategies. In fact, in the recent past more investor assets have been reallocated to passive investment strategies and away from active strategies. According to Morningstar Mutual Funds, over the past year active funds have lost $326 billion while indexed funds have gained $563 billion in investor assets. The question is why is this occurring? Are active managers like us unable to outperform an index over time?
At Global Value Investment Corp., we recognize several fundamental and relevant issues that impact long-term investment and investor results. In our opinion, a well-defined and consistently executed active portfolio strategy has a high probability of achieving significant outperformance over the long-term. Most investors we speak with tell us they are long-term oriented, which we construe to mean they have a 10 year or greater investment horizon. A typical investor, age 40 or under, in reality, has a very long horizon potentially spanning three to five decades.
The Challenge: How Big is Too Big?
What we find, however, is that most investment funds actually have a very short investment horizon, somewhat paradoxically to the goals of their investors. What do we mean by that? Well, mutual funds are ostensibly paid by collecting fees based on assets under management (AUM). As such, “successful” funds are measured by total assets under management, with the largest funds today managing well over $100 billion. You might think the most successful funds have the best performance – not necessarily the case. It should come as no surprise then, that most fund managers have compensation incentives tied to successful outcomes – not necessarily percent return on investment, but rather, the addition to assets under management. In order to continue to attract new client assets, funds need to report favorable short-term results. Funds are all too often measured and compared to one another every 91 days (quarterly), thus incenting managers to realize success measured in 91 day increments.
Adding assets and return on investment aren’t necessarily exclusive. Generating high returns is one way of increasing AUM. There are times, however, despite generating excellent historic returns, a fund may fall out of favor for extraneous reasons and experience investor withdrawals of assets with a corresponding reduced fund management fee. So, funds and their managers are under constant pressure to increase AUM, whether by organic growth or through marketing to investors who can make deposits. Thus, the dilemma.
The Diversity Dilemma:
A successful fund is under constant pressure to achieve short-term results in order to attract new assets. This in itself isn’t an absurd idea, but it can lead an analyst to avoid making intelligent long-term investments – the type of decisions that develop over many months or quarters – in an attempt to earn more speculative short-term returns.
Further complicating the challenge for fund managers is success itself. What does this mean? If a fund succeeds it necessarily grows its assets. There is little debate, the more focused on sound investments a fund remains, the better the investment returns over time. Assume a hypothetical analyst is adept at selecting attractive investments. When asked to select 5 high conviction ideas, he can easily list 5 names. When asked to offer another 15 names, bringing the total selection to 20, he will likely hesitate as his list approach numbers 18, 19 and 20, having much less conviction in the latter. He now has a portfolio of 20 names all of which he knows reasonably well and follows closely. These are names in which he has a high level of confidence, albeit, the top 5 are of much higher conviction.
Now assume a non-hypothetical in which the analyst needs to offer up 113 names. You can imagine, by number 50, 75 or 100 our analyst is very likely selecting securities in which he has a far lower level of conviction and knowledge of each security. The portfolio would now hold the current industry average for a US equity mutual fund – that’s right, the average US stock funds today holds 113 stock names.
We believe an analyst with refined security selection skills, managing his or her top 10-20 ideas (a ‘Best Ideas’ approach) will easily outperform his or her portfolio comprised of 113 stocks over the long-term.
At this point you rightfully may ask why a fund would hold 113 rather than just 20
names? Back to our earlier point, most funds define success by total assets under management – keep in mind, funds collect a fee tied to total assets under management – more assets equal more revenue for the fund. Again, the diversity dilemma, a fund that manages a modest $10 billion of assets (the largest funds today manage 50x this much) is challenged to utilize a ‘Best Ideas’ approach. Assuming a fund with $10 billion intended to invest in just 20 stocks, the fund would invest $500 million in each, a sizable stake in a single company. Committing this much capital to any company means the fund will limit the number of publicly traded companies in which it can invest. Alternatively, a fund can invest much less in each company but be forced to hold many more stocks, i.e. 113. In fact, we’ve seen funds holding 500+ stocks.
This overdiversification comes with an added expense – all trading costs are absorbed by the fund’s investors. More stocks owned means more trading which means more expense. In addition to diluting the effect of the analyst’s ability to select a relatively few high conviction ideas, the fund has increased its operating expenses, thus reducing the return to its investor.
The Fund Manager’s Challenge:
The prolific writer and investor, Howard Marks, put forth the idea of a risk which he identifies as ‘career risk.’ He describes this as the risk an analyst faces of losing his job if he fails to produce satisfactory results, which translates into not attracting assets to the fund. Wall Street is notorious for replacing fund managers at a rate in excess of Pro-Football head coaches. This is a “dog eat dog” workplace environment.
Faced with the risk of losing his or her job by virtue of performing out of step with the benchmark index to which the fund is compared, many managers embrace a closet-index strategy. They make slight modifications to their holdings in comparison to the list of securities that makeup the benchmark index, with the hope of performing slightly better (but not more than slightly worse) than the benchmark.
With a 91 day horizon for many funds, an analyst can underperform for a few quarters, but much longer and they may face a career ending risk. The safe strategy is to attempt to stay close to, but slightly above, the benchmark every 91 days. The headwind most mangers face is the expense charged against assets under management which a benchmark does not incur. The average fund’s investment expense, paid by the fund’s investors, expressed as a percentage of assets under management, is roughly 1.39% (Advisors Perspectives, C. Thomas Howard, Phd. January 26, 2016). This means the fund must outperform its benchmark by 1.39% just to break even. Trying to match a benchmark, which may hold several hundred securities, while essentially holding the same securities, by this margin, is a statistically challenging assignment.
The idea of “hugging” a benchmark and simultaneously outperforming it strikes us as wishful thinking at best.
The Market or ‘Marketing’ Reaction:
We believe the vast majority of “actively managed funds” are to some degree closet indexing, seeking short-term results roughly in line with the benchmark. We see little evidence of funds willing to invest with a long-term horizon, holding relatively few securities, shutting off new investor deposits in order to manage the size of AUM and consequently keep a wide range of potential investments, thus enabling ownership of large and small companies.
We think the marketing departments of the many Wall Street advisory and brokerage firms recognized this dilemma years ago and reacted in the only way they could, embracing the strategy, “If you can’t beat them, join them,” leading to the proliferation of indexed funds and the overwhelming push of individual investors into passive indexed funds. The corresponding ad campaigns then began touting a nonsensical mantra that, “You can’t outperform the market, so don’t bother trying, instead use a passive index strategy.” Legions of misinformed brokers and advisors bought into this logic and prospered by gathering billions of dollars in new AUM to be re-allocated into passive investment strategies. This trend has been going on for many years now, as hard as this may seem to believe. Never underestimate the power of Wall Street’s marketing departments in persuading investors to act in ways that benefit Wall Street.
Thanks to the excellent research of C. Thomas Howard at the University of Denver, we can share the following data:
When looking at domestic “actively” managed equity mutual funds (a universe of roughly 4,000 funds), the top group representing just 4% of the total, and a fraction of a percentage of AUM, had average returns (alpha) of 1.73% above their benchmark (between 2001 – 2014), whereas the average fund underperformed by -.29% on average. The same group charged explicit fees of 1.62% annually versus the average fund’s charge of 1.39% – the adage “you get what you pay for” at work). The small group of funds tended to hold far fewer securities, managed roughly $50 million in assets and produced superior results.
Our firm, Global Value Investment Corp., has achieved consistent, above benchmark investment returns for long-term clients. When we read about or hear our peers supporting passive index strategies we shrug in disbelief. All we know is for ages many investment professionals and firms such as ours have produced returns well above comparative benchmark indices.
We are reminded of the renaissance scientist Nicolaus Copernicus who suggested the sun was at the center of the universe and the earth orbited it, not the other way around. He was criticized and his work banned as heretical thinking. Copernicus is often regarded as having launched modern astronomy through his scientific revolution. Likewise, we think one day in the future active investment management will be recognized for its true investment merit.