Active management is dead… or soon to be

Active management is dead… or soon to be

Active management is dead… or soon to be At least that’s the opinion of a very well-known passive indexer who sees it getting harder and harder for active managers to outperform their benchmarks. However, you won’t believe why.

New York City-based financial advisor Josh Brown, known to many as the Reformed Broker, posted a very interesting article Tuesday that discusses the future success or failure of active management.

Citing evidence from Larry Swedroe’s new book, The Incredible Shrinking Alpha, co-written with Andrew Berkin, director of research ar Bridgeway Capital Management, the duo show that just 2% of all active managers generate statistically significant alpha, one-tenth the number that did so 20 years ago.

In other words, the death knell is ready to sound.

Manisha Thakor is a colleague of Swedroe’s. On February 12, Thakor was a guest contributor to the Experts column in the Wall Street Journal. In the column she outlined four main reasons for this phenomenon. The words below are entirely her own.
  1. The sources of alpha are disappearing as they get converted into beta (the exposure, or loading, on a factor that can be accessed with index funds or ETFs at much lower costs).
  2. The supply of victims that can be exploited is shrinking. Investors drop out of the active management contest as they get tired of losing a zero-sum game to those with superior knowledge or better skills.
  3. The competition is getting much tougher. Today’s active managers possess much more skill than their predecessors. They come to the industry armed with M.B.A.s and Ph.D.s in finance from leading universities. They have high-speed, data-crunching computers not previously available. And they now hire world-class scientists and mathematicians charged with uncovering sources of alpha and exploiting them.
  4. The number of dollars chasing the shrinking sources of alpha and the dwindling supply of victims has grown dramatically.
Of the four points Thakor mentions, the second is the one Brown really jumps on.

Essentially, Swedroe argues that with retail investors abandoning active management for passive strategies, the only people left to play the game will be active managers, who historically have feasted on the mistakes of retail investors.

Without this significant source of alpha available to active managers, it will become increasingly difficult to deliver benchmark-beating performance.

However, Oakville-based portfolio manager Bob Sewell, CEO of Bellwether Investment Management, believes there’s still a place for active management.

“We believe there is a place for both passive and active investing,” says Sewell. “That’s why we offer both solutions to investors. Really what investors need to understand is that there are pros and cons to both and ensure that they have a good advisor to help them navigate the process to find the right solution for them.”

 That’s only common sense.

However, to further press the argument that active management isn’t working, Brown uses data from Savita Subramanian, the head of Bank of America Merrill Lynch’s Equity and Quant Strategy group.

According to Subramanian, “We found that the 10 most underweight stocks in the S&P 500 by large cap active managers outperformed the 10 most overweight stocks by managers by 32 percentage points in 2014.” So far in 2015, the same trend of active managers pouring money into the wrong stocks, continues.

It all could be a coincidence – or as Brown suggests, it could be active management falling off a cliff. 
 
2 Comments
  • Tim Affolter 2015-02-18 12:54:09 PM
    Might this underperformance by active managers not also be attributed to managers looking for defensive value stocks versus expensive growth stocks? 2014 was about as lopsided a year as we've seen in a long time, with the top quartile of the US market returning 18.2% at 35.7x p/e, while the bottom quartile returning only 2.8% at 13.8x p/e. I remember Peter Cundill suffering tremendous outflows in his Value Fund in 1999-2000 because he refused to buy expensive tech stocks (notably Nortel) in the Tech Bubble run up. His critics were singing a different tune in early 2001 tough... just saying...
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  • Will Ashworth 2015-02-18 2:25:16 PM
    Tim,

    Very good point. I had to think about the name Nortel for a second. They're still around?

    Passive vs. active will never die.

    If active disappears what happens to passive? Does it flatline?

    That's a topic for another day.
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