This thought has been churning around my head for a while. Howard Marks dealt with a similar subject in his most recent newsletter and it made me want to revisit it. There’s been a lot of money moving into passive managers lately, is this justified? When will it end? Is there even a need for active managers anymore?
When I talk about active managers, I’m referring to hedge fund managers who take risks that diverge meaningfully from the known benchmarks. The kind of people that charge 2 and 20 (2% management fee and a 20% performance fee) for managing other people’s money. This differs from the passive investments offered by ETFs that track the market indices and have become the flavour of the month these days.
It looks like there will be a future for active managers but it’s going to be far leaner than it has been in the past. There will likely only be a place for those managers that can articulate why they’re able to readily reproduce alpha over time. This will only apply to a small proportion of the fund managers that are currently goosing around in financial markets.
Active managers use a range of styles to outperform their benchmarks. One of the easiest groups of active managers to make a comparison against is those that utilise value investing strategies. As a whole active managers were paid too much for too long for underperforming. This post will focus on value investing strategies because it’s easier to make a comparison of apples to apples when you’re comparing a strategy that’s meant to outperform equity indices as opposed to one that implements a range of different strategies.
Common sense suggests that passive strategies cannot continue to ride on the coat tails of the active managers in perpetuity. If there are no longer any active managers that are able to eek a living out of financial markets, markets will become less efficient at pricing in all known information. Eventually, the pendulum will swing the other way as the rewards for picking stocks will justify the risks of the endeavour. However, there needs to be a clearing out of the undergrowth before this can occur and we’re likely only seeing the first stages of this.
Are Active Managers Necessary?
Active managers have had a bad rap after the last few years of underperformance. Institutional investors could be questioning whether it’s really necessary to pay for performance that fails to meet the same return as passive instruments. This criticism isn’t unjustified and could arguably be explained by a number of factors. I would break down the recent past into two critical periods: 1) The high beta phase, and 2) The Fundamental Quagmire or Momentum Regime.
Just as they would say in commodities markets, “The cure for higher prices is higher prices.” The bleeding out of active managers and specifically macro managers will be stemmed when passive investing destroys price discovery and creates pockets of long-term value in capital markets.
There will be a necessity for active managers to innovate and create new structures that have risk profiles that reflect a more absolute nature, for a majority of the industry this will also force a reduction in fees. A number of notable funds have shut down in recent years; Tilson’s Kase Capital, Eric Mindich’s Eton Park Management, Neil Chriss’ Hutchin Hill Capital, Hugh Hendry’s Eclectica Asset Management, John Griffin’s Blue Ridge Capital, Leland Lim’s Guard, John Burbank’s Passport Capital, and Richard Perry’s Perry Capital. That’s a pretty nasty Killed in Action list for hedge fund managers in the last couple of years.
Here’s what Whitney Tilson had to say about the matter:
reporting sustained under-performance to you was making me miserable… Historically, I have invested in high-quality, safe stocks at good prices as well as lower-quality ones at distressed prices. Given the high prices and complacency that currently prevail in the market, however, my favorite safe stocks (like Berkshire Hathaway and Mondelez) don’t feel cheap, and my favorite cheap stocks (like Hertz and Spirit Airlines) don’t feel safe.
This is somewhat similar to what happened in 2009–10, as captured by Bloomberg in the images below:
As far as I can see, there have been two meaningful contributors to the downfall of active managers. Firstly, the high beta phase where hedge fund managers were only leveraging market movements because they had access to complex derivatives and pure leverage through their prime broking agreements. Secondly, there has been the fundamental quagmire where value investing has consistently underperformed momentum investing. This typically happens from time to time during market cycles but this period has been even more pronounced for reasons that I won’t touch on in this post.
The High Beta Phase
After the 90s, investing in hedge funds became all the rage as there wasn’t a lot of access to the various financial products. Especially leverage. Retail investors love leverage. It’s never good enough to do well, you have to be doing better than the next guy and doing it quickly. The easiest way to do that is with leverage.
Initially, it was more difficult for individual investors to get access to global equities, derivatives and other financial instruments. Global broking platforms were either non-existent or nascent. Naturally, anybody who could fog a mirror, had some broad understanding of financial terms and could talk a good game felt compelled to get into the industry and become a master of the universe.
While this might be too broad of a generalisation considering Ibbotson, Chen and Zhu’s 2010 study, which demonstrated that hedge funds do add a level of alpha on average, I would argue that the study likely masks the dispersion of smaller funds that were typically levered to take advantage of equity market fluctuations. The larger funds that put a significant effort into research and developing proprietary systems would likely have a disproportionate impact on the alpha produced by the group as a whole.
If you think about the traditional model, an active manager could be thinly capitalised and raise external assets, which, with the help of a prime broker, could be levered to create a notional portfolio that is a couple of multiples of the capital base (if we just consider the leverage that’s available in equities without any regard for the other derivatives that could be layered on top of the initial portfolio).
Combining the multiple layers of leverage (client funds and the leverage provided by the prime broker without considering the derivatives available), active managers are able to asymmetrically skew the return profile in their favour, if things turn out well. If things don’t turn out so well, they only end up risking their original capital without any regard for the investors. This is likely a more cynical view of the actual situation. Regardless, investors started to question why they were paying for market exposure that they could get through ETFs, which were increasing in popularity at the same time.
This started the shift from active managers to passive managers. It started at the higher levels as institutional investors; including fund of funds and pension managers, started to question the necessity of portions of their portfolio allocated to high fee managers. To understand why there has been a shift away from active managers in pension funds and other real money managers, we need to understand why they adopted the asset class to begin with.
Initially, pension funds had tried to replicate David Swensen’s “Yale Model”, which sought to earn a premium for taking on illiquidity risk. As Drobny points out in his book The Invisible Hands, Swensen’s formula was likely pushed by consultants and banks as they encouraged other real money managers that they could emulate his success (growing assets from $1.3bn in 1985 to $22.87bn in 2008 with only one negative year).
While the idea may have been right, it’s unlikely that the followers would have had the same timing, resources or ability to negotiate similar fee arrangements, which could dramatically impact returns. As a result, institutional managers were disappointed with the returns that they earned from hedge funds and in recent years they have been cutting their allocations. This is no surprise that this correlates with an uprising in the amount of passive investment instruments that offer investors a low-cost way to diversify into capital markets.
As global broking platforms and prime broking-light models became available to investors, there was no longer the need for them to go to some guy who could talk the talk while dressed in a three-piece suit in the middle of summer. The broader acceptance of passively managed products, not to mention leveraged ETFs, gave everyone from retail to institutional investors more choices in how they managed their capital. They no longer needed to pay the exorbitant fees unless they were getting value for their money. Which brings up the next question, was there any way that they could justify the fees they were paying?
The Fundamental Quagmire or Momentum Regime
Value investing, or investing based on a company’s fundamentals has been underperforming momentum investing for an extended period. Typically, this will happen from time to time but the pendulum generally swings back the other way. While the move to passive investing could have accentuated this, value strategies haven’t outperformed for a long time. Look at Buffett, even the oracle of Omaha is struggling to beat the indices.
Taking a brief interlude… The thing about value investing or stock picking is that it’s hard. Not only do you have to disagree with the EMH but you also have to believe that you have the ability to pick the best managers ahead of time. This is a two tiered test. You need to think that it is possible to beat the market through superior research, insight, intellect, discipline, whatever edge that you believe an investor may possess. Then secondly, you need to believe that you, not the investor you’re picking but you, have the ability to work out who the best managers are ahead of time. Typically, if a manager has outperformed for a number of years they see inflows to their funds, which can cause a performance drag (and possibly style drift) because the things that they did at a smaller scale no longer work at a larger scale.
A recent CFA article addressed this with a Kahneman quote,
in order for skill to be acquired, two factors must be present:
1. An environment that is high-validity, or sufficiently regular to be predictable; and
2. An opportunity to learn these regularities through prolonged practice.
It’s difficult to say that financial markets are “high-validity environments” as economics isn’t a pure science. Hell, I don’t think it’s much of a science anyway (check out this book for more). A large majority of the rules in economics are based on the fact that people are rational wealth maximisers. I see things on a daily basis that prove this cannot be true. If it were, it would be incredibly complex for people to make trade-offs between their present consumption and future savings. Most people fall back on heuristics to make decisions and most of the time, these heuristics don’t lend credence to the underlying notion that individuals are rational wealth maximisers.
There’s another layer to add on here, the reflexivity of markets. Financial markets create pricing signals, which people use to determine future actions. A good example of this is the company comparison valuations used by sell-side brokers. If a group of companies in an industry is trading at a given multiple then if we make some adjustments for qualitative factors (or not — most of the time, there isn’t as much thought given to the process), then one of the other companies in the industry should be worth a similar multiple. This gets increasingly complex as prices lurch higher (lower), multiples move higher (lower), which justify higher prices (lower) and higher (lower) multiples until the system collapses (bounces back).
Therefore, to pull the above concepts together, we have a large set of heterogenous people that are all making irrational decisions (which they believe to be rational based on their heuristics) and which feed on each other. The overall result can be somewhat unpredictable (at least with traditional economics models) so it’s hard to say that it’s a “high-validity environment” because the results can differ from time to time, it’s impossible to falsify any hypothesis and even historical events may not be an appropriate guide to the future.
The same CFA article referenced above noted that “92% of 10-year top quartile funds spent at least one three-year period in the bottom half of their group, while 56% languished in the bottom half for at least one five-year period.” Value as a strategy underperforms and when it does, it can underperform for long periods. This poses a significant business risk to active managers because they face redemptions and low or no performance fees, which can cause them to close up shop as happened to the group mentioned above.
What’s the solution?
Active managers exist to make a return from exploiting market anomalies or inefficiencies. They can only do this if those inefficiencies correct themselves over time. This hasn’t been happening, as noted by Potomac River Capital’s Mark Spindel, “Markets had become increasingly disconnected with economics and politics.” If the inefficiencies don’t correct themselves then value investing is going to underperform and active managers are going to underperform as well (especially after the fees are deducted).
The industry has been plagued by managers that weren’t able to demonstrate a repeatable alpha over time. A majority of the fund managers don’t deserve to be there as they were just levering up their capital and trying to get the additional leverage from client funds and prime brokers on top of that to ride buoyant markets. In 2009, the tide went out and a majority of the managers got caught with their pants down.
The disregard for absolute performance in the prior period and a subsequent period of underperformance have given investors no choice but to turn to the lower cost passive products. It’s acknowledged that active investors will underperform the market for extended periods of time but they also have to be able to withstand the business risks that it entails. The graveyard of active managers is growing more crowded by the day as managers aren’t able to keep the doors open.
If there is no one ironing out the market anomalies, as the market moves to more passive instruments then it’s more likely that more pricing discrepancies will exist. It might require longer-term capital to take advantage of the pricing anomalies but the returns should more than outweigh the additional illiquidity risks as capital is drawn to longer-term strategies.
As Howard Marks concludes, “the greatest investors aren’t necessarily better than others at arithmetic, accounting or finance; their main advantage is that they see merit in qualitative attributes and/or in the long- run that average investors miss.” There will continue to be a place for active managers that are able to take an alternative view and hold positions for longer periods of time. Short-term belongs to the computers but I believe that the longer-term investing returns will still be made by humans.
