Active management outperforms–fact or fiction…

The mutual funds industry has recently latched onto some recent research that has stated that active funds out perform and is using these arguments to sell its active funds while ignoring the fact that not all active funds are the same and that most of its advisors, who operate under loose professional and ethical standards, lack the expertise, ability and accountability to deliver.

There is a rationale that states that deeply active managers are more likely to outperform and the more active they are the greater the probability of out performance.  At a physical level this is likely true if we equate deep active with contrary and assume that deep active is a small minority and is playing off the index-like active/inactive majority. 

If a market is inefficient, and the majority are averse to the risk of under performing the index and have a marginal preference for out performance, the impact of the majority as it tries to increase or reduce an allocation is likely to drive prices (way) above and (way) below where they should be.  This is simple physics.  This is the same physics that states that trying to outperform the majority at all points in time is likely to lead to a very high probability of under performance after costs.

What is not made clear is the size and timing of the performance differentials from a deep active versus a straightforward index strategy.  A deep active contrary strategy will likely have long periods of under performance as overvalued out performing stocks out perform and undervalued under performing stocks continue to under perform. 

The more managers become deeply active the lower the returns and the higher the risks of a such strategies and the more random and uncertain that return.   Such arguments are in no way arguments for recommending the vast majority of active fund managers, and, indeed, to be successful you need to be aware of the components of the market place and their relative and absolute pricing differentials.  

The other area of deep active where there is evidence of out performance is momentum strategies and I would have thought that the more the marginal investor attempts to outperform on a day to day basis, or hedge performance risk on a day to day basis (index investments), the greater the probability of momentum based strategies out performing. 

Vayanos and Woolley (2013) Momentum and value strategies underlie much of active management. Momentum strategies ex-trapolate recent trends, buying assets whose price has increased in the recent past and selling assets whose price has decreased. Value strategies exploit differences between price and measures of fundamental value, e.g, earnings or book equity, buying assets whose price is low relative to fundamental value and selling assets whose price is high. A large empirical literature documents that momentum and value strategies are profitable.

Momentum strategies should capture part of the upside of both sides of the coin, as it were.   A deep contrarian would sell early and buy early/sell short early and buy back early (losing performance at the start), whereas a momentum player would buy later and sell later still (losing performance at the end of the strategy)/sell short later and buy back later still.  

Crowding of strategies caused by excess interest in active will likely dilute deep active contrarian returns and inflate the risk of momentum based strategies.

The trouble is the for most investors and advisors delineating the “truly active for valid reasons fund” from the majority requires a level of valuation expertise, knowledge and resources that few actually possess.   The mutual funds industry has recently latched onto some recent research that has stated that active funds out perform and is using these arguments to sell its active funds while ignoring the fact that not all active funds are the same and that most of its advisors, who operate under loose professional and ethical standards, lack the expertise, ability and accountability to deliver.

Thanks to Ken Kivenko for passing me the IA Clarington communication which sparked this post!

And some reading:

A Theoretical Analysis of Momentum and Value Strategies – Vayanos and Woolley

Active Management Myth Busting

Momentum Crashes – Kent Daniel and Tobias Moskowitz

Profitability of momentum strategies: Application of novel risk/return Ratio stock selection criteria

Hot Potato: Momentum As An Investment Strategy

The strategic case for momentum

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