By Jack Forehand, CFA (@PracticalQuant)
Active managers as a whole have always been pretty bad at their job. Depending on what data source you use and what time frame you look at, somewhere north of 80% of active equity managers underperform their benchmarks after fees over long periods of time. When building Validea, we’ve tried to key in on those individuals and strategies that have a long term record of success, but the number of those methods is few and far between. Finance theory tells us that active managers as a whole can’t beat the market because in aggregate their gross returns have to match the market’s returns and their net returns will fall below the market’s return by the amount of fees they charge. But that still leaves room for some managers to buck that trend and produce outperformance over the long-term as long as others are matching that with underperformance on the other side.
So how have the manager’s that have beaten the S&P 500 over the long-term been able do it? The answer to that question not only helps us better understand the past, but it also helps us recognize why producing alpha is likely to be much harder in the future. To appreciate why this is, you first need to take a look at the bar that asset managers are trying to exceed, and how it has changed over time.
For as long as I can remember, most active managers have been judged against the S&P 500, which is a large-cap index that is weighted based on market capitalization. This isn’t a fair comparison in many cases because a significant portion of active managers include small and mid-cap stocks in their portfolios, but it is nonetheless the reality that managers face.
Being compared to the S&P 500 opens up a variety of opportunities for active managers to produce excess returns. Firstly, research has shown that weighting your portfolio based on pretty much anything but market cap will lead to outperformance over a market cap weighted index over time. On top of that, using factors like value and momentum will add on additional excess return above the benchmark.
If I was an active manager twenty years ago, I could buy cheap stocks and weight my portfolio equally and I was likely to produce a long-term return that exceeded the market as a whole. Research has shown that when you break down the portfolios of many of the star managers of the past using factors, this is exactly what they did. But the rise of factor investing has changed all of that.
Now that factors are more understood and products using them are more commercially available, the bar that active managers must cross has also risen. Investors can now get exposure to factors like value and momentum for expense ratios that are less than .15%. As an active manager, you now not only need to beat the S&P 500, you also need to beat the factor you are following itself. The low hanging fruit of beating the market by just buying stocks using any given factor and weighting your portfolio by something other than market cap is now no longer available. The challenge of beating the market, which the data shows was very difficult to start with, has now gotten much harder.
Let’s look at an example. Assume you are an active manager and below is the chart of your performance against the S&P 500 since 2013 (your fund is the darker blue line).
Pretty impressive, right? You must have a great stock picking system to beat your benchmark by that much. That type of performance, if it continued over time, would certainly justify fees that are well above an S&P 500 index fund. If you were an active manager in 2003, this type of performance would likely lead you to grow your fund significantly and be looked at as a great stock picker. It could have made your career.
So who is this highly skilled active manager who soundly beat his or her benchmark? It isn’t an active manager at all. It is the iShares Edge MSCI U.S.A. Momentum Factor ETF, which currently charges a fee of 0.15%. If I am an active manager who invests in momentum stocks, the S&P 500 is no longer the bar I need to exceed – this type of ETF is.
Value has obviously struggled in recent years, but the same concept applies to it and all the other factors. A simple, diversified implementation of all the major factors is now available for a very low fee from a variety of ETF providers. If you are a manager who uses those factors, regardless of whether you do it directly or indirectly, those ETFs are now the bar you should be judged against. That is a significantly more difficult long-term challenge than just beating the S&P 500. And most active managers weren’t even up for that task.
None of this is meant to say that active management is impossible. If history is any guide, there are certainly ways to beat a diversified exposure to a factor like value. For example, if you are willing to live with the tracking error that comes with it, focused portfolios built using factors tend to beat more diversified ones over time. These types of portfolios are also much less likely to be offered by the large providers who charge the lowest fees because they don’t scale. That offers an opportunity for patient managers who can stomach short-term volatility and underperformance in the pursuit of long-term excess returns. But the days of justifying high fees by building portfolios with simple factor exposures are over. Trying to beat the market has always been a very difficult game. With the rise of factor funds, it has become much harder.
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