It has again been a very long time since my last post. Sorry again. But I have now decided that it might be fun to get involved in the ongoing discussion over the merits of active management, particularly since so much of it is self-serving nonsense — incidentally on both sides.
UBS has now weighed in with its defense of active investment. In a recent paper, the bank calls the superiority of passive investment a myth and claims that, on average, active funds have outperformed both their benchmarks and passive funds. This result contradicts decades of academic research but, if true, would obviously be very good news for the beleaguered active management industry. But is it true?
Given that investment in any market is largely a zero sum game before fees for all investors taken together, somebody else would have to underperform if active funds are to outperform,. UBS claims to have found the main victims: direct investors, i.e., those not investing via UCITS or mutual funds. But direct investors are a very heterogeneous group. UBS has chosen to focus on retail investors to whom they assign most of the blame for the underperformance. But institutional investors such as hedge funds and insurance companies are also part of this group and it is not obvious why their performance should be worse than that of active funds, particularly since their portfolios are often managed by the same investment teams that also manage funds. Finally, direct investors also include stakeholders, those long-term strategic investors whose holdings are often excluded from the free float-based indices. In many markets, stakeholders are the single largest group of investors in equities (the US are an outlier in this respect). Since they usually hardly trade at all, they behave more like passive investors, except with a much more concentrated portfolio. Again, it is not obvious why they should do systematically worse than other investors, as a group. Paradoxically, UBS recently published a study on family-dominated firms that suggested that family firms tend to outperform. Family firms are, of course, the most obvious stakeholder dominated firms (I am being somewhat opportunistic here since I do not fully believe the results of that other UBS study either). Thus, there is really no evidence that institutions and stakeholders underperform relative to funds and there are not enough retail investors left to drag down performance in a meaningful way. Consequently, there is no obvious counter-party that can provide the required underperformance to allow active funds to outperform. This still leaves us with the task of finding an explanation for the results of the study.
UBS insists that they have taken great care to use the funds’ actual benchmarks in their analysis in contrast to other studies that force a standard benchmark on all funds. But a fund’s benchmark is not necessarily fair or even reasonable. There are obvious incentives for funds to choose inappropriate benchmarks. Bill Gross, while at Pimco, routinely used a (low risk) US government benchmark for his funds, even though his investment universe was much broader and included higher risk assets such as high yield and emerging market debt. Not surprisingly, his performance relative to his benchmark was often rather good. But even though he insisted on calling it alpha, he simply harvested a series of additional risk premia. In order to be fair, a benchmark should include the entire investment universe of a fund whenever possible (and even then we should beware of systematic style biases).
Most standard equity benchmarks do not cover the entire market; they are biased towards large cap stocks; smaller companies are mostly excluded. Also, within a cap weighted index, the largest constituent may be ten or a hundred or more times bigger than the smallest constituent. But managers of active funds tend to be much closer to an equal-weighted portfolio, with relative position sizes ranging from, say, one to five times. That means that whenever a smaller index constituent is included, it tends to be overweighted. Many managers also include smaller stocks outside the benchmark. This combines to give many actively managed portfolios a small cap bias. Certain managers actively seek out small cap stocks, believing that they represent a less efficient part of the market, giving them a better chance to add value. This is a well known, well documented, fact. We find that whenever small caps in a market outperform, the proportion of active managers of large cap funds that outperform their benchmark tends to soar.
We can get an indication of how that fact applies to the UBS study by using the data in their Figure 27. It shows the year-by-year outperformance of active funds (ex US/Global) relative to passive funds for the 2001 to 2016 period. Lacking more precise information and based on the description of the sample given in the study, I assume that ex US/Global means mostly funds invested around a European theme. Therefore, I compare this outperformance (reading off the graph) to the outperformance of the MSCI European Small Cap Index over the standard MSCI Europe Index (the small cap premium) in the same year (see graph below). I only have data since 2003, which gives me fourteen data points. The results are quite striking. There is a clear positive relationship between the observed “outperformance” and the small cap premium. The R squared suggests that a substantial part of the “alpha” is linked to the small cap premium. Taking the regression line as a point estimate, we find that by adding about six per cent of the small cap index to the passive funds, we could have achieved the same return as the active funds. In my experience, the small/mid-cap content of active large cap funds is typically rather larger. In other words, the outperformance is likely to be not alpha but at least partially the result of a misspecified benchmark.
The study raises a number of interesting points but it arrives at its convenient conclusion too quickly. More, and more serious, work will be required to analyse their results. There are simply not enough poorly informed investors foolish enough to provide an aggregate alpha to the active fund management industry that is positive. It is understandable that active managers would like the study to be correct; they would much rather argue that the industry as a whole adds value than having to argue that they are among the exceptions that outperform.
Incidentally, even if the results of the study were correct, betting on an active manager without further information is still not a worthwhile bet. Their figure 12 shows that their claimed 0.42% alpha is associated with a 8.34% volatility, i.e., if I simply pick an active manager more or less at random, I have a significant chance to experience a big loss or gain. To make active management attractive, we must know much more about an individual manager’s prospects. Wishful thinking about the performance of the industry will not do.