This piece at FactSet asked an important question: “is active investment management dead?” As more evidence of the difficulties of active investment management points investors in the direction of “passive” funds, we have to wonder if active investment management is beginning to die off. I don’t think so. Here’s why.
First, this probably says a lot about the current state of the market cycle. It’s inevitable that we will ask this question at the point in the cycle where it looks like a long only monkey dart throwing strategy beats most “active” managers. Of course, the whole discussion will shift as soon as we’re in a bear market. So let’s keep that in mind as we ponder the above question.
Second, I hate the distinction between “active” and “passive” investment management. As I’ve explained before, we are all active to some degree. The idea that anyone is totally passive is a pure myth. It was a line drawn in the sand to create a distinction that does not truly exist. So we should just all agree that we’re all active to some degree and that, in general, reducing your degree of activity will reduce frictions in your portfolio which will increase your average real, real return.
Thirdly, the “investment” industry needs to dump the term “investing” and replace it with “saving” or just asset allocation. The allocation of assets on a secondary market is not investment. It is allocation of saving. This might not seem like an important distinction, but I think it is. The idea of investment implies that you can or should try to generate sustained outsized returns in your portfolio through the use of allocating assets on a secondary market. I find this concept to be completely misleading. True investment is done on primary markets for the most part and savings are allocated on secondary markets. And when we think of allocating our savings we are likely to take a different approach than what often turns out to be a gamblers mentality through the idea of “investing” in a secondary market.
Fourth, more active managers prove their value during bear markets. The thing is, bear markets are pretty rare relative to bull markets. If we look at the business cycle, the economy tends to be in expansion for about 80% of the business cycle and only dips into recession for 20% of the cycle. That means there’s a 4 in 5 chance that your bearish overall outlook will be wrong if it’s sustained over the course of the entire cycle. Exhibit A is all the permabears who have been crushed for the last 5 years.
But this doesn’t mean more active managers are useless. In fact, they earn their keep when the you-know-what hits the fan. And the reason why is because market losses are devastating. A 50% loss requires a 100% return to recover just to your break-even point. Any manager who can help reduce that sort of negative variance in a portfolio is doing his/her clients a great service. And that ultimately gets at the problem of a long only “passive” approach – it often doesn’t protect us sufficiently from negative variance. As I’ve stated before, these approaches not only are not “passive”, but they are specific macro long only bullish bets. In fact, most passive approaches based on Modern Portfolio Theory are extremely stock heavy which means that the variance in the portfolio is higher than most investors even think (much higher than your allocation says). And that means exposure to negative variance in our savings portfolio can be extremely disruptive to our portfolios even if we’re in a so-called “passive” allocation.
And that’s the thing – as long as there are bear markets there will be active managers implementing strategies designed to reduce tail risk in portfolios. And they will be providing their clients with an extremely valuable service. In general, I think it’s probably safe to say that there’s an excess of more active managers at present and that many of these active managers are charging fees that they can’t justify. But that doesn’t mean they’ll become extinct. Not unless we can extinguish the business cycle. And that ain’t happening because irrational animals (humans) dealing with a tool (money) they don’t understand very well will continue to make mistakes predicting the future with it – and ironically, that active manager (who probably can’t predict the future better than your dog can) will often be there to protect you precisely from the errors in thinking that lead to the variance in the business cycle that ultimately make him/her valuable.