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Have Active Managers Received a Bum Rap?
(Note: companies that could be impacted by the content of this article are listed at the base of the story [desktop version]. This article uses third-party references to provide a bullish, bearish, and balanced point of view; sources are listed after the Balanced section.)
In a November 4th ChannelChek.com article titled “Taking Stock of Index Funds,” we highlighted how stock index funds and exchanged traded funds (ETFs) now hold more assets than the traditional actively managed funds, with passive funds making up 50.2% of the US stock mutual fund pie, while actively managed funds made up 49.8%. One of the key tenets from market observers in the rise of index funds and ETFs is that actively managed funds historically underperform. Only 23% of all active funds topped the average of their passive rivals over the 10-year period that ended in June 2019, according to Morningstar.
In a fortuitous circumstance, the most recent Financial Analysts Journal (Fourth Quarter of 2019) contains an article titled “Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds.” (Cremers, Fulkerson, and Riley). The authors reviewed the past 20 years since that is when Mark Carhart published a landmark study on mutual funds, with a conclusion that the data did “not support the existence of skilled or informed mutual fund portfolio managers.” Cremers, et al review of the 20 years of academic research, however, “suggests that the conventional wisdom is too negative on the value of active management.”
Following, we highlight some of the authors’ findings. (We refer readers to our November 4th article for a Bull and Bear Case on Index Funds.)
Conditions Have Changed aka The Free Market Works! Competition, in the form of index funds and ETFs, has caused changes on the active management side over the past 20 years. Specifically, the average mutual fund expense ratio has declined significantly. The asset-weighted average expense ratio for actively managed equity funds fell from 1.06% in 2000 to 0.78% in 2017.
Active Portfolio Managers Do have Skill! One of the criticisms of active managers is that few have skills in excess of costs. Recent research raises questions about this conclusion, however. Recent research has found that many active managers have significant observable skills, that those skills create real value for investors, and that those skills persist over time. For example, almost all academic papers measure the skill of an active manager as the net alpha of the fund, which is the return of the fund after fees compared with a benchmark. But the choice of the benchmark model and the quality of data available for analysis using that model have a large impact on conclusions about the net alphas of funds and, in turn, on conclusions about the skill of active managers. Several studies have considered the impact of the benchmark model chosen and highlighted the limitations of current models for evaluating the value of active management and showed that common performance measures often underestimate the value of active management.
Timing Play a Role. Puckett and Yan (2011) found that many estimates of stock selection skill are downwardly biased because the quarterly fund holdings data used in most studies do not account for interim trading, although other researchers have come to the opposite conclusion.
What is the Appropriate Model for Evaluating Fund Performance? Mutual funds are commonly evaluated using the multifactor model of Carhart (1977). But the factors used in the Carhart model may not be the appropriate set. Harvey, Liu and Zhu (2016) and Hon, Xue, and Zhang (2017) identified hundreds of potential pricing factors that could be used, and the choice of factors has a significant effect on the conclusions about fund performance.
Impact of Constraints. Most research models assume active managers are unconstrained and able to allocate assets optimally to maximize risk-adjusted returns. In practice, however, managers operate under a number of constraints that may affect their decisions and their ability to create value for investors. Among the most notable constraint is a need to provide daily liquidity for potential redemptions and the need for regulatory compliance. Numerous researchers have demonstrated how the need for liquidity generates real costs for individual mutual funds and can negatively affect mutual funds as a whole and the overall markets. Regulatory compliance, such as frequent portfolio disclosure lowers mutual fund performance by making it easier for other investors to front run trades.
Recent academic research presents many varied viewpoints regarding the value of active money management. What does seem to stand out from the recent research is that the old rule that active managers underperform after fees and few managers have skill in excess of costs is not quite as black and white as earlier research would indicate. Investors would be wise to look past the headlines to take a more nuanced view of the value of active money management.