The CFA Curriculum is biased towards passive investing. Studies cited show that passive or index investing outperforms active investing over the long term. This investment manta is replayed in other literature. I’m curious to hear from those in the industry who are removed from the academic world. Those who work in an active investment manager, how has performance compared to the index you benchmark against (or the S&P if no benchmark is used). I interviewed for an actively managed fund the other day and posed this question. While the fund;s performance has underperformed since inception, it has outperformed since 2008-current compared to the benchmark. I realize this is one of those CFA vs MBA type of threads, but sometimes a refresher is nice to hear. We all saw a lot from 2007 to current, and I’m curious if active management does have a place during times when the bottom falls out. This MCB fund did not follow the benchmark all the way down in 2008, but since inception, it has not kept up with the pace of the Russell Mid Cap index.
I think the CFA’s stance is that the markets are semi-efficient (not are markets are the same) and some markets are in varies stages of efficiency. Generally for efficient markets you should index. For in-efficient markets you should find active managers. Think there was the Black-Treynor (?) model on level 2 PM that address this in the context of the of active allocations in the optimal portfolio. Also I forgot who said this (Peter Lynch?) relative return managers aka the guys who try to beat the major indicies face career risk by straying too far from the benchmark and placing their ideas before markets react because usually if you underperform for a year or so investors start selling. Absolute return guys do not face this problem.
Bump
In general, and on average, passive investing will beat active investing. If I remember my curriculum correctly, semi-active investing is the way to go. I always thought this was very similar to Treynor-Black, but it’s been a long time. Anyway, the concept as I recall is that the bulk of the portfolio is passive. Maybe 80% to 90% or whatever, depending on your allocation, and then the remainder is active. The bulk of your portfolio tracks the market and with the active portion you make a few of your best bets. I believe this method had the biggest alpha and highest information ratio. But heck, it’s been two years since L3 and I don’t do this stuff much.
Also even if you pick passive funds there is active investing in your asset allocation decisions (how often you should rebalance, what type of rebalancing, etc). Do you want to do a fundmental weight, cap weighted, value weight index? Etc.
You are talking long only. Some of us work in the world of hedge funds - it is all active and all (supposedly) absolute, not relative returns. In an efficient market world, there wouldn’t be so many large hedge funds (perhaps a few round the sides to keep prices ‘true’). Few people in the markets have much time for efficient markets. Simply put, it is b/s.
Andrew Lo points out that markets may be “adaptively efficient,” which simply means the degree of efficiency varies from time to time. He looks at autocorrelation of returns as an indicator of efficiency. The idea is that returns should not be autocorrelated if markets are efficient (though there are presumably types of inefficiencies that wouldn’t show up in autocorrelation), and therefore the degree of autocorrelation should indicate when there are more possibilities for active management to outperform. Autocorrelation almost certainly jumped up during the panic of 2008 and also much of 2009 (though I haven’t checked myself, and it depends on whether you are testing daily, weekly, or monthly autocorrelation - and monthly probably doesn’t have enough data to get you much of anything significant, or at least nothing in time for you to act on it). However, that would suggest that there is more opportunity for a hedge fund to outperform in that environment.
Even though active funds haven’t outperformed net of fees, studies and academic theory do show that including active investments in your portfolio optimization process improves the efficient frontier.
It makes sense that not many portfolio managers outperform their index consistently and over the long term. But, there are those that do. The other day I looked at all our funds that have at least a 10 year track record to see how many beat their benchmark. Out of the 36 funds we have, 18 exceeded their benchmark. Just put all your money into Fairholme and Yacktman and you’ll be fine.
Well if markets were not partly inefficient, Hedge Funds and active investment firms would not exist. And some managers out there do consistently beat the market.
It also depends on how you are defining the question. Do active management funds outperform. Clearly, some of them do. Have they done it because of skill or luck? That’s harder to tell. Have the funds outperformed on a post-fee basis. Clearly, some have done that too. Because of survivor bias and backfill bias, it’s very difficult to know if these have been due to luck or skill. Supposing that active managers have talent in identifying mispricings and beating the market, can YOU figure out who they are before you invest in them. That’s something for deep introspection. I think there are a fair number of funds that exist simply because of promotion and charisma of their management and staff. Bernie Madoff comes to mind. His fund looked like it outperformed greatly, and people rushed to invest with him. Arbitrage Pricing Theory says that the presence of a small number of active managers performing arbitrages should be enough to keep market prices in line with fair value. However, it may well be that the presence of active managers actually creates exploitable inefficiencies. If markets are efficient, then you shouldn’t mess with them… and yet, clearly a lot of people are trying to mess with markets, which can make them inefficient as active investment ideas catch on and circulate through the economy. In any case, it seems to pay well to believe in active management, since someone who believes in passive management would simply decide to invest in index funds, and there’s not that much money in that, unless you are Vanguard and can take 20bps off of enormous asset bases.
it is all about risk/reward. Put your retirment savings and kids college fund in small cap index fund and fu cash in money market. take a few 10k and trade (deep OTM)options, if you can anticipate catalysts and are right a few times the returns from this will crush passive 100% of the time. Of course if you are idiot you will lose it all
It depends on your universe. I work for a small cap equity manager and our benchmark is the Russell 2000. We have utterly destroyed the Russell 2000 – and every other equity benchmark – over every period, from 1 year to 20+. We are not even the best manager in the small cap space. Many of our clients index for Large Cap but go active for Small, Mid and emerging markets. I tend to be of the same mindset. While I will never try to outsmart the 50 other analysts covering Intel, I will look for overlooked small cap stocks. In fact, I consider EMH a ridiculous proposition for small cap stocks. There simply isn’t enough coverage. Many stocks in our portfolio aren’t covered by a single sell side analyst, and those that are tend to be too small to warrant very much attention. EMH requires several agents seeking to exploit inefficiencies or at least one agent taking a very large position to exploit inefficiencies. This just isn’t the case for small stocks. The sell side research deficit isn’t the only reason. You should read Joel Greenblatt’s book.
Most fund managers have a distinctive style that differs from their “benchmark” ie they are larger/smaller cap or more value-y or growthy. If you adjust the benchmark to match the style using returns based analysis… ie a proclaimed small cap growth fund might actually be “larger” and “less valuey”… in that case the benchmark should be a composite of the 400, 400 growth, 600, and 600 growth instead of just comparing it too the 600 growth. when you adjust for style differences you learn that a.) most funds “active” component is just a style difference from their stated benchmark and the style difference is pretty constant and b.) as a result most funds are semi-index like and very few funds tend to consistently outperform their style based benchmark. To me active management is mostly tactically managing your portfolio’s beta exposures and changing them as needed while incorporating active managers in the least efficient sectors… i.e. merger arbitrage, emerging markets… most of the “active” is hedge funds in a mutual fund… i.e. gateway, merger, arbitrage, calamos market neutral, etc. if an emerging markets fund always has smaller weights on the BRIC countries it shouldn’t be “a bad fund” if the BRIC’s rally as it “underperforms” the index… and shouldn’t necessarily get credit for “outperforming” when the brics underperform.
Agree with JoeyM. Also, what is never taken into account in these theoretical discussions about active versus passive is the firms trying to do these things are in the business of money management. This introduces incentives many do not consider.
I just posted to ensure that the "Women in Investment Banking / Finance " thread didn’t have more posts than this thread.
This is helpful information. Thanks. A follow up question, for those of you in a fund management, analysis, or ER, do you ‘eat your own cooking?’
"when you adjust for style differences you learn that a.) most funds “active” component is just a style difference from their stated benchmark and the style difference is pretty constant and b.) as a result most funds are semi-index like and very few funds tend to consistently outperform their style based benchmark. " Even if this is true, if a manager is smart enough to pick a style that consistently outperforms the market over the long-term then that is to the manager’s credit. You can’t dismiss that as adding no alpha. At the most basic, let’s say Warren Buffet’s style is to buy and hold great companies. Now clearly this strategy will outperform any standard benchmark. If you compare his returns to a style adjusted benchmark of ‘only great companies’ then you will find that his ‘active’ component does indeed come from style difference. But he’s the guy who creates the style in the first place, so why shouldn’t he take credit for it? On another point - I work for a buy side asset manager that has a lot of ‘actively’ managed funds (long only) which charge clients 100-150bps per annum in fees. These funds are in my opinion quasi-passive funds which are structured to never out or under perform the benchmark to any significant degree. In the long-run, I have no doubt that after fees these funds will underperform the index. It is not hard for me to see how a lot of academic research in this area concludes that ‘active’ management returns underperform passive in the long run. However, I think it is very possible to create a truly active strategy that can outperform indexing in the long-run. Frankly, if I didn’t believe that I’d be looking for a new industry to work in.
Basically, your firm is an enhanced indexer and still charges 100+ bps? Ugghhh. I guess those are the shops that academics focus on.
Hey, I’m not the CIO! But yeah, I don’t particularly like it myself and would never buy into one of our funds with my own cash. We are far from the only firm out there with this model. Look at the long only ‘actively managed’ equity funds in many of the large asset management firms and you’ll find quasi-passive strategies are common if not the norm.