Don’t Bet on the Active Manager Revival

The massive migration of assets from actively managed equity funds to index funds has attracted a lot of attention lately.1-6 The discussion varies, including worries about the future of active managers, concerns about market efficiency, and claims that active managers are about to outperform, and a variety of social impacts caused by this trend.

The flow of assets among U.S. equities is massive and may be a sea-change inflection point in the financial markets. The transition toward indexing has accelerated in the U.S. as more and more professional investment advisors have finally acknowledged the failure of active management. New Department of Labor fiduciary rules also make it more difficult for investment advisors to recommend active managers without exposing themselves to potential litigation risk. Figure 1 from a recent Wall Street Journal article, using data from Morningstar, shows the accelerating trend.1 Similar trends are occurring more slowly among bond funds and international equity funds.

Figure 1.

Many articles, mostly wishful thinking from those selling active stock picking, suggest the “performance pendulum” will eventually swing back in favor of active managers outperforming. John Rogers, a highly respected portfolio manager for the Ariel Funds, recently captured active stock pickers’ common sentiment about active versus passive management.

“This is going to be the decade for stock pickers. … It’s been a long trend we’ve gone through where active managers have underperformed. We know in 30 years of doing this … we have gone through these waves. Things become very popular, very hot and everyone follows that concept. What’s worked yesterday gets everyone excited and people give up on what’s not working and often that’s where the opportunities are.” 6

Barron’s seems to be hot on this idea, with multiple articles suggesting active stock picking will make a comeback.7,8 Perhaps they’re nostalgic for the investing world of the 1980s and 1990s when stock pickers were the investment stars.

A much talked about research piece out of Sanford Bernstein, titled “The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism”, lamented a world where indexing dominated the markets.4 Figure 2 shows the parabolic rise in the number of indices used to track various slices of the markets. (more…)

Efficient Markets Hypothesis Foundations

iStock_000044400072_FullIn a previous blog I discussed the efficient market hypothesis (EMH), which can be summed up with the following statement by recent Nobel Prize winner Eugene Fama.

An efficient capital market is one in which security prices fully reflect all available information.1

I presented the following three arguments in favor of pragmatically adopting an efficient markets view when investing.

  • The logic of hyper-competition in a fair trading arena – any trading edge will quickly attract competition and be arbitraged away.
  • The mathematical fact that investors as a whole cannot beat the market, and since professional investors manage the majority of assets, aggregate professional alpha must be close to zero before fees.
  • While acknowledging that there can be long-term skilled winners, the empirical evidence suggests it’s very difficult to distinguish luck and skill when evaluating past performance, even when judging your own trading ability.

In this blog I’ll go one level deeper to discuss the fundamental foundations for an efficient market. Why review these? Mainly to develop a better understanding of “the enemy,” and to identify weaknesses in the EMH assumptions that may lead to trading edges. Rather than argue about whether a market is efficient, let’s search for nuanced moments in time and securities-space when the EMH assumptions may not hold – leading to an exploitable trading edge for us. (more…)

Efficient Markets

iStock_000038631732_XSmallThe efficient market hypothesis (EMH) can be summed up with the following statement:

An efficient capital market is one in which security prices fully reflect all available information.1

What does this statement mean? It implies that all information that is commonly used to make investment and trading decisions is already accounted for, without bias, in current prices. It implies that technical and fundamental analysis have no value in beating the market. It implies that luck is the primary factor in determining investment manager winners and losers. It implies that buying and holding the market over the long term is the most logical approach to participating in the markets.

The EMH can never be proven either empirically or mathematically. However, this is one economic idealization that is actually pretty useful in practice. There is an enormous amount of academic evidence that is consistent with the EMH. The efficient markets logic is also very compelling. As a trader, we need to acknowledge that dealing with the mechanisms that make markets efficient is part of the game.

Trading books never talk about efficient markets or its implications. If they do, it’s done quickly and disparagingly. Why is that? (more…)

Finding an Edge 

findingedge

What is the goal of trading and active portfolio management? It’s not just to make money or to get rich. The goal is to generate wealth for yourself and/or your clients at an above-average risk-adjusted return.

With respect to trading and investing, there are two major markets used for wealth creation – the stock market and the bond market. Each market represents an arena where thousands, or even millions, of competitors battle to enhance returns.

Figure 1 shows the annualized returns for U.S. stocks, bonds, T-bills (as a benchmark for cash) and inflation since 1926.1 The annualized standard deviation of returns is used as a measure of risk (there are many other risk measures to choose from).

(more…)