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If history repeats itself, I should think we can expect the same thing again. — Terry Venables
Every year numerous studies by S&P, Vanguard, Morningstar, and others report that the vast majority of active managers fail to outperform their passive counterparts. What explains active investing’s underperformance vs. passive investing over the last several years? And why do investors continue to hire active managers?
In his popular book What Investors Really Want, Meir Statman explains that investors want to play the investment game and they want to win. They believe their investment advisers can identify skillful active managers. Yet, unfortunately, history does repeat itself: Active managers consistently fail to earn their fees year after year.
What can change this pattern of repeated failure? Investors need to demand better due diligence to separate out the losers. Intermediaries must improve their manager research. The search for skill continues to be conducted with the same lazy tools that have never worked in the past and never will in the future. It’s like the allegory of the drunk and the streetlamp: The drunk loses his keys at night in a park across the street, but he looks for them under a nearby streetlamp because it’s easier to see.
Antiquated Evaluation Tools
The old performance evaluation tools are indexes and peer groups. These are awful barometers of success or failure. Indexes don’t work because many skillful managers don’t live in style boxes, nor do they hug indexes. Peer groups don’t work because they are loaded with biases and are comprised of losers since most fail to outperform their benchmarks. Beating the losers does not make a winner. Peer groups of hedge funds are exceptionally silly because hedge funds are unique, so by definition they can’t be grouped together: “Unique” means without peer. Hedge fund peer groups epitomize classification bias because the members don’t belong together. (For further details, see “The Compelling Case for Changing Hedge Fund Due Diligence.”)
Investment management consulting is a fungible credence good: a service that is difficult if not impossible to properly assess before or even after consumption. Credence good markets emerge when sellers are much more knowledgeable than buyers. This fact has propelled so-called “robo-advisers” into the limelight, because if you can’t tell the difference, you might as well buy the cheapest.
Clients (buyers) need to wise up. There’s a good reason why active managers selected by consultants fail to deliver value add: Consultants aren’t trying hard enough because they don’t have to. This laxity applies to advice-only consultants as well as outsourced chief investment officers (OCIOs). It would be better to not pretend at all. That’s why intellectually honest robo-advisers have given up on the search for skillful active investment managers.
Competent consultants earn alpha by abandoning the old ways and stepping up to contemporary due diligence. Investors pay for competence: They should demand it.
Contemporary Due Diligence
The odds of actually finding skill can be improved with custom benchmarks and scientific peer groups. Custom benchmarks address the make-or-buy decision. We can replicate (i.e., make) most managers inexpensively with blends of exchange-traded funds (ETFs) long and short, as determined through custom benchmarking approaches like style analysis or factor exposures.
Scientific peer groups, or universes, use hypothesis testing to determine if performance in excess of a custom benchmark is statistically significant. The hypothesis “performance is good” is tested by comparing the manager’s actual return to the returns on all the portfolios the manager might have held by following their portfolio construction rules and using the eligible stocks. It’s a portfolio simulation.
In its benchmark subcommittee report, CFA Institute recommends custom benchmarks and cautions against the use of peer groups. Custom benchmarks are a good suggestion, but they come with a particular problem: It takes many decades to establish statistically significant alphas with custom benchmarks. Scientific universes solve this waiting problem by testing the hypothesis “performance is good” in the cross-section of all possibilities, whereas alpha tests this hypothesis across time using regression analysis.
Demand Better and Consolidate the Best
Clients need to learn the difference between haphazard and assiduous due diligence, between pay-to-play-based and objective recommendations. In other words, clients need to research and understand consulting processes so they can get what they pay for.
In the research post “There Are Too Many Active Managers,” Towers Watson theorizes that active managers should constitute only 30% of all managers rather than the firm’s current estimate of 80%. This realignment would be more cost effective for investors and would continue to keep markets efficient. Put another way, active management should mostly fade away but not die out altogether.
A reduction in the number of active managers will happen naturally if clients insist that intermediaries (consultants and fund-of-funds) actually figure out who’s good and who’s not. Then Darwinian principles will prevail, so only the fittest will survive. Clients hire intermediaries to perform a talent search, but that fails because the processes remain in the dark ages. Contemporary manager due diligence could change all that and condense the active manager pool down to just the most worthy. Advisers who are looking for ways to compete against robo-advisers should wave the contemporary due diligence flag as an important differentiator, especially its potential for outperformance.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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