The Evidence-Based Investor

Tag Archive: active money management

  1. Persistent outperformance remains very elusive

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    By LARRY SWEDROE

     

    Persistence of performance is an important issue for those who believe that active management is the winning strategy. The reason is that if persistence is not significantly greater than should be expected at random, it’s extremely difficult for investors to separate skill-based performance (which might be able to persist) from luck-based performance (which eventually runs out). Reading Standard & Poor’s March 2019 report “Does Past Performance Matter? The Persistence Scorecard” provides familiar evidence: Persistence of performance tends to be less than would be randomly expected.

    The following are highlights from the just-released March 2019 Persistence Scorecard, with data through March 2019.

     

    Of the 498 domestic funds that finished in the top quartile over the five-year period ending March 2014, only 16.1 percent managed to repeat that performance over the five-year period ending March 2019. Randomly, we would expect 25 percent to do so. On the other hand, 31.5 percent of the first-quartile funds fell into the fourth quartile, more than would be randomly expected to do so.

    Breaking it down by market capitalisation, just 18.8 percent of large-cap funds, 13.5 percent of mid-cap funds, 23.4 percent of small-cap funds and 15.7 percent of multi-cap funds that were in the top quartile as of March 2014 managed to remain in the top quartile at the end of the five-year period ending March 2019. Again, we would expect 25 percent to do so randomly. In addition, with the exception of the category of large-cap funds, more first-quartile funds fell into the fourth quartile than repeated.

    Of the 996 domestic funds that finished in the top half over the five-year period ending March 2014, only 38.2 percent managed to repeat that performance over the five-year period ending March 2019. Randomly, we would expect 50 percent to do so.

    Breaking it down by market capitalisation, 38.8 percent of large-cap funds, 28.2 percent of mid-cap funds, 42.3 percent of small-cap funds and 32.4 percent of multi-cap funds that were in the top quartile as of March 2014 managed to remain in the top quartile at the end of the five-year period ending March 2019. Again, we would expect 50 percent to do so randomly.

     

    The bottom line is that there was little to no evidence of persistence in performance greater than randomly expected among active equity managers.

     

    The Paradox

    The year-end 2018 Scorecard reported that over the latest 15-year investment horizon, 92 percent of large-cap managers and 91 percent of small-cap managers failed to outperform on a relative basis when calculating performance data with results from closed funds included. That’s even before considering that the largest expense for the taxable investors in the typical actively managed fund is taxes. Despite the persistent failure of active managers to outperform, active funds still manage far more assets than passive funds.

    Unfortunately, many institutional investors (such as endowments and pension plans) still engage in the practice of selling funds or firing managers once they have underperformed the market over the previous three or five years, typically replacing them with funds or managers that have recently outperformed. They do this while ignoring the evidence from studies such as “The Selection and Termination of Investment Management Firms by Plan Sponsors” by Amit Goyal and Sunil Wahal that have found the fired funds go on to outperform the newly hired funds. While repeating the same due diligence process, they never seem to stop and ask: “If the process didn’t work previously (which is why I’m firing fund managers), why do I think the process will work this time?”

    They are doing what Einstein called the definition of insanity!

     

    Summary

    The SPIVA scorecards provide powerful evidence regarding the persistent failure of active management’s ability to persistently outperform. They also provide compelling support for Charles Ellis’ observation that, while it’s possible to win the game of active management, the odds of doing so are so poor that it’s imprudent to try — which is why he called it “the loser’s game.”

     

    LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of several investing books.

     

    Larry is a regular contributor to TEBI. Here are some of his other recent articles:

    US hedge fund performance underwhelmed again in Q2

    Resulting — what it is and why it misleads poker players and investors alike

    Why use passively managed structured portfolios like Dimensional’s?

    Active managers no better able to manage risks than passive indices

    Four reasons why the SEC’s Best Interest rule doesn’t cut it

    Active investing is becoming harder, not easier, as passive grows

     

     

  2. The surprisingly strong case for selling stocks at random

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    Imagine two fund managers, Manager A and Manager B.

    Manager A tells you he’s going to pick stocks he expects to outperform the market in the future, and sell stocks he expects to underperform. Manager B has the same approach as Manager A to buying stocks, but a rather unusual approach to selling. Instead of trying to identify stocks that are going to underperform, he says he’s going to pick funds to sell entirely at random.

    I’m guessing you would plump for Manager A. But what if I told you that Manager B is likely to produce far superior returns?

    That’s the extraordinary finding of a new research paper, Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors.

    The researchers looked at 2 million sells and 2.4 million buys made by institutional portfolio managers between 2000 and 2016 — a period that included at least two market crashes, and two recoveries.

     

    Good and bad news

    The good news is that the investors they analysed did show skill in buying; in other words, the stocks they bought tended to outperform the stocks they didn’t. The bad news is that they showed very little skill in selling. The stocks they sold outperformed the ones they held onto.

    In fact, the researchers found, they would have produced significantly higher returns if they had simply sold stocks at random.

     

    Possible explanations

    Why, then, should money managers be so much better at buying than selling? One possible explanation put forward by Brad Barber and Terrance Odean from the University of California, is that buying and selling are driven by two distinct psychological processes: purchase decisions are forward looking while sales are backward looking. The retrospective nature of selling decisions means that they’re subject to behavioural biases which, say Barber and Odean, professional managers are just as prone to as the rest of us.

    Another explanation suggested by the authors of Selling Fast and Buying Slow is, as the title of the paper suggests, that managers allocate more time and resources to buying than they do to selling.

    “Identifying new investment opportunities,” the report says, “is seen as perhaps the most critical aspect of a portfolio manager’s role. Moreover, the decision to add an asset to the portfolio or substantially increase the size of an existing position often follows lengthy periods of research and deliberation.

    “In contrast, there is substantially less emphasis on decisions of what to sell. PMs mostly discussed selling decisions in the context of raising money for the next purchase; they viewed selling as necessary in order to buy. Additionally, many readily admit that sell decisions are made in a rush, particularly when attempting to time the next purchase.”

    The authors also suggest that managers are more likely to be affected by a salience bias when selling than buying. Assets with extreme returns are more than 50% more likely to be sold than those that either under- or over-performed only narrowly.

     

    Conclusion

    This latest report makes grim reading for proponents of active money management. After all, why would anyone want to give up a substantial chunk of their returns to pay an active manager to decide what and when to sell when doing so produces substantially inferior results to a strategy based on random chance?

    On a brighter note for active managers, the research does at least provide some evidence of skill in buying stocks. It’s their dismal record at selling them that they really need to focus on.

     

    You can read the report here:

    Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors