By VWArticles. Originally published at ValueWalk.
Dodge & Cox: Understanding The Case For Active Management
H/T Dataroma
Executive Summary
While many active equity managers do not outperform the market in any given year, there are a number of skilled active investment managers who have outperformed over long investment horizons. However, in order to benefit from this kind of long-term outperformance, investors must be prepared to take a long-term view and have the discipline to withstand inevitable periods of underperformance. Those who stay the course are more likely to achieve meaningful incremental results that accumulate over time.
Academic and industry research has identified six attributes of active managers who have the highest probability of generating above-benchmark long-term results. This research has also confirmed that investors are well advised to take a long-term view, not only because few investors can accurately time the stock market, but also because few can effectively time their decisions to hire and fire investment managers.
The Active Versus Passive Debate
One of the fiercest ongoing debates in investing concerns the merits of active versus passive approaches to investing. There has been substantial focus on the fact that a high percentage of active managers have underperformed their passively managed peers in recent years. But the case against active investing is not as clear cut as its critics suggest. There are, in fact, substantial opportunities for astute managers who take an active approach to outperform passive alternatives. While no active manager can beat all markets all the time, a significant number of active managers have outperformed over longer-term intervals.
The most frequently cited evidence against active management is that the majority of active managers fail to beat their benchmark each year. But that turns out to be flawed approach to measuring long-term investment performance. Evaluating and comparing results for a calendar year may be convenient but not necessarily meaningful. In fact, 12 months, and particularly the 12 months that start each January, is an interval that generally doesn’t encompass a complete market cycle, nor does it capture the success or failure of active management strategies, which tend to have longer investment horizons. A value manager who adds a stock in January may still be waiting for the value he or she saw to be reflected in the market in December. Was the manager right or wrong? It’s too soon to tell. Similarly, a growth stock manager may buy a stock in April, anticipating that the company is about to move onto a higher growth trajectory. The manager’s thesis may be right or wrong, but it won’t necessarily be proven by the end of that year.
The Long-Term Perspective
Let’s now shift the focus of the active versus passive debate to longer-term performance. According to Morningstar, 107 U.S. large-cap active equity funds have outperformed their benchmark over the past 20 years, out of a universe of 305 funds that have 20-year performance data.(a) These figures are flattered by the fact this universe only includes the funds that have survived 20 years. The median outperformance by the 107 funds was 0.6 percentage points per year, with a high of 4.2 percentage points. Clearly outperformance is a game of inches, but because of the power of compounding, even modest outperformance can lead to substantial incremental returns over the long run.
It is telling that among those funds that have outperformed over the most recent 20-year period, when their respective results are divided into five calendar-year performance periods, the average fund outperformed in only 10 of the 16 five-year periods during the last 20 years. In short, over the long term certain active managers can add significant value, but that process involves an uneven road in which there will be years of sub-par performance as well as years of very good performance. Nonetheless, about a third of active managers described above beat the benchmark over the long term.
Passive investing advocates may protest: Who invests for 20 years? Answer: Many individuals, foundations, pensions, and other investors have investment horizons stretching 20 years and beyond. Foundations and endowments generally aspire to exist in perpetuity, so their investment horizon should be very long. Pension funds also typically have a long-term horizon; defined benefit plans may be taking in contributions for employees in their 20s to fund benefits that will not begin to be paid for as long as 40 years in the future, and then may last for another 30 years. As for individual investors, many people, whether making personal investments or participating in a defined contribution retirement plan, have long-term investment goals. Because of increasing longevity, even investors in their 70s can often expect to live another 20 years. Of course, not all investors invest for the long term; those with short-term financial needs should consider their investment horizon in selecting the strategies and asset classes that best meet their needs.
Issues like immediate financial needs or simply a lack of patience may lead investors to take a shorter-term view—and that may also lead their managers to adopt a shorter-term view in order to please their clients. But taking the long view is critical when investing in equities; similarly, measuring active managers over the long term is the best way to discover which ones truly have stock-picking skill.
Choosing The Right Active Manager
Assuming there are opportunities to benefit from active management, the next question is how to choose the right manager. What are the attributes of active managers who have the greatest potential to outperform? There is a body of research seeking to delineate the characteristics of successful active managers, and this research has identified six key features: Four are associated with the characteristics of the portfolio, and two are related to the nature of the investment manager. Each is linked in a statistically significant way to long-term outperformance, identifiable in advance, persistent, and under the control of the investment manager.
High “Active Share”
An active manager can only add value relative to the index by deviating from it, but there can be vast differences in the extent to which a manager is “active.” In fact, active and passive are not polar opposites but rather ends of a spectrum or continuum, and managers may be situated at various points on that spectrum. Close to the passive end, there are enhanced indexing strategies and smart beta strategies. These begin with an index tracking approach, but the managers apply judgments regarding when and how to deviate from the index. In addition to these explicit efforts to move along the spectrum from passive to slightly active, there is also the phenomenon of “closet indexing.” In this approach, ostensibly active managers consciously but quietly choose to track the index in many ways and make only a limited number of departures from it. This enables them to come close to tracking the results of the index, but hopefully outperform it by a little.
In contrast to these quasi-active (or are they quasi-passive?) investors, there are those who are truly active managers—those whose investment decisions move their portfolios far afield from the benchmark. One way to measure how active an active manager is entails measuring a portfolio’s “active share.” This determines the proportion of a portfolio that is different from its benchmark. Active share can range from 0% (which implies a portfolio and its benchmark are the same) to 100%, which denotes
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