Passive versus active.
Passive management is an investing strategy that attempts to get the same return as an index, which serves as a proxy for the overall market. An example of a passive investment is a fund which tracks the performance of the S&P 500 Index, an index of the five hundred largest US stocks. Active management, on the other hand, attempts to outperform an index by picking and choosing the particular securities the manager thinks are the best investments. While a passive S&P 500 Index fund would buy all five hundred stocks in the S&P 500, an equity manager of an active fund attempting to outperform the S&P 500 would buy some stocks and eschew others.
The goal of all investors is to obtain the best after-fee investment performance. Active fees are higher than passive fees because of the significant time, effort and skill necessary for the research and analysis involved in finding undervalued securities. Active managers hope that their security-picking prowess will more than compensate their investors for paying higher fees, thus delivering higher performance after fees when compared to passive. On the other hand, advocates of passive investing don't think active managers will outperform in aggregate after fees. Therefore, they argue that investors should be content to merely track the return of an index and pay low fees, rather than attempt to outperform with an active manager.
Passive investing is en vogue.
Recent data seems to support advocates of passive management. Studies often show that the average active mutual fund generates zero gross alpha (i.e., performance equal to passive before fees). This implies a negative net alpha (underperformance versus passive after fees) since active manager fees are higher.1 Estimates of the negative net alpha range from -.65% to -.87% annually.2
As a result, active management is out of favor. Investment dollars are piling into passively managed funds at an unprecedented rate. Over 40% of US equity fund assets are in passive vehicles, up from 19% a decade ago.3 In 2015, active funds saw massive annual outflows. Since 1990, active funds have experienced net outflows only once before, in 2008.4
Bireme is active.
We agree with the general passive investing thesis: many investors have been ill-served by active management. Investors have paid high fees for middling performance. For the many investors being underserved and overcharged by underperforming active managers, it makes a lot of sense to switch to passive and merely accept the return of the market minus fees.
However, when you look deeper into the academic research on this topic, you'll find that the headline numbers are misleading. As you'll see below, poor after-fee returns to active in aggregate are due largely to active managers who are doomed to underperform for various reasons. Outperforming active managers exist if you know where to look.
At Bireme, we're active investors. We think Bireme shows all the characteristics of an active manager who will outperform passive after fees. Furthermore, we think the trend towards passive is fantastic news for our clients. Active investors have always competed among themselves for limited outperformance dollars. As more assets pile into passive strategies, the remaining active investors will face less competition. We think this means outperformance will be easier in the future than it was in the past.
Identifying active managers who outperform.
Think outside the mutual fund universe.
The majority of academic studies on active management performance are focused on mutual funds. Research concentrates on mutual funds mainly because they are easiest to study. Data is widely available because mutual funds have been around for a long time, because they are required to publicly report returns and holdings, and because their relatively simple strategies are easy to compare to passive index benchmarks. In contrast, research on hedge funds, another major galaxy in the active management universe, is confounded by its relatively short history, lack of publicly available returns and holdings data, and often complex strategies which can be difficult to properly benchmark.
In our view, researchers' concentration on mutual funds gives active management an unduly bad name. Mutual funds are a notoriously poor subset of active management; mutual funds are commonly considered "dumb money" for a reason.5
When we look at research outside the mutual fund universe, returns to active look significantly better. Hedge funds and private equity funds have historically generated .49% annual outperformance after fees.6 This alpha is not a fluke of small size; in fact, as of 2012 these funds represented $43 trillion of assets versus only $27 trillion in retail mutual funds.
At Bireme, we don't sell our clients mutual funds. We do our own active management. Our separately managed account structure allows us to pursure more creative and sophisticated strategies than mutual funds, while retaining other significant benefits such as control, transparency and liquidity for our clients.
Avoid conflicted advisors.
We're proud of our incentive alignment with clients. Misaligned incentives cost investors roughly 1% annually. Nowhere is the return differential between conflicted and unconflicted advisors more pronounced than in the mutual fund universe.
There are two varieties of mutual funds: those primarily direct-sold to investors by fund managers, and those primarily broker-sold to investors by brokers. Researchers found that an agency conflict between brokers and their clients meant that there was no relationship between alpha and flows into broker-sold funds.7 In other words, brokers don't invest their clients' assets in funds based on fund performance. Instead, brokers invest their clients' assets based on other fund characteristics, such as commissions the fund might pay to the broker. Therefore, broker-sold funds have a smaller incentive to outperform, since their fund flows are largely independent of performance.
Naturally, broker-sold funds underperform their passive benchmarks massively, to the tune of -1.15% per year after fees. Direct-sold funds on the other hand, which must compete for inflows among investors searching for outperformance, show enough skill to make up for their higher costs, generating an after-fee alpha of zero.
The well-documented underperformance of the average actively managed fund is driven by the large number of underperforming broker-sold funds.
We see again that the negative headlines surrounding active management are misleading. Even within the "dumb money" mutual fund world, the gap between after-fee returns to active and passive management is completely eliminated once we weed out those active managers who have little incentive to generate alpha.
Don't pay high fees for a closet indexer.
In order to outperform a benchmark, an active manager must take positions that differ from that benchmark. Yet many managers are content to merely keep pace with the index. These managers are called "closet indexers." They gather the higher fees due to active managers, while not making any truly active bets. As their holdings (and thus returns) largely mirror the index they are purportedly seeking to outperform, they necessarily underperform after fees. One study found that closet indexing accounted for nearly one-third of all mutual fund assets in 2013.8
Researchers devised a measure called "active share" to determine to what extent a fund differs from its benchmark.9 Those funds in the lowest active share quintile underperformed by -1.42% per year after expenses. In contrast, funds with the highest active share outperformed by 1.13% after expenses.
At Bireme, we're truly active. We have no interest in closet indexing. For example, in our Fundamental Value strategy, we typically hold less than 20 stocks, which gives us an extremely high active share.
Find a patient manager.
Data also shows that, like high active share managers, patient investors tend to outperform.10 Even among funds in the highest quintile active share, the least-patient quintile suffered a negative net alpha of -1.94%. Those funds in the highest quintile of both active share and patience, however, were an enormous success for their investors, generating a net alpha of 2.3%.
At Bireme, patience is an integral and essential part of our investing philosophy. In fact, we think that outperformance requires a long-term mindset: short-term returns are mostly noise, but long-term returns are highly predictable. As a result, our dynamic allocation and our proprietary strategies target multi-year holding periods.11 We believe Bireme's patience is a substantial advantage for our clients.
Other alpha sources.
- Avoid US large-cap equity.12 US large-cap equity is a very well-analyzed, efficient space. In the US large-cap space, active underperforms passive by -.31% annually, but active outperforms passive in US small cap by 1.46% and in international large-cap by 1.18%.
- Invest in smaller funds.13 Smaller funds are more agile, have less price impact when they trade, and can take positions in smaller, less-analyzed assets.
- Hold concentrated portfolios.14 Managers best ideas outperform, but their other holdings do not. Therefore, portfolios should be concentrated among a manager's best ideas.
- Be a contrarian.15 Funds that deviate aggressively from their peers outperform. You can't outperform by doing the same thing everyone else is doing.
At Bireme, we take this research into account when devising our strategies and portfolios. Our relatively small size allows us to buy small-cap stocks that others must avoid, and gives us the agility and flexibility to pursue niche ideas. Our Fundamental Value strategy holds concentrated, contrarian positions.
Headlines say that active underperforms passive on average. But research also says that by looking at some simple manager attributes, investors can find active managers are more likely to outperform.
The hidden costs of passive.
There are two kinds of costs: implicit and explicit. Explicit costs, like fees and transaction costs, are well documented. Here, passive undoubtedly has an edge. However, implicit costs are not often discussed. Implicit costs are unobserved reductions in performance of an index due to its construction or trading activity.
A major implicit cost is rebalancing drag. Passive indexes, like the large-cap S&P 500 or the small-cap Russell 2000, must periodically rebalance. When they do, they select companies that, for various reasons, tend to underperform. This results in a -.43% annual cost to large-cap investors.16 Small-cap indexes suffer a similar effect, resulting in a -2.22% drag on performance versus a buy-and-hold portfolio.17
Passive indexes are capitalization-weighted: assets are owned in proportion to their value. The higher the value of an asset, the more influence it has on the index. Therefore, passive indexes necessarily participate in asset bubbles. For example, the S&P 500 held a nearly 50% weight in technology stocks in 2000, and a nearly 40% weight in financials in 2008.18
Another implicit cost paid by passive investors is index turnover cost. Indexes must announce changes in the stocks that make up the index before the actual effective date of that change. In the gap between announcement and effective date, active investors can front-run passive investors, buying and selling those stocks before the passive investors do. Research estimates this cost to be roughly -.24% annually for the S&P 500 and -.57% annually for the Russell 2000.19
With sophisticated active management, we can avoid these hidden drags on performance.
The unmitigated downside of passive.
Passive investing, by its very nature, is completely exposed to the downside of the economy and financial assets. Assets which have traditionally delivered diversification, like bonds, international equities, and commodities, have lost some of that benefit recently as correlations between asset classes have increased. Perversely, these common alternative assets lose their diversification value as more and more investors seek their benefits. In contrast, we think our unique alternative asset solutions, QII and QMN, will deliver positive returns to investors regardless of market direction.
The downturns that purely passive equity investors are exposed to can persist for decades. For example, as recently as 2013, the S&P 500 was below its real total return peak set over 13 years ago in 2000.19 In Japan, the world's third largest economy, passive equity investors have experienced even greater pain. Japan's TOPIX stock index is still down over 40% from its total return peak in 1989.20 That's more than 26 years of investment losses.
Not only will passive investors participate in all future long-term drawdowns, but they are actually likely to fare worse. Research shows that investors pile into index funds at market peaks, and tend to lose their discipline when markets fall. It's psychologically easy to invest in passive funds when recent market returns are excellent. It's a lot harder to maintain that conviction after years of disappointing returns. Emotion-driven mistakes cause allegedly passive investors to underperform the buy-and-hold results they expect by -2.72% annually.21 This difference between expected and actual performance is called the "behavioral return gap."
With our dynamic allocation, we try to avoid future drawdown scenarios for our clients. We hope to not only eliminate the behavioral return gap, but reverse it, by tilting towards assets which are attractively valued. We hope to turn the behavioral return gap, a source of perpetual underperformance for other investors, into a source of outperformance for our clients.
Don't settle for the return of the market minus fees and transaction costs. With the right research, the right time horizon, and the right manager, you can do better.
Cremers and Petajisto study "How Active is Your Fund Manager? A New Measure That Predicts Performance."
2 Guercio and Reuter study "Mutual Fund Performance and the Incentive to Generate Alpha."
3 The Financial Times.
4 Morningstar research report "Average Fund Costs Continued To Decline in 2015."
5 Akbas et al study "Smart Money, Dumb Money, and Capital Market Anomalies."
6 Gerakos et al study "Asset Manager Funds."
7 See footnote 2.
8 Petajisto study "Active Share and Mutual Fund Performance."
9 See footnote 1.
10 Cremers and Pareek study "Patient Capital Outperformance."
11 The strategies FV, GRV and FISS hold to this long-term time frame. Our alternative asset solutions, QII and QMN, are exceptions. Due to their market-neutral, long-short nature, they necessarily have higher turnover. Though transaction costs are inevitably a drag on returns, we think the benefit of an uncorrelated return stream is more than worth the costs for our clients, and we still expect QMN and QII to outperform other alternative asset solutions over the long term.
12 Fidelity white paper "U.S. Large-Cap Equity: Can Simple Filters Help Investors Find Better Performing Actively Managed Funds?"
13 Clare et al study "Are Investors Better Off with Small Hedge Funds in Times of Crisis?"
14 Cohen et al study "Best Ideas."
15 Sun et al study "The Road Less Traveled: Strategy Distinctiveness and Hedge Fund Performance."
16 Research Affiliates white paper "Equity Methodology Overview."
17 Cai and Houge study "The Long-Term Impact from Russell 2000 Rebalancing."
18 Daniel Crosby article "Active Management Stinks, But It Doesn't Have To."
19 Pedersen study "Sharpening the Arithmetic of Active Management."
20 Real total return of the S&P 500 Index. Analysis by Bireme Capital. Data from Bloomberg Finance LP.
21 Real total return of the TOPIX Index as of 11/8/16. Analysis by Bireme Capital. Data from Bloomberg Finance LP.
22 Hsu et al study "Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies."