Passive versus active.
Passive management is an investing strategy that attempts to passively track the return of an index, and typically the index will serve as a proxy for the overall market. One common example is the S&P 500 Index, which consists 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. On average, actively managed funds charger higher fees than passive funds 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 their fees, thus delivering higher performance after fees when compared to passive. On the other hand, advocates of passive investing argue that active managers will underperform in aggregate after fees1, and therefore, investors should be content to track the return of an index and pay the lowest possible fees.
Passive investing is en vogue.
Historical data seems to support advocates of passive management. Studies 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 on average. Estimates of the negative net alpha range from -.65% to -.87% annually.2
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 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 a bit misleading. As you'll see below, poor after-fee returns to active in aggregate are due largely to returns from a subset of managers with certain traits. Managers who lack those traits tend to generate returns that match or exceed the market on average.
At Bireme, we're active investors. We think Bireme shows has many of the characteristics of an active manager who can outperform passive after fees. Furthermore, we think the trend towards passive is good 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. This may make outperformance easier in the future than it was in the past.
Identifying active managers who outperform.
Think outside the mutual fund universe.
A large portion of the academic research on active management performance is focused on mutual funds 5. This is likely 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.6
When we look at research outside the mutual fund universe, returns to active look significantly better. For example, investment managers hired by institutions generated 0.42% annual outperformance after fees compared to their benchmarks according to one study.7 This alpha was not a fluke of small size; in fact, over the period analyzed these funds represented $36 trillion of assets versus only $19 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 funds sold by middlemen.
We're proud of our incentive alignment with clients. Misaligned incentives cost investors roughly 1% annually.8 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.9 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.10 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 the willingness of active managers to take the career risk associated with those bets differs widely. On one end, "closet indexers" hold stocks that largely overlap with the index despite purportedly seeking to outperform.
While the prevalence of closet indexing has declined, funds with >40% overlap with the index still managed more than 10% of active mutual fund assets in 2014.11
To quantify this phenomenon, researchers devised a metric called "Active Share", which measures the extent to which a fund's holdings deviate from its benchmark. This has historically been correlated with returns, with a 2015 paper12 showing low Active Share funds underperforming by about 0.86% per year. In contrast, funds with the highest Active Share outperformed by 1.14%.
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.13 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 2.22%.
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 most of our proprietary strategies target multi-year holding periods.14 We believe Bireme's patience is a substantial advantage for our clients.
Other alpha sources.
- Avoid US large-cap equity.15 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.16 Smaller funds are more agile, have less price impact when they trade, and can take positions in smaller, less-analyzed assets.
- Hold concentrated portfolios.17 Managers best ideas tend to outperform, but their other holdings do not. Therefore, portfolios should be concentrated among a manager's best ideas.
- Be a contrarian.18 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 that 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 tend to underperform, resulting in a -.43% annual cost to large cap index fund investors globally.19 Small-cap indexes suffer a similar effect, resulting in a -2.22% drag on performance versus a buy-and-hold portfolio according to a 2008 study.20
Passive indexes are generally 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 bubbles that emerge in segments of the index. For example, the S&P 500 held a nearly 50% weight in technology stocks in 2000, and a nearly 40% weight in financials in 2008.21
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 2000.22
With sophisticated active management, we hope to avoid these hidden drags on performance.
The unmitigated downside of passive.
Passive investing, by its very nature, is exposed to the downside of the economy and financial assets. Assets which have traditionally delivered diversification relative to core US stocks, like bonds, international equities, and commodities, have lost some of that benefit recently as correlations between asset classes have increased. In contrast, our alternative asset solutions, QII and QMN, have historically had little or negative correlation with equity markets.23
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 2000.24 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 1989.25 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, as research shows that individuals have poor timing when it comes to index investing. This can explained by human psychology: it's 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 passive investors to underperform the buy-and-hold results they expect by -2.72% annually.26 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.
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, we believe you can do better.
William Sharpe piece "The Arithmetic of Active Management." Reprinted from The Financial Analysts' Journal Vol. 47, No. 1, January/February 1991. pp. 7-9
2 Guercio and Reuter 2012 study "Mutual Fund Performance and the Incentive to Generate Alpha."
3 Insitutional Investor 5/21/18.
4 ThinkAdvisor piece summarizing findings of Morningstar's 2017 fund flow report.
5 A search on SSRN yields 196 papers with "Mutual Fund Performance" in the title, but only 64 titles containing "Hedge Fund Performance". Accessed 12/17/18.
6 Akbas et al study "Smart Money, Dumb Money, and Capital Market Anomalies."
7 Gerakos et al study "Asset Manager Funds."
8 The Executive Office's Council of Economic Advisers (CEA) 2015 report "The Effects of Conflicted Investment Advice on Retirement Savings."
9 Guercio and Reuter 2012 study "Mutual Fund Performance and the Incentive to Generate Alpha."
11 Cremers and Curtis Nov 2015 “Do Mutual Fund Investors Get What They Pay For? The Legal Consquences of Closet Index Funds”
13 Cremers and Pareek 2014 study "Patient Capital Outperformance."
14 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.
15 Fidelity white paper "U.S. Large-Cap Equity: Can Simple Filters Help Investors Find Better Performing Actively Managed Funds?"
16 Clare et al study "Are Investors Better Off with Small Hedge Funds in Times of Crisis?"
17 Cohen et al study "Best Ideas."
18 Sun et al study "The Road Less Traveled: Strategy Distinctiveness and Hedge Fund Performance."
19 Research Affiliates white paper "Equity Methodology Overview."
20 Cai and Houge study "The Long-Term Impact from Russell 2000 Rebalancing."
21 Daniel Crosby article "Active Management Stinks, But It Doesn't Have To."
22 Pedersen study "Sharpening the Arithmetic of Active Management."
23 Monthly returns for QII and QMN have been -60% and 5% correlated, respectively, with the S&P 500 from inception to 12/19/18.
24 Real total return of the S&P 500 Index. Analysis by Bireme Capital. Data from Bloomberg Finance LP.
25 Real total return of the TOPIX Index as of 11/8/16. Analysis by Bireme Capital. Data from Bloomberg Finance LP.
26 Hsu et al study "Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies."