Many people argue in favor of active management over passive management because they believe that “experts” actively managing a portfolio will be able to outperform the relevant passive alternative. The wisdom of this view has been debated for decades. We do not plan to review the arguments in this issue, but do note that the experiences of 2008 will likely lead to increased focus on the challenges of active management—and the benefits of allocating at least the core portfolio to a well-structured passive portfolio. Given current equity valuations, we think the time is right for investment committees to revisit their allocations to a well-structured passive strategy.
Active Management in 2008
The dust is still clearing on 2008—a horrendous year for the capital markets. Hidden within the dreadful returns of the market averages was the relatively uninspiring performance of active managers. By one measure, it was the worst calendar year of performance for a mainstream portfolio of active managers going back to 1990—exactly when manager excess returns were needed most!
Hedge funds, arguably the ultimate active management vehicle, fell 21.0% in 2008 as measured by the Hedge Fund Research Institute’s Hedge Fund of Funds Composite Index—virtually matching the –22.1% slide of the traditional 60/40 stock/bond “balanced” portfolio.1 This invites the question: Where was the manager skill, the ability to sidestep the worst of the equity markets? Free from the constraints of traditional manager guidelines, hedge funds can short securities (they are, after all, hedge funds!), employ leverage, and trade derivatives. Excluding government bonds, shorting was 2008’s only path to positive returns. Perhaps the hedge funds were squeezed by the credit contraction. As Keynes once quipped, “The market can stay irrational longer than you can stay solvent.” This especially rings true for the leveraged, but that doesn’t provide much comfort for the hedge fund investor.
Interestingly, traditional managers with no leverage and only long exposure to mainstream stocks and bonds returned similarly poor performance. As Table 1 shows, the median active manager in 2008 underperformed the commonly used benchmark in four of the six core asset categories.2
The poor performance of active managers is not without precedent. As Table 1 shows, it has happened a number of times in the past 19 years. Core plus fixed-income underperformed the BarCap Aggregate by a whopping 8 percentage points in 2008—it’s worst year ever. Small-caps had their second worst year with the median manager trailing the Russell 2000 Index by 2.6 percentage points. International equity active managers posted their third worst year since 1990 while large-cap value managers posted their fifth worst year. And these numbers are before fees.
The impact of the active management shortfall in 2008 is more sobering when we combine these active and passive asset class results into a classic 60/40 stock/bond portfolio. 3 Under this mix, we find that a portfolio of median active managers trailed a passively implemented portfolio by 3.4 percentage points, before fees. This shortfall more than doubled the previous worst calendar year (1998) when the active implementation would have only cost 1.4 percentage points in relative performance (again before fees!).4
Granted, making an assertion about active management with just one year of data is contrary to the “long termism” embedded in our investment culture. However, the cumulative hurdle of higher fees becomes relentless over longer time periods.
We see a silver lining in the aftermath of 2008: The global meltdown in virtually all risky assets has finally brought long-term return expectations to attractive levels. As we have stated in the past, dividend yields comprise the lion’s share of stock market returns over long time periods.5 As of February 27, 2009, the dividend yield on the S&P 500 Index was 3.9%, the highest since the recession in the fall of 1990. This figure is also very close to the historic return from dividends as shown in Figure 1. The premium for bearing market risk (as measured by equity dividend yields) is finally in line with the historical average. If it “pays” to be a long term investor, isn’t it time to take a hard look at equities again?
We believe that last year’s disappointment with active management will likely reignite the active–passive debate in investment circles, and that many investors will come down on the side of passive management. In short, we believe investors will favor simplicity over complexity, lower fees over higher fees, liquidity over lock-ups, and transparency over opacity. Beta exposure can get most investors in the ball park of their long-term return targets, without the risks and costs of active management. The recent headlines will accelerate this trend. How many times has an index fund been indicted for a multi-billion dollar fraud? If investors progressively embrace this view, their allocation to index funds will rise as should their scrutiny on the way these indexes are constructed.
In summary, we believe the recent investment disappointment combined with (finally) reasonable attractive equity valuations suggests advisors and investment committees would be well served to revisit their allocation to passive equity strategies in their portfolios.
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1. Using the S&P 500 for stocks and the BarCap Aggregate for bonds.
2. Source: eVestment Alliance. Returns are gross of management fees. Peer group data is notorious for biases, chief among them survivorship bias. Typically, trailing data only includes those products that were still in existence at the end period. Thus, it is only a snapshot of survivors who we can only predict had better performance than the funds that went the way of the dodo bird! eVestment Alliance partially protects against this bias as it still includes calendar year returns for “inactive” funds. The other primary bias embedded in this type of data is backfill bias, where a presumably strong performing manager can enter in previous calendar years when they begin entering regular data to the databases. In short, the historical data analyzed since 1990 is probably being overly generous to active manager performance.
3. The portfolio is broken down as follows: 20% large core, 10% large value, 10% large growth, 10% small-cap, 10% international equity for a total of 60% equity; and 40% core plus fixed-income.
4. We will not explore the impact of fees on net performance in this issue beyond noting the fact that the cumulative impact of fees on performance can be substantial.
5. “Patience Helps in Low-Return World.” 2008. RAFI Fundamentals (September).