Golf has many parallels to the world of investing. Both are fickle. Some days every putt seems to drop and every stock seems to pop. But success can be fleeting—golf and investing have a nasty habit of transforming the best into mere shadows of themselves.
Many activities comprise a round of golf—putting, chipping, bunker shots, pitching, driving off the tee, and approach shots with the iron. Some are more important than others. Judging by a trip to the local practice facility, one would assume the most important shot is the first, where the golfer uses the longest club in the bag—the driver—to ensure a shorter approach shot onto the green. Station after station holds weekend hacks whacking away with the driver. But one golf professional, Dave Pelz, found that almost 80% of the shots lost to par (those that lead to poorer scores) occur inside of 100 yards of the hole.1 Yet we see precious few golfers spending long hours on the putting green and chipping surfaces practicing their “short game.”
Clearly, the practice activities of golfers are misaligned with results. In the passages ahead, we highlight the investment equivalent of the driver—seeking positive alpha through manager selection—and offer an important tip on where many investors can better allocate their precious resources in the search for excess returns.
The selection of active managers, whose philosophy and process are geared to produce market-beating results, is an exhaustive and time-consuming activity. Certainly, some can take a shortcut, relying on historical track records (such as the typical trailing five years of returns) to gauge skill but, as mutual fund advertisements proclaim, “past performance is no guarantee of future results.” Indeed, the goal of manager research is to determine if the manager and its strategy will be successful in the dark and unknowable future. And that requires separating the wheat from the chaff or, in this case, manager skill from pure luck. Unfortunately, this is easier said than done. Statistically speaking, it requires a track record of approximately 35 years to determine whether the average active manager has demonstrated skill.2
Because essentially no funds and institutional products sport such a lengthy tenure (especially with the same people at the helm), proper selection of the “best” managers has to take several additional steps:
Manager research is unquestionably a resource-intensive undertaking. Is all of this work likely to be rewarded? One way to gauge the effectiveness of manager research is to examine the hiring decisions of sponsors of traditional pension plans. Goyal and Wahal (2008) compiled a database of over 8,700 hiring decisions by 3,400 plan sponsors between 1994 and 2003.3 During this period, the plan sponsors hired managers to run more than $600 billion in assets. If the tremendous efforts expended on manager selection paid off, we would expect these new managers to have produced returns in excess of their respective benchmarks. But the study found otherwise:
Pre-hiring performance is significantly positive using all three measures of excess returns. For the full sample, post-hiring performance is statistically flat… Recall that the sample of hiring decisions is for active mandates in which, presumably, plan sponsors hope to earn future excess returns. Our results suggest that, on average, plan sponsors are unsuccessful in this endeavor.
That is an extraordinary amount of time and resource expended for mediocrity. What’s the point?
Can One Win at the Active Management Game?
Some can and will play the active management game… and win. But a frank assessment is in order. How will the investor or the institution earn excess returns from manager skill versus the trillions of assets geared toward the same goal? What is your comparative advantage? Is it resources and talent? Can you out-resource the largest and most sophisticated institutional investors and their consultants? What about patience? A commitment to active management is a lot like a marriage. The relationship will be occasionally strained and often will continue based solely on faith. Would you, as the legendary economic historian and consultant Peter Bernstein once recommended, be willing to sign a five-year contract with your managers?4 Some investors believe that a first mover advantage exists; they try to identify superior managers early in their trajectories. But placing money with an unproven firm can be uncomfortable and nerve racking.
Unless the investor hiring active managers clearly can define his “edge,” the game shouldn’t be played. An old adage said around the poker table, “If you’re not sure who the ‘fish’ (an inexperienced and clueless player) is, then you are likely the fish.” Investors should conclude they probably are the “fish” and don’t have any compelling advantages (it’s OK, most investors don’t!). Thus, they save the heartache of chasing the ever-changing roster of “best” managers and watching their investments fail to beat the benchmark.
A Flying Fish
Even where active managers deliver alpha, so much of their added value is eaten up by fees that investors end up not being compensated for the additional risk they are taking. Instead, many investors turn to indexed investments, which offer a simple way to track the market at a low cost. John Bogle, the founder of the Vanguard Group, has spent nearly half his life preaching this gospel, and found that 87% of active managers fail to beat the market index after fees.5
But traditional passive management has its flaws too. Chief among them is that capitalization-weighted indices overweight overvalued stocks and underweight undervalued ones, creating a drag on performance. Our research shows that this drag ranges from 2–4% for developed markets, and more for inefficient markets.6
Investors now have other options. In recent years, a whole new category of investments—called “alternative betas”—has emerged. Some of these alternative beta strategies, including the Fundamental Index™ approach, use various structural schemes to select and/or weight securities in the index. In that sense, they fall between traditional cap-weighted approaches and active management: they pick up broadly diversified market exposure (beta) but seek to produce better results than cap-weighted indexes (what is desired from active managers).
Our CIO, Jason Hsu, and research staff have replicated the basic methodologies of many of these rules-based alternative betas, ranging from a simple equal-weighted approach to the straightforward Fundamental Index strategy to the truly exotic such as risk clustering and diversity weighting.7 The potential rewards are promising. Of the 10 non-cap-weighted U.S. equity strategies studied, all outperformed the passive cap-weighted benchmark. The range of excess returns by alternative beta strategies was between 0.4% and 3.0% per annum—matching a reasonable estimate of the top quartile of active managers—that is, the small cadre of managers who generally are successful at beating the benchmark (see Table 1). The bottom line: investors can obtain top-quartile performance with far less effort than is required to research and monitor traditional active equity managers.
An old golfing adage proclaims: “Drive for show and putt for dough.” Hiring winning active managers is inherently more fun and sparks interesting cocktail chatter. But like a consistently straight 300-yard drive, we assert this is an incredibly difficult and time-consuming skill to learn—for the relative handful who can master the skill. We prefer alternative beta strategies, which often display the benefits of the best active managers, are far easier to research, and generally are available at a far lower cost. By no means are these strategies “gimmes,” but, methodically practiced, should help investors avoid the double bogeys of active management and traditional passive management, giving them a better chance of beating par.
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1. see pelz golf.
2. using a very optimistic 2% excess return at the typical 6% tracking error level, for an information ratio of 0.33. an information ratio of 0.50 would take 16 years to confirm statistical significance, while a 0.25 ratio would take 62 years!
3. amit goyal and sunil wahal, 2008, “the selection and termination of investment managers by plan sponsors,” journal of finance, vol. 63, no. 4 (august):1805–1847.
4. based on a comment in his march 1, 2004, newsletter, economics & portfolio strategy.
5. john c. bogle, 2007, the little book of common sense investing, new york: wiley, p. 79. of 355 equity funds operating in 1970, with only 21 beating the index by 0–1% through 2006 and another 24 winning by 1% or greater by the end of the study period—roughly one-eighth of the total.
6. robert d. arnott, jason hsu, and philip moore, 2005, “fundamental indexation,” financial analysts journal, vol. 61, no. 2 (march/april):83–99.
7. tzee-man chow, jason hsu, vitali kalesnik, and bryce little, 2011. “a survey of alternative equity index strategies, financial analysts journal, forthcoming.