The passive management industry has done an incredible job of projecting their mantra into the investing zeitgeist, and each year we are subjected to claims like “74% of active managers underperformed their index.” Like all good cons, this is not an untrue statement. It is however, an excellent use of misdirection – making implications about passive strategies that are untrue.
“If that many active managers underperform, I guess I’ll just go passive.” This is the inference that the passive industry seeks from the world, and sadly one that the uncritical investor has fallen prey to. The following is not a rejection of passive strategies, but a few thoughts on how to more accurately consider the active vs. passive debate.
Let’s start with an obvious point. It may be the case that 74% of active managers underperform their index in a given year, but what is left unsaid is that if all passive managers are doing their best to follow their investment policy, 100% of them will underperform! Why? Investment strategy returns can be reduced to a reasonably simple equation:
Strategy Return = Market Exposure + Alpha – Fees
So if your alpha is 0% (all passive strategies), and your fees are > $0 (all businesses), then your returns are lower than what pure market exposure would produce. 100% of passive strategies should underperform their indices. 74% isn’t great, but it’s better than 100%.
Passive managers are well aware that active managers’ returns are a product of their market exposure (Beta), and their skill (Alpha). The fact that the passive industry continues with the ruse of comparing all active managers to a non-risk-adjusted performance figure is deplorable, because it confuses most investors.
Most active managers run less risky portfolios than their index or benchmark. Asset management is risk management, and prudent risk reduction should not be penalized. When sophisticated investors compare managers, they compare risk-adjusted returns. The only way we should be determining an active manager’s value is by measuring alpha generation.
ZERO SUM GAME
Alpha does not exist in nature. If alpha is created in one manager’s portfolio, it necessarily means that another manager has generated negative alpha. Picking the manager that can generate long-term alpha isn’t a trivial exercise, but it is certainly worth the effort considering the impact that the power of compounding over decades has. Even if there is no alpha on average, there are many managers who generate it.
You wouldn’t stop watching the NFL and say, “Another terrible year, on average the league was just.500, again.”
So when is an active manager worthy? Don’t compare returns to an index, compare alpha to expenses. If an active manager generates more alpha than they charge in fees, they are worthwhile. In fact, it is a little easier than that, because the next best alternative to a good manager, indexing, has some costs. So a manager is worthwhile in practice as long as their alpha, less their expenses, is greater than the -10bps associated with passive management fees.
It is more work to analyze managers under this far more accurate framework, but it is absolutely worth the effort. Passive investors are certainly better than active managers’ whose fees exceed their alpha – I just wish they would say that instead of perpetuating their con.