I recently read a white paper written by American Century Investments titled "Six Reasons to Emphasize Active Investment Management ." It struck me as having the potential for a little entertainment in exposing the lies behind such stories, so this column puts the six reasons under the microscope. We'll look at each claim and a quote supporting it, and then go about telling the truth.
Markets Look Forward, Indexes Look Back
"Passive managers buy and hold a security, ignoring any information about either company prospects or market conditions. Intuitively, investing based on that information should benefit active managers. On the other hand, passive investment management-sometimes called index investing-makes no attempt to identify mispriced assets or distinguish between attractive and unattractive opportunities for investors." Also:"While passive/index investing tracks yesterday's world, it is active investing that tends to be more forward looking."
Exposing the Lie
Passive investors do accept that the market price is the best estimate of the right price. Who is setting market prices? They're set by active investors who are looking forward, paying attention to company prospects and market conditions. And for every active manager that beats the market, there must be another that underperforms. Collectively, active managers must always underperform passive investors in all asset classes and in bull or bear markets because of expenses. It's just simple math. As Nobel Prize winner William Sharpe points out in "The Arithmetic of Active Management," "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."
What's amusing is that the live data on American Century's own funds provides evidence against its theory. Its website states:"At American Century Investments, our commitment is rooted in focusing on delivering superior investment performance … Our track record of performance … [set] us apart in the industry." Lots of investors must believe that story, as Morningstar reports that American Century manages more than $100 billion in assets.
We'll see if their claim holds up to scrutiny, and if the confidence of investors is justified, by comparing the returns of their funds with those of Vanguard's index funds and Dimensional Fund Advisors' passively managed funds. The data cover the 10-year period ending May 2013. For each asset class, we used all funds fitting a particular category and chose the lowest-cost version of each fund, as long as it had a record of 10 years or more.
American Century All Cap Growth
American Century Equity Growth
American Century Growth
American Century Select
American Century Ultra
DFA US Large Company
Vanguard 500 Index
US Large Value
American Century Capital Value
American Century Equity Income
American Century Income & Growth
American Century Large Co Value
American Century Value
DFA US Large Cap Value III
Vanguard Value Index
American Century New Opps
American Century Small Cap Growth
American Century Small Company
DFA US Small Cap I
Vanguard Small Cap Index
US Small Value
American Century Small Cap Value
DFA US Small Cap Value I
Vanguard Small Cap Value Index
American Century Real Estate
DFA Real Estate Securities I
Vanguard REIT Index
American Century Intl Growth
DFA Large Cap International I
Vanguard Developed Markets Index
International Large Value
American Century Intl Value
DFA Intl Value III
American Century Intl Discovery
American Century Intl Opps
DFA Intl Small Company
American Century Emerging Markets
DFA Emerging Markets
Vanguard Emerging Markets
American Century vs. DFA
Equal-weighting the American Century funds in each asset class, American Century outperformed in three of the nine asset classes and underperformed in the other six. An American Century portfolio that equal-weights the nine asset classes produced a return of 10.1 percent per year, underperforming by 0.5 percent per year a similar DFA portfolio that returned 10.6 percent.
American Century vs. Vanguard
American Century outperformed Vanguard in three of the seven asset classes where they had similar funds and underperformed in the other four. A portfolio of American Century funds underperformed a Vanguard portfolio by 0.1 percent per year (10.1 versus 10.2).
The data shows that at least over the past 10 years, American Century Investment's actively managed funds have failed to deliver the superior investment performance they boast of. The question is, given the underperformance, Why do they still have over $100 billion of assets under management? Could it be the triumph of hype and hope and marketing over wisdom and experience?
Proof That Active Can Do Better Than Passive
"Even a simple equity portfolio, such as an equal-weight portfolio, has historically outperformed its market cap-weighted counterparts over various market cycles. The equal weighting captures an important stock price behavior, the mean-reversion."
Exposing the Lie
There are three problems with the above statements. First, the paper confuses indexing/passive investing with the exclusive use of a total stock market fund or an S&P 500 Index fund.
Second, an equal-weighted portfolio's outperformance over a market-cap one has nothing at all to do with mean reversion. An equal-weighted portfolio simply has more exposure to the small-cap and value premiums. Investors who want to achieve more exposure to those stocks can buy index or other passively managed funds in those asset classes. In addition, there are equal-weighted ETFs such as the Guggenheim S&P 500 Equal Weight Fund (NYSEArca:RSP). You don't need to own an active fund to equal-weight.
Third, if active managers were able to persistently identify in advance which sectors/stocks were going to outperform or revert to mean, we would see evidence of persistent outperformance beyond the randomly expected.
Not All Active Managers Are The Same
"Large fund families (such as American Century Investments) tend to outperform because of economies of scale in building the rigorous, sophisticated infrastructure required to harvest information opportunities. An additional benefit to American Century Investments comes from its flat organizational structure, where each manager has an independent voice, thus allowing innovation to flourish in spite of size."
Exposing the Lie
While it's true that not all active managers are the same, it's also true that the vast majority of active managers underperform. And the evidence is clear that investors haven't been able to identify the very few future winners ahead of time. Even pension plans that don't have the extra hurdle of taxes that active management imposes on taxable investors have failed at this endeavor. And pension plans have the following additional advantages over individual investors:
- They control large sums of money, giving them access to the best active managers, even ones individuals can't access.
- Many hire large professional consultants to interview and select the best.
- They pay much lower fees.
Yet, despite these advantages, the evidence from three major studies on pension plans each came to the same conclusions:There's no persistent performance above benchmarks; past performance isn't prologue; and those relying on past performance are likely to be disappointed.
Not All Investors Are The Same
"Investors are diverse, which means that not all of them should invest in a passive/market portfolio."
Exposing the Lie
It's true that not all investors are alike and that investors should tailor their portfolios to their unique ability, willingness and need to take risk. It's also true that you don't need to use active funds to implement your investment plan. You can be passive and, depending on your needs, have exposure to U.S. large-cap, small-cap and value stocks; developed-market large, small and value stocks; emerging market large, small and value stocks; and in many cases, REITs and commodities as well.
Time Variation In Active Management Opportunities
"How active managers perform relative to their index is highly dependent upon their market environment."
Exposing the Lie
There's an explanation for why people believe this. Dunn's Law states that when an asset class does well, index funds will outperform active managers in that asset class. However, when an asset class does poorly, active managers have a greater chance to outperform their benchmark index due to style drift. Style drift occurs when managers invest differently, or "drift," from their fund's objective. For example, large-cap growth managers may hold small-cap growth stocks in their funds.
Let's say the asset class of large-cap growth does well, while small-cap growth does poorly compared with its historical returns. Most of the large-cap-growth active managers in that asset class will likely lag the index, possibly due to exposure to small-cap growth. However, small-cap growth managers now have a significant advantage, as any exposure they had to large-cap growth would give them a boost over the returns of the small-cap growth index, which obviously doesn't have such exposure.
Active Management Drives Efficiency Into Capital Markets
"An individual investor could still capture some, but not all, of the active management benefits by simply following the market."
Exposing the Lie
First, the header is the one statement in the paper with which we agree. Still, the supporting evidence needs addressing. In his 2008 paper, "The Cost of Active Investing," Professor Ken French found that investors spend 0.67 percent of the aggregate value of the market. Society's capitalized cost of price discovery is at least 10 percent of the current market cap.
Under reasonable assumptions, the typical investor would increase his average annual return by 0.67 percent if he switched to a passive market portfolio. French also estimated that if all investors paid passive fees, and there are no hedge funds, the cost of investing in 2006 would have been just 0.09 percent.
The difference between the actual and passive estimates measures the cost of active investing. Bottom line:Active investors are engaging in a massive transfer of wealth-about $80 billion annually-a figure based on market capitalization of about $12 trillion.
Despite the enormity of the costs, French's estimate is too low. The reason is that it doesn't account for the incremental burden of higher taxes incurred by active investors with taxable holdings.
French did make the important observation that the cost of active investing isn't a pure loss to society-the price-discovery activities of active managers improves the accuracy of financial prices and allows for an efficient allocation of capital. The good news for passive investors is that they get to be "free riders," benefiting from the activities of active managers without paying the costs.
Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management. The firm has DFA in client portfolios.
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