Peter Lynch, George Soros and Bill Miller are some of the best active equity fund managers the market has seen, and to a certain degree, they also seem to be a disappearing breed. Active equity managers who become household names on the heels of stellar year-after-year outperformance are harder and harder to find these days.
Lynch is famous as the stock investor who took the Fidelity Magellan Fund from its small beginnings in 1977 to $14 billion in assets by 1990, all the while beating the S'P 500 Index in 11 of those 13 years. Soros, meanwhile, is known in part for running the Quantum Fund for nearly 20 years, which generated an average annual return of more than 30 percent under his watch.
And Legg Mason’s Bill Miller was once coined the best money manager of the 1990s for his performance at the helm of the Legg Mason Capital Management Value Trust. Miller beat the S'P 500 for 15-consecutive years—a record in the mutual fund industry.
These investors have served as inspiration to myriad followers for decades, offering a testament to the benefits of having your portfolio in the right active hands. But in today’s market, the equity fund space seems increasingly devoid of star power, with few household names still making headlines—such as Pimco’s Bill Gross or DoubleLine Capital’s Jeff Gundlach, for instance—being mostly active managers whose turf is the bond market.
Some say part of the reason for that phenomenon is that in today’s world, investors have much more access to information, as well as access to the market as a whole thanks to do-it-yourself platforms, among other things.
The quick proliferation of low-cost passive investing, and exchange-traded funds—which account for about a third of trading volume in U.S. exchanges today—is another factor here, although BAM Alliance’s Director of Investor Education Carl Richards wouldn’t point the finger at indexing as the culprit for the declining staying power of the star manager.
“I don’t think indexing is to blame,” Richards told IndexUniverse in a recent interview. “Reality is to blame; statistics are to blame.”
“Being a star manager is really hard, and while it’s not impossible for someone to outperform the market for a long period of time, it’s highly improbable,” he said. “It makes sense that we don’t have too many star managers. These guys emerge and last for a couple of years, until they don’t anymore.”
Investors are also increasingly discerning when it comes to costs. Active management has a reputation—and a well-deserved one—for costing a pretty penny. As an example, an actively managed U.S. stock mutual fund easily costs investors north of 1 percent in net fees a year, or $100-plus per $10,000 invested. By comparison, an index S'P 500 mutual fund in the market today has a net ratio of up to about 0.60 percent, while the SPDR S'P 500 ETF (SPY) has a net expense ratio of 0.09 percent, or $9 per $10,000 invested.
That hefty cost structure in exchange for a secret sauce is getting harder to justify in the face of low-cost passive investing, particularly in times when the market is doing well. The issue here is that data show that the costly secret sauce often doesn’t deliver that extra kick.
“Increasing investor awareness is raising the bar as to what investors accept,” iShares’ Head of Fixed Income Strategy Matt Tucker recently told IndexUniverse. “It makes it more difficult for active managers to justify their fees.”
Active Track Record Friendlier To Bond Managers
For most of the last decade, active management in general has underperformed in most stock and bond asset classes, with only a handful of managers beating their benchmark.
This generalization wouldn’t be fair without also pointing out that active managers did relatively well in 2012—particularly in the bond space—and in 2009, when the broad stock market collapsed. Apart from that, the last year active management fared better was in 2000, when 40.5 percent of managers failed to beat their indexes, versus 2009’s 41.67 percent, according to the Standard ' Poor’s Indices Versus Active Funds Scorecard (SPIVA).
Tony Davidow, vice president of Alternative Beta and Asset Allocation Strategist at Schwab Center for Financial Research, recently told IndexUniverse that active management, combined with passive investing, can serve investors well. Diversification in approach can provide a good cushion in times when the market turns south, he said. Active managers, he noted, can step in and adjust exposure to minimize the downside in a way that passive investing can’t.
In 2012, most active managers of U.S. government bond mutual funds performed unusually well relative to benchmarks in 2012, according to SPIVA for the 12 months ended Dec. 31, 2012.
The SPIVA report showed that 70 percent of active managers in intermediate government bond mutual funds outperformed the Barclays Intermediate Government Bond Index in 2012, and handily—returning on average 4.02 percent compared with the index's 1.72 percent performance in the 12-month window.
That stellar performance was also seen in the one- to three-year government bond space last year, where 60 percent of active managers beat the broad Barclays benchmark. Meanwhile, results in the stock market were much more in line with historical patterns, with most active equities managers failing to beat their benchmarks in 2012.
One of the reasons the fixed-income space remains conducive to active management is that the bond market has not become nearly as commoditized as the equities market is, TCW’s Chief Investment Officer Tad Rivelle told IndexUniverse.
“There are literally millions of contracts and bonds that exist out there, and the ability to have specific knowledge based on proprietary analysis of what these contracts represent may not exist within the ETF space that’s trying to replicate some type of an index,” Rivelle said. “Be that as it may, if what I’m saying is so, the active managers will produce the alpha that justifies their incremental fees.”
On the equities side, growing trading bandwidth in the equities market is partly to blame for the slow demise of the role of equity active managers, Rivelle said.
Back in 1929, a mere 15 million shares at one time were enough to collapse the entire NYSE, and today billions of shares trade seamlessly. That limited bandwidth kept access to the stock market constrained and allowed stockbrokers to charge “an arm and a leg” for each transaction, Rivelle said.
But the growing bandwidth we’ve seen due to technology in the past generation opened the door for companies like Fidelity and Charles Schwab to step in and reprice stock trading, ending an era where only a few were lucky enough to trade stocks.
“That was then, this is now,” Rivelle said. “The convergence of institutional pricing on transaction to retail pricing was a key thing.”
Another factor was new regulation introduced in the early 2000s suggesting that there was a preferential flow of information to equity managers, and one that needed to be closely monitored and tracked. That higher scrutiny has all but dried up the hot stock tips so many equity managers had relied on for years, Rivelle says.
“The active equity manager lost his cost advantage and preferential information advantage,” Rivelle said. “So, passive funds and ETFs are now much more formidable competitors.”
Legg Mason’s Miller, for instance, offers a good cautionary reminder of just how elusive that ability to stock-pick and look ahead can be. After outperforming the market for 15-straight years through 2006, his luck seemed to have run out for a few years, and the “best fund manager” of the 1990s “ended up losing more money than he ever made for investors,” said Allan Roth, an investment advisor at Colorado Springs, Colo.-based Wealth Logic, which has more than $1.5 billion of assets under advisement.
Miller seems to be back at the top of his game this year, leading his Legg Mason Capital Management Opportunity fund to gains of more than 40 percent year-to-date, or roughly double the gains seen in the S'P 500 in the same period, according to YCharts.
“When you have thousands of managers, some will have great track records out of sheer randomness,” said Roth, who is also known for his blogging acumen on DareToBeDull.com and prolific contributions to various media outlets.
But whether that bandwidth and pricing evolution will happen in fixed income to a point where names like Pimco’s Gross and DoubleLine’s Gundlach go into history books remains to be seen.
“It might happen,” Rivelle said. “But we’re not there yet.”
Time To Rethink Active Equity Management?
Still, some note that the dominance of market-capitalization-weighted strategies among equities ETFs today is a deterrent to passive investing, because it makes investors’ portfolios susceptible to overexposure to large companies in a way that’s not necessarily good for overall returns.
A Janus report detailing the 10 reasons why active-equity investing makes sense—published on the firm’s website—argues that such an approach allows a company to represent a big part of a passive portfolio, regardless of future expectations for that company’s performance, among other things.
“We believe that surging inflows to ETFs have magnified this phenomenon,” the report said. “This investment approach looks backward, not forward, and doesn’t seek to distinguish future winners.”
Roth himself, a big proponent of keeping portfolios simple and allocated to low-cost, passive instruments, agrees that active managers are necessary for index investors in order to keep markets efficient, because active investors can act out of pure emotion in a way that passive investing doesn’t allow.
Think Jim Cramer, he says.
“If investors all invested rationally, no one would try to time the market, as research shows that the more we trade, the lower our returns,” Roth said in a recent blog. “That knowledge would drastically lower the volume of trading in stocks and mutual funds, and markets would come to a virtual standstill.
“By encouraging his viewers to buy hot stocks and move in and out of the market, Jim Cramer does more than anyone on Wall Street to keep markets efficient,” Roth said in his blog. “Unintentional though it may be, Cramer creates the market mechanism that allows long-term investors to profit from the foolishness of those who think they know what the near-term future holds or what the next hot stock will be.”
Active managers are so key to markets, that without them, “the landscape of investing would be a pretty barren place,” Roth said.
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