Who would be an active fund manager?

Published in The Sunday Times on 15th September 2024.

There aren’t many other professions I can think of where performance is so regularly scrutinised, and the assessment is so objective. 

As a stock picker there’s just one yardstick for success – did you beat the benchmark? We can argue the toss about what the appropriate timeframe to measure this over is, to be able to conclude whether a manager is skilled or unskilled – but there’s just no hiding from the market.  

And the media zealously piles on the criticism. To be fair, there’s much to condemn. A recent survey by Standard & Poors (S&P) shows a grim statistic for the proportion of large cap US equity fund managers that underperformed the S&P500 over the last five years – no fewer than 78% failed to beat the benchmark. You might reasonably argue that I’ve selected the hardest subcategory there, but European managers fared even worse on average. And the picture decays with time – the ten-year numbers are, well, awful.  

We’ve known about these unfavourable odds for decades

There’s nothing new in this. We’ve known these unfavourable odds for a long time. They bounce around, but rarely favour the stock picker. So, what’s going on here? Your intuition is that if you randomly pick stocks, you can at least be average. Burton Malkiel’s rather harsh blindfolded dart-throwing monkey analogy supports the thesis. So how do so many professionals fall so far short of that standard?

Commentators will typically point to finance theory which long ago predicted that markets are too tough to beat because information is factored into prices extremely quickly. So, you can’t successfully trade using an informational advantage. The efficient markets hypothesis (EMH) has been the bedrock of the finance curriculum since the 1950s. But that doesn’t quite square the circle. Beating the index is going to be hard if stock market prices accurately reflect value as the EMH posits – but why does it seem to be so hard that so many more than 50% fail at it? 

Coin toss analogies are not helpful

Coin toss analogies and the random walk theory are regularly cited. However, what’s often overlooked is the distribution of stock returns. When you consider this, the fact is that if you randomly pick stocks, you are starting well behind average. 

One of the most consistent characteristics of global equity markets is that returns of stocks are positively skewed. When graphed, the distribution of returns has a long right tail i.e. a small number of stocks with colossal returns and a majority that fall short of the average. This is logical – a stock can only lose 100%, but has unlimited upside. 

The index return is driven by an extremely small number of incredibly strong performers. So, what does that mean for stock picking?

A useful analogy for stock returns distribution

A helpful analogy from a 2016 academic paper illustrates the point well. Say you have five poker chips: four worth €10 and one worth €100. The five chips have an average value of €28, but what if you reach into the bag and pull out two chips over and over? That’s roughly how active funds approach stocks, with managers picking portfolios that are subsets of the broader group. The problem is that most two-chip selections will not include the €100 chip. There are ten two-chip portfolio combinations with an average value of €56. However, six out of ten of these combinations have a sum of €20, well below the average. The same thing happens with stocks chosen from a benchmark. The average return of the market is circa 10% per annum over the long term. But the median return of stocks in the index is considerably lower, reflecting that dynamic of a small number of extreme outliers dragging up the index average. 

Only a few active managers will own those extreme outliers, so those S&P active manager numbers begin to make a lot more sense.

All is not lost, the active managers lot has improved according to some

Market efficiency isn’t necessarily the bogeyman for stock pickers. Beating the benchmark is exceptionally hard, but not impossible. Cliff Asness, an outspoken quantitative hedge fund manager, has weighed in recently on this topic, arguing that in his 35-year career the market has become less efficient. According to Asness, the active manager’s lot has improved.

He argues that as more and more assets move from active to passive, it is the more skilled managers that are exiting. In a market dominated by unskilled managers and passive assets, that are price takers, the payoff to active is larger but lumpier. Lumpier because the unskilled have more influence than they used to in the short to medium term (as they are a proportionately larger part of the market). 

The case for active value

I’m not sure I fully agree with his thesis. It seems to me that the most likely exits from active will be the unskilled, not the skilled. But he does make a compelling case for value. We’ve witnessed a massive shrinking of value investors’ assets and influence over the last decade making the market more subject to wild valuation spreads. Those spreads are at extremes – of cheapness for value. 

The case for active is a hard one to make. The case for active value, is somewhat less so. I’m happier to be on the buy side of this though. Who would be an active manager?

The views expressed herein are personal and do not necessarily reflect the views of the Davy investment team.

Source: Data is sourced from Bloomberg as at market close 29th December, returns are based on total indices in local currency terms, unless otherwise stated.

Gary Connolly is Investment Director at Davy. He can be contacted at gary.connolly@davy.ie or on twitter @gconno1.