The question in the title of this post continues to make the press and stir debate. Can active managers outperform consistently after all fees, or is the search for alpha generally a Loser’s Game?
At the end of each quarter, most wealth advisors, investment managers and consultants send out quarterly performance and allocation reports.
On behalf of our partners, Fiduciary Wealth Partners receives and analyzes many of these reports from firms like Goldman Sachs, Morgan Stanley and JP Morgan.
This quarter is the first time in many reporting periods that we are seeing some active managers outperform their benchmarks over a trailing three month period. Longer-term results, however, continue to show that most firms are having a difficult time finding active managers that add value, especially after all fees.
Before I write more, I know that some might consider our ideas to be overly biased toward our index oriented investment approach. Because of this, when publishing our thoughts, I try to make sure our blogs are evidence based and backed up by independent academic research or articles researched and written by well respected journalists and publications.
The inspiration and initial back-up for this blog is the following NY Times article:
Wall Street Banks’ Mutual Funds Can Lag on Returns – NY Times – April 13, 2015
Similar to what I am noticing in the investment reports we are currently receiving, the article highlights that, according to the paper’s analysis of data from Morningstar, “most of the funds run by each of the four largest banks in the business — Goldman Sachs, Morgan Stanley, JPMorgan Chase and Wells Fargo — have underperformed their basic benchmarks over the last 10 years.”
The graph below helps to illustrate what a Morningstar analyst, Laura Lallos, is quoted in the NY Times as saying, “We do not consider their overall long-term performance to be a success any way you look at it.”
Beyond looking at performance, we also encourage you take notice of the average annual fee column. With fees this high as compared to index funds, it is no wonder that the evidence is what it is.
We understand that some think the press has been particularly tough on active funds of late. So, let’s look beyond what has been written recently in publications such as the Times to academic studies.
In searching an academic research database, SSRN (a great resource supported by institutions such as the University of Chicago and Stanford University), I came across a study published in the Journal of Finance on the ability of institutional investment consultants to pick valued-added active managers.
Surely, I thought, as I have been told over the years, independent consulting firms that endowments, foundations and pension funds use to invest trillions of dollars perform better than the large investment banks or brokerage firms, especially when the latter’s default can be internal products and proprietary funds.
Unfortunately, analysis done by Tim Jenkinson and Howard Jones from the Saïd Business School at the University of Oxford in the U.K., and Jose Vicente Martinez from the University of Connecticut School of Business suggests not.
For their analysis, Jenkinson, Jones and Martinez started with data from one of the most respected institutional consulting firms, Greenwich Associates (GA), which has been collecting data from investment consultants since 1988.
Next, to make sure they used the largest data set available, the researchers focused on a detailed GA study of consultant recommended U.S. active equity managers over the period 1999-2011. According to Pensions & Investments, the GA study included 90% of the consulting market worldwide, 91% of the U.S. consulting market and all top ten investment consultants by market share.
Finally, the researchers cross-checked the GA data with information provided by the underlying investment managers to eVestment and Informa Investment Solutions (IIS). eVestment and IIS databases report data submitted by investment managers themselves, including monthly returns, assets under management and fees.
Before I get the punch line, keep in mind that investment consultants focus almost 100% percent of their resources on trying to find the best active managers available in the marketplace. These firms coined the “best of breed” and “open architecture” phrases that you might have heard from manager selection groups. Investment consultants are independent organizations that focus on hiring top professionals, have what many consider to be the best access to managers, and do not generally have conflicts. As a whole, I think it is fair to say that institutional investment consultants generally are considered to be the best active manager pickers in the world.
So, what do the Oxford and University of Connecticut researchers find about the success of investment consultants?
The following are some quotes:
“We find no evidence that consultants’ recommendations add value to plan sponsors.”
“Our analysis shows performance in gross and net terms. The cost of pursuing a strategy of picking actively-managed funds, encouraged and guided by investment consultants, is considerable. Moreover, plan sponsors pursuing an active strategy tend to switch managers more often than those adopting an indexed approach, incurring transition costs which further widen the gap between the two approaches.”
The full study is relatively long but if you have time we encourage you to read at least the abstract, background and conclusions, which can be found at the following link:
How are the study’s findings so? Well, near the end of the study, you will find a strong statement about what might be contributing to the problem:
“Consultants face a conflict of interest, as arguably they have a vested interest in complexity. Proposing an active U.S. equity strategy, which involves more due diligence, complexity, monitoring, switching, and therefore more consultancy work, drives up consulting revenues in comparison to simple, cheap solutions.” Something similar could be said, perhaps even more strongly, of investment banks and brokerage firms.
More simply stated, as is mentioned in the NY Times article and as I have personally experienced, if more index funds were used it would be harder to justify high fees, and the business models supporting some organizations, and their compensation structures, would break down.
All of the above is what led to the title of this blog: “Is Trying to Pick Active Managers a Loser’s Game?” For those who have looked at our Approach page and our recent Recommended Book List, you will recognize this as a line taken from both Charles Ellis, a founder of Greenwich Associates, and from the group at Sensible Investing driven by Robin Powell (see the below links for more on their work).
Sensible Investing Documentary – The Evidence For An Index Oriented Approach
(a well done documentary on the fund industry)
The active vs. index fund debate often reminds me of the “say it ain’t so, Joe” line from the movie Field of Dreams. It is hard for many alpha oriented personalities to swallow, but the evidence continues to be consistent. Keep-it-simple index oriented strategies often win.
Until we find data that point us in a different direction, we will continue to encourage clients to focus on simple to understand solutions that, in addition to outperforming many complex strategies, provide our partners with greater transparency and peace of mind.
Preston D. McSwain is a Managing Partner and Founder of Fiduciary Wealth Partners, an SEC registered investment advisor forming fiduciary wealth partnerships with clients, professional colleagues, and the community. To see more of his posts and follow him on Linked In and Twitter please visit the following: