Over half the equity market in the US is controlled by passive investment vehicles that mimic index holdings. Vanguard founder John Bogle urged millions of people to abandon their search for the needle in the haystack and to just buy the haystack. It worked. Over the last couple of decades, those who bought indices and ignored individual stock picking did well. Those who searched for needles, the active stock picking crowd, struggled on average to outperform and have not justified the fees they’ve collected.
Business Decisions vs Investment Acumen
We believe the inability for the average active manager to perform better stems largely from business decisions and only a small part from market structure, other shifts and bad analysis. From our perspective, it appears that many large, professional active management firms set themselves up to grow assets rather than to perform well. And after a while they begin to mimic the market to avoid the embarrassment of large underperformance.
In the 1980s and early ‘90s star managers like Peter Lynch and Bill Miller attracted so much money that it hampered their ability to be nimble. In some firms, the centralized research process was so entrenched that every manager owned the same basic portfolio. Changing direction in one was detrimental to all the others. Alas, the biggest firms became average by becoming the market.
As such, the history of active management and the performance of active funds is something more of a history of groupthink than it might initially appear. If so, the real decisions an individual or advisor need to make focus on finding managers whose process and outcomes are not average.
What to look for to find “Not Average” Management
Fund selectors look for the four P’s – Process, People, Performance, and Products
Process – How does the team describe what they do? What are the hallmarks that make it different? How fluid are they demonstrating what they do in addition to “how it did?” Most importantly, does the process appear to support long-term performance or does it embed biases that will work only in certain market environments?
People – What makes these people different from other teams? Do they work harder, think differently, apply new technology in a special way? Is there something about the way they work together or their previous lives that supports their ability to make decisions and get things done?
Performance – Most importantly, does the process described do a good job of explaining the historical performance? Simply, is it logical that the process would lead to out- or underperformance as has been experienced? Then, is the performance in line with the risks, either active or absolute, that the managers have taken?
Products – All products have pro’s and con’s, but most managers offer whichever wrappers are needed.
We contend that most managers tend to beat themselves through longer term embedded biases, growing too large, straying from their process and paying too close attention short term impacts to performance.