When Does Active Management Make Sense?

As we like to say, experience has taught us not to be ideologues when it comes to the active versus passive management debate. As a practical matter, our base case view is that, for long-term investors, indexing makes the most sense. Successful active management ultimately comes down to successful forecasting. In turn, this depends on having access to superior private information about a security or asset class, and/or using a superior model to analyze publicly available information. Over a long-period of time, superior sources of private information are hard to sustain, and models lose their effectiveness due to either copying by competitors or changes in the economy that invalidate their assumptions. This is why, as the length of time is extended, a geometrically smaller proportion of active managers have been able to outperform the relevant index fund. There is a reason people like Warren Buffett are so well known: their skills are incredibly rare.

However, there are four important exceptions to our general rule that, for investors with a long time horizon, indexing makes the most sense.

The first exception is that, over the course of an investing lifetime, almost everyone will come into possession of superior private (which is different from illegal) information, that creates the opportunity for an active management success. For example, an investor may be aware of different developments in her industry that lead her to conclude that the market as a whole is underestimating its future growth rate, which should soon accelerate. In this case, she might allocate a portion of her portfolio to an exchange traded fund that tracks the industry, and watch its returns outperform the overall market index over the next year. Of course, this also raises the point that successful active management also requires knowing when to sell, realize one's profits, and reinvest them back into index funds. In essence, two forecasts are involved: one that says it is time to buy, and one that says it is time to sell. Active opportunities like the one just described don't happen very often for most people. In addition, if your superior information is limited to developments at your own company about which the public is unaware, you run the risk of committing the crime of insider trading if you trade your company's shares rather than a broader ETF.

The second exception is one we have frequently written about: bubbles, or, more technically, situations in which one or more asset classes appear extremely overvalued. When these situations occur, and when the asset class in question is well above its target weight in your portfolio, prudent risk management demands that you make an active management decision to reduce your allocation to well-below its target weight.The purpose of our Asset Class Valuation Update section is to help investors make these decisions.

The third exception to our preference for indexing is an asset class (e.g., timber, or, in some regions, foreign currency bonds) where no indexed investment vehicle is yet available, or where current indexing methodologies are quesitonable (as we have noted in our writing, the use of market capitalization weighted indexes to track the performance of bond markets is arguably an example of this).

The fourth exception is the most challenging. We all know that in hindsight, it is possible to identify active managers who have outperformed a comparable index fund. But to be confident that this reflects skill and not just luck requires either a long track record of outperforming and index fund by a modest amount, or a shorter record of outperforming it by a substantial amount. In practice, this degree of statistical confidence about the existence of manager is very rare; that is what makes people like Warren Buffett so special.

However, even in those cases where statistics give us confidence that historical performance reflects skill and not luck, we confront a second problem. It is one thing to identify Warren Buffett with the benefit of hindsight; it is far more difficult to identify the next Warren Buffett. Hindsight is not foresight. Study after study has shown that past performance is not a good predictor of future performance.

Under these difficult circumstances, people who believe they have identified a truly skilled active manager usually use some variation of the "four Ps" to reach a conclusion about whether said manager will continue to outperform a comparable index fund in the future. They assess the quality of the manager's People; the logic and clarity of the manager's investment Process; the extent to which it is consistently reflected in the composition of the manager's Portfolio; and whether that portfolio has delivered superior Performance in the past.

Finally, an investor contemplating the use of an active manager in an asset class where a viable index fund alternative is avaialable must also conclude that the fees charged by the active manager (and any additional taxes generated by the manager's trading) will be more than offset by the additional returns (above the index fund return) he or she is expected to produce.

In sum, the argument in favor of using an actively managed fund instead of an index fund rests on three propositions: (1) The manager is truly skilled; (2) His or her superior performance will continue in the future; and (3) His or her incremental returns will be greater than their incremental costs. The point most people overlook is that the probability of an active manager outperforming an index fund (other than by luck alone) is the joint probability that these propositions are true. For example, even if you are 80% sure that each proposition is true, you are only 51% (80% x 80% x 80%) sure that your active manager will outperform a comparable index fund. Hiring an adviser to choose active managers for you does not improve these odds. In fact, it adds another layer of uncertainty: the probability that your adviser is skilled at identifying skilled managers.

One last consideration is that the greatest benefit to a portfolio is when any allocation made to active management is focused on funds that attempt to deliver returns that are uncorrelated with the returns that can be earned by investing in asset class index funds. Technically, these are funds whose objective is to produce "uncorrelated alpha." In contrast, traditional actively managed funds deliver a mix of overall asset class returns (technically known as "beta") and alpha. However, an investor can obtain the asset class returns more cheaply by buying an index fund. He or she should only pay higher fees for returns that are not only above those on index funds, but also uncorrelated with them (because such returns add the most diversification benefit to a portfolio).

Our target return model portfolios with equity market neutral funds take this exception into account. They allow for an allocation of up to ten percent of the portfolio's assets to investments in equity market neutral funds whose objective is to deliver uncorrelated alpha through superior security selection. As we have discussed in our writing, another approach would be to use so-called "global macro" funds, which attempt to deliver uncorrelated alpha (over time, if not in any one year) by switching investment allocations to different asset classes as economic conditions change.

As you can see, we are not rigid ideologues in the indexing versus active management debate. Rather, our objective is to highlight how each approach can best be used by an investor to achieve his or her long term goals.

For a longer analysis of the indexing versus active management issue, you can read our book: Indexing Versus Active Management: The Trial of a Prudent Investor.

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