A Laundry List of Excuses for Active Managers

Welcome to MutualFunds.com. Please help us personalize your experience.

Select the one that best describes you

Your personalized experience is almost ready.

Join other Individual Investors receiving FREE personalized market updates and research. Join other Institutional Investors receiving FREE personalized market updates and research. Join other Financial Advisors receiving FREE personalized market updates and research.

Thank you!

Check your email and confirm your subscription to complete your personalized experience.

Thank you for your submission, we hope you enjoy your experience

Channels

Find the latest content and information here about the 2019 Charles Schwab Impact Conference.

Advisors

Receive email updates about fund flows, news, upcoming CE accredited webcasts from industry thought leaders and more.

Content focused on helping financial advisors build successful client relationships and grow their business.

Content geared towards helping financial advisors build better client portfolios.

Get insights on the industry trends and investment news from leading fund managers and experts.

Cartoon figure in front of many arrows

News

A Laundry List of Excuses for Active Managers

Larry Swedroe Jan 26, 2016

As sure as the sun rises in the east, at the start of each year, you’ll hear from “gurus” appearing in the financial media that this year will be a stock picker’s year. And as sure as the sun sets in the west, when the year ends, you will hear various excuses for why it was a difficult one for active managers, and why next year will surely be different.

Phishing for Phools

After the financial crisis, a popular excuse from stock pickers was that correlations had risen. Then correlations fell sharply, so another excuse had to be invented. In 2014, it was that the dispersion of returns was narrow.

All of these excuses are easily shown to be nothing more than what economists George Akerlof and Robert Shiller would call an exercise in “phishing for phools.” The “phish” is a way to get someone to make a decision that’s to the benefit of the phisher, but not to the benefit of the phool. They explain that if you can divert a story someone is telling himself in your favor but not in his, you have ripened him up to be phished for a phool.

Active managers need investors to accept they will outperform, so they create supporting stories to earn your belief. Often, they will even sound plausible. However, like in The Wizard of Oz—when Toto pulls back the curtain exposing the Wizard as a fraud—once you dig under the surface, the story is exposed as nothing more than another fairy tale.


Pulling Back the Curtain

The year 2015 was no different. It was another awful year for active managers. For example, the admiral shares version of Vanguard’s 500 Index Fund (VFIAX) outperformed 80% of large, blended active funds (after outperforming 82% the prior year). An excuse that’s been making the rounds is that this poor performance was due to the market being very “narrow,” driven mainly by the “FANG” stocks (Facebook, Amazon, Netflix and Google).

Thanks to Cliff Asness, managing and founding principal of AQR, we can show that this excuse is simply a phish, or more plainly a fraud, because 2015 wasn’t very much different from any other year.

Asness performed the following exercise. Beginning in 1995, he removed the N number of stocks with the biggest positive impact on the S&P 500 each year (and re-weighted the index over the remaining 500 minus N stocks). Doing so will always get a lower return. The following table shows the impact in 2015 of removing the N largest-contributing stocks, the average impact of doing this same exercise each year over the period from 1995 through 2014, and the “standard deviation event” of the 2015 result (the impact in 2015 minus the average impact over the period from 1995 through 2014, divided by the volatility of the annual impacts).

Result of Removing N Stocks Table
The impact in 2015 of removing the top five best-performing stocks was only slightly above average. The impact of removing anywhere between the top six and the top 20 biggest contributors was average to very slightly below average. Thus we can conclude that 2015 was just another ordinary year for stocks. Asness warns investors that it’s important to be wary of anecdotes, especially when they are repeated often enough that they become “conventional wisdom.”
Another way to expose the “narrow market” excuse as just another example of an attempt to phish for phools is to show the returns of the top and bottom performers within the S&P 500.

While the S&P 500 Index returned just 1.4% in 2015, active managers had great opportunity to generate alpha as there was a very large dispersion in returns between the best and worst performers—not the narrow market claimed by phishers.

For example, there were 10 stocks in the index that returned at least 46.6% and 25 that returned at least 34.2%. All an active manager had to do to outperform was overweight these superperformers. On the flip side of the coin, there were 10 stocks in the index that lost at least 55.6% and 25 stocks that lost at least 45.8%. To outperform, active managers simply had to underweight, or simply avoid, these dogs. And yet very few did.

As Asness demonstrated, this wide dispersion of returns is not at all unusual. Yet, despite the opportunity, year after year, in aggregate, active managers persistently fail to outperform.

The Bottom Line

These results show that active management is a strategy perhaps best described as one that’s fraught with opportunity. Year after year, active managers come up with a new excuse to explain why they failed and then predict that next year will be different. Of course, it never is.

Sign up for Advisor Access

Receive email updates about best performers, news, CE accredited webcasts and more.

Please Enter Your Email
Please Select Your Advisor Type

Popular Articles

Download Our Free Report

Why 30 trillion is invested in mutual funds book