What We’re Reading Now
April 30, 2019
Periodically on this blog we share a collection of some of the articles we’re reading that speak to the active and passive conversation, and that help to propel the dialog. Here’s a selection of recent articles we find helpful to the discussion.
In this point-counter-point article in The Wall Street Journal, Professor Martijn Cremers, a dean and professor of finance at the University of Notre Dame, argues that lower fees and rising volatility make active management more competitive.
“Now is the time for actively managed funds, as long as they are truly active. The explosion in passive investing in recent years has led many active managers to lower their fees, making their services more affordable. Active management takes advantage of mispriced securities, and in the process mitigates the mispricing. Thus with fewer active managers there are more opportunities to find mispricings. And, for portfolios stuffed with passive products, active management provides critical diversification in this time of heightened volatility.”
Professor Cremers cites evidence that “challenges the conventional wisdom” that active management does not generate value for investors. In fact, his own academic research supports the fact that through improved methodology and more data, “the typical active fund manager has skill and does not underperform after fees.”
Professor Cremers indicates that new research repeatedly shows that active managers “have performed better than many people realize, as [he] and [his] co-authors concluded.” The survey article, commissioned by the IAA’s Active Managers Council, considered the findings of more than 200 research papers.
Brett Arends, a columnist for Marketwatch leverages the research of finance and accounting professors Linda Chen of the University of Idaho and Wei Huang of the College of Saint Benedict & Saint John’s University, and George Jiang of Washington State University, to shine a light on their findings – that there is substantial evidence that many skilled money managers are adept at picking stocks.
The exhaustive study looked at nearly 2,000 U.S. mutual funds’ stock trades by month from January 1998 to March 2015. “Mutual fund trades outperform their benchmarks,” they wrote. And, critically, they are good at picking the stocks that are going to beat earnings expectations ahead of time: “[L]arge active trades by mutual funds prior to the month of earnings announcements have significantly positive abnormal returns in the subsequent one-, two- and three-month horizons,” they wrote. That’s true even when you adjust for the major stock market “factors” such as value, stock size, and price momentum, they wrote.
Most startling, the researchers found the top 20% of funds beat the bottom 20% by a remarkable 1.27 percentage points a year. This outperformance is even true when fund managers’ fees were taken into account.
The article concludes that “low-cost exchange traded funds and index funds are a response to the long term underperformance of “active,” stock-picking mutual funds. Ironically, though, they seem to address the wrong problem. They do nothing whatsoever to counterbalance the issue of mistiming. Quite the reverse: They’re so cheap and easy to buy and sell that they positively encourage Joe and Joanna Public to trade in and out.
This article comes from across the pond. FT Adviser takes a look at the active/passive conversation with a focus on a slightly different performance gauge – information ratio.
FT Adviser writes: “It is straightforward to gauge the performance of passive funds – since the objective of these funds is to track their benchmarks, the tracking error of these funds will show whether they have been successful in doing so or not. However, to do the same for active funds is not as simple. For these funds, the information ratio is a great (if not the best) metric to use.”
We won’t get into the math here, in this blog, except to point out that this metric, as the article explains, is “a versatile and useful risk-adjusted measure of actively managed fund performance. It assesses the degree to which a manager uses its active skills and knowledge to enhance the fund returns.”
“It is also interesting to note that the performance of an active manager significantly improves” as the investment horizon increases. While the average information ratio varied by type of fund, over 10 years, 51.7% of funds produced a positive information ratio.
But what is the takeaway for investors? The author concludes with what seems to be an obvious and important consideration, a “clear trend that cannot be ignored. Investors should focus and decide on fund selection at the beginning of the investment process and should probably hold their investments over a long time.”