A huge change in market conditions casts new light on fund fees
by Raul Elizalde - 2017-11-29
Fees charged by fund managers have come under attack, and this is especially true for “active” funds that try to beat an index. In recent years, they have struggled to perform better than much-cheaper “passive” funds that simply match their benchmarks, so their higher fees have been harder to justify.
From this, some observers have concluded that active management has proven to be pointless and all investment in the future will be passive – that is, nobody will even try to beat a benchmark anymore. This is a wild exaggeration, to say the least. Active management will have its moment in the sun again, and, as we will see, that moment may be coming soon.
Critics also accuse active managers of barely deviating from their benchmarks anymore. If that is true, they provide little, if any, added value or diversification, and therefore they are charging too much for a job they are not even performing.
There is some validity to the claim that active managers have not been very “active” in recent years. But there is more to this than meets the eye.
We measured the correlation between some popular large-cap mutual funds and the S&P 500, and found credible evidence that after the financial crisis “active” funds indeed became more “passive”, i.e. more correlated with the index. The group we studied, which includes funds large and small, clearly provided much less diversification or additional value over the S&P 500 from 2008 to today.
But it may be incorrect to conclude that managers have simply become too lazy to do their job. A deeper look at market dynamics suggests that scaling back their efforts to outperform the market was a rational response to a significant change in market conditions.
When we looked at the characteristics of this group over 20 years, we found that regardless of size, the funds least correlated with their benchmarks performed better than the ones that followed their benchmarks more closely. In other words, the ones that were more “active” reaped the largest returns.
But the last 9 years of so show a very different picture: the closer those funds matched the index, the better they performed. Trying to produce returns different from the index was not a successful strategy. What changed?
The simplest explanation, and the one that much of the financial media has embraced, is that managers have indeed gone lazy or “lost their touch.” In our view, it is quite unlikely that a whole industry of professionals could have somehow become incompetent almost overnight.
The more likely explanation is that a change in market dynamics made it much more difficult for them to beat their benchmarks. If this is so, then we need answers to three questions: what kind of change took place; did managers respond to that change correctly; and is that change temporary or permanent. The answers to these questions yield a much more favorable picture of active managers than the financial media has been willing to paint.
After the financial crisis, individual stock price changes became highly synchronized, making it very hard to identify which stocks would deliver above-average returns without increasing portfolio risk beyond prudent levels. There is plenty of evidence that this is the case.
Trying to squeeze extra returns from assets that move close together is a losing strategy. Margins are slim, and whatever a manager may be able to extract is likely to be wiped out by trading costs, behavioral biases, and mistakes. In such an environment, the rational response for a professional portfolio manager is to embrace the benchmark. Interpreting this as a sign of laziness or ineptitude is too harsh. In our view, active managers came to a realistic admission that they cannot beat the market through stock-picking when stock correlation goes through the roof.
The opposite is true when correlation drops. When the spread between outperforming and underperforming stocks widens, the reward for choosing the “right” basket of assets is much higher. Leaving aside the much-debated question of whether it is actually possible to identify such basket, the fact is that in low-correlation markets, such basket in principle exists and its potential payoff is much higher.
A high-correlation environment became prevalent after the financial crisis, but it is finally coming to an end. In the last few months, inter-asset correlations have dropped noticeably and, remarkably, the group of funds we studied has itself become less correlated with the index. Active management seems to have been doing its job all along – decoupling with the index when correlations were low and hugging the index when correlations were high.
The decline in inter-asset correlations has important consequences. First, it argues against the premise that in the future all investing is destined to become passive (i.e. merely index-following). As stock picking becomes once again a likely source of excess returns, the attraction of active funds will grow. Second, it bodes well for the market as a whole. Lower correlation is usually accompanied by a drop in volatility, which is a key component in bringing back the retail demand for equities, which has been weak in the wake of the financial crisis. All this supports our view that the mid- to long-term outlook for risky assets such as stocks has significantly improved, and that the bull market is far from over.
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