It was a terrible year for active equity managers in 2014 with 80% of all US large-cap active equity managers underperforming the S&P 500 benchmark*, a trend that was unfortunately replicated worldwide. This bad performance has unsurprisingly ignited a debate in the press and among investors on whether or not active fund managers are worth backing – even a great stock picker like Warren Buffet is suggesting that passive index investing might be the best way forward.
A fair question to ask is: shouldn’t a group of professional investors that have dedicated so much time and effort to beating the average, outperform the private, strategic and passive investors that are the remaining part of the market? I believe the answer to why not lies in behavioural deficiencies caused by the structure and general incentives of the fund management industry, coupled with basic human nature leading to bad decision making.
The behavioural pitfalls of investing are plentiful and I will only touch on a couple of important ones here:
Many hedge funds and mutual fund companies reward fund managers on yearly performance, just as the press, rating agencies and clients tend to put an excessive focus on recent past returns. Stars are made – and broken – based on five-year, three-year or even shorter track records. These financial and personal incentives will, in many cases, lead active managers to focus on optimising short-term returns. The average equity holding period has dropped markedly over the last few decades, which means more speculation and less proper investing, higher trading costs, excessive distractions and more emotional behaviour – this, I believe, has contributed to widespread underperformance.
We live in a world where information is easily accessible. However, more information does not always lead to better decision making processes. In the online dating world, when faced with too much choice, the brain tends to just go for superficial good looks/sexiness (so I’ve heard). Probably not the perfect criteria for picking a life partner – just like a ‘good story’ or a ‘good theme’ is not the most important thing when investing for the long term. However, many investors fall into this trap.
Some argue that the market has become more difficult to beat as information has become much more easily accessible, leading to highly-efficient markets. I believe the contrary to be the case. The market absorbs information quickly but not necessarily efficiently. The value of a company is determined by its cash flows and return on invested capital over future decades, but stock prices of relatively large, established and stable companies can vary 10-15% on quarterly earnings numbers. This should leave plenty of opportunities for long-term investors to exploit short-term noise, while a disciplined investment philosophy, a narrowing of the investment universe and, most importantly, limiting the number of investment decisions is essential to help avoid bad decisions caused by information overload.
Fund managers that have managed to build a long track record with a history of long holding periods and relatively few holdings will probably be less likely to fall in to this behavioural trap. Or at least it is a good sign that the manager is less susceptible to short-term pressure and market noise.
- The comfort of conformity – herding
Herding is a strong, and in many cases healthy, animal instinct. If a gazelle gets lost from the herd the risk of being attacked by a lion is much higher. Likewise, for fund managers there is serious career risk associated with straying too far from the herd in terms of divergence from their benchmark or direct competitors – large underperformance over even a relatively short period of time can lead to unemployment, while few get fired for delivering in line with the competition. The same tendency can be seen when specific equities or themes become either ‘fashionable’ or deeply out of favour. Herding makes outperformance less likely.
Most of the great long-term investors in history like Keynes, Graham, Fisher, Buffet, and Templeton have been contrarians. They made superior returns by going against the tide, fighting human nature. To stand out from the crowd, investors need to be brave, actively using herding and short-term sentiment to help identify attractive entry points when buying equities.
Will passive investing solve the problem?
Passive investing does remove all emotions from investing, but do passive investors behave less badly? Increasing flows into passive index funds and ETFs are actually creating the ultimate herding effect. Investors are indiscriminately buying equities independent of their fundamentals and valuation just because they are included in a constructed index. This leads to less efficient markets and creates fluctuations in stock prices driven not by fundamentals but by irrelevant index changes.
Many equity managers will probably continue to behave badly in the future, but this could and should lead to better opportunities for long-term, focused, rational, contrarian investors.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.