Hotchkis & Wiley Fund commentary for March 2015, titled “Active vs. Passive Equity Investing.”
“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally”
John Maynard Keynes (1883-1946), from The General Theory of Employment, Interest, and Money
Hotchkis & Wiley: Active vs. Passive Equity Investing
The debate over active versus passive investing has spurred numerous studies, which in turn, have produced many thought-provoking theories on the subject. Despite countless data, sophisticated statistical techniques, and brilliant researchers tackling the issue, there are few palpable and universal conclusions one can draw from these studies. This is somewhat predictable given that these studies use unique data sources, evaluate different periods, and employ diverse statistical methods—not to mention are subject to human biases. As such, we are not brash enough to claim that we could conduct a better study as we would be subject to these same shortcomings, including our own biases. Rather than recreate analysis that has been recreated many times over already, we are going to focus on the few common findings from these studies that appear to be largely undisputed. We will first describe these conclusions, illustrate why they exist, and then explain why we believe markets are inefficient and why active management can add value net of fees.
Hotchkis & Wiley: The Three Findings
After reviewing innumerable research papers that dissect the benefits and drawbacks of active and passive investment management, we have identified three results that appear to be widely acknowledged as fact:
Fact 1: The average active manager has underperformed the passive benchmark after fees
Fact 2: Some active managers have demonstrated ability to outperform the passive benchmark after fees
Fact 3: High conviction is a common characteristic among active managers that have outperformed
Fact 1: William Sharpe’s 1991 article in the Financial Analysts Journal asserts:
“…it follows (as the night from the day) that the return on the average actively managed dollar must equal the market return. Why? Because the market return must equal a weighted average of the returns on the passive and active segments of the market. If the first two returns are the same, the third must be also”.
After fees, therefore, the average active manager should underperform the passive index due to those higher fees. Empirical evidence from the studies we reviewed supported Mr. Sharpe’s proclamation.
Fact 2: Here is another passage from the same 1991 article:
“It is perfectly possible for some active managers to beat their passive brethren, even after costs.”…”It is also possible for an investor (such as a pension fund) to choose a set of active managers that, collectively, provides a total return better than that of a passive alternative, even after costs.”
Again, empirical evidence from the studies we reviewed supported Mr. Sharpe’s contention. The magnitude of that outperformance, however, and its statistical significance are factors without universal and conclusive acceptance. The important takeaway is that while it is true that the average manager underperforms after fees, not all managers are average.
Fact 3: Table 1 summarizes several of the interesting studies we reviewed, each with findings that support Fact 3.
Each of the studies in Table 1 concludes what we view as the same general theme: high conviction managers outperform. The definition of “conviction” varies—low R2, high concentration, high active share—but the general spirit of what they are capturing is the same. The findings are quite intuitive. To outperform a benchmark, one must be different from the benchmark; to outperform by a lot, one must be considerably different.
The Active Share research paper by Cremers and Petajisto (2009) has received a lot of well-deserved attention. Chart 1 highlights some of their findings and helps quantify the outperformance of high conviction managers. It shows that mutual funds with the highest active share outperformed after fees, while those with the lowest active share underperformed after fees. The most active did best.
Hotchkis & Wiley: Are Equity Markets Efficient?
Who is the greatest investor of all time? Perhaps Benjamin Graham or Warren Buffett? Maybe Peter Lynch, John Templeton, George Soros, or Julian Robertson? It would be difficult to argue against any of these icons (and many others not mentioned), but that is what you would be doing if you claim that equity markets are perfectly efficient. If perfect market efficiency truly exists, Warren Buffett’s chances of beating the market on a risk-adjusted basis would be no different than Jimmy Buffett’s, so all of us investment professionals might as well set sail to Margaritaville. Arguing that these investors do/did not possess superior skill that translated into above-average performance seems preposterous—especially given their track records—and should be reason enough to discredit the concept of perfectly efficient markets.
See full PDF below.
