Michael Mauboussin: Since the end of 2006, investors have withdrawn nearly $1.2 trillion from active

Michael Mauboussin: Looking for Easy Games: How Passive Investing Shapes Active Management

Michael Mauboussin is the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Harvard Business Review Press, 2012), Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, 2009) and More Than You Know: Finding Financial Wisdom in Unconventional Places-Updated and Expanded (New York: Columbia Business School Publishing, 2008). More Than You Know was named one of “The 100 Best Business Books of All Time” by 800-CEO-READ, one of the best business books by BusinessWeek (2006) and best economics book by Strategy+Business (2006). He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns (Harvard Business School Press, 2001).

Visit his site at: michaelmauboussin.com/

Michael Mauboussin: Looking for Easy Games: How Passive Investing Shapes Active Management

“As they say in poker, ‘If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.’” - Warren E. Buffett

• Investors are rapidly shifting their investment allocations from active to passive management. This trend has accelerated in recent years.
• The investors leaving active managers are likely less informed than those who remain. This is equivalent to the weak players leaving the poker table. Since the winners need losers, this can make the market even more efficient, and hence less attractive, for those who remain.
• Active management provides price discovery and liquidity, valuable social goods. However, the fees are higher for active managers than passive ones, identifying skill ahead of time is not easy, and there is a cost to assessing skill.
• Passive management has lower costs and hence higher returns per dollar invested than active management does in the aggregate. But passive management introduces the possibility of market distortions.
• Active managers have to constantly ask, "Who is on the other side?" The unrelenting objective is to find easy games, where differential skill pays off.

Executive Summary

• Investors are shifting their investment allocations from active to passive management. This trend has accelerated in recent years. The investors who are shifting from active to passive are less informed than those who stay. This is equivalent to the weak players leaving the poker table. Since the winners need losers, this can make the market even more efficient, and hence less attractive, for those who remain. If you can’t identify the patsy, or weak player, it’s probably you.
• Active management provides price discovery and liquidity. These are valuable social goods. However, the fees are higher for active managers than passive ones, identifying skill ahead of time is not easy, and there is a cost to assessing skill. Average fees for the industry have declined as the result of the rise of passive investing, and closet indexers have been the biggest losers.
• Passive management has lower costs than active management and hence delivers higher returns per dollar invested than active management does in the aggregate. However, passive management introduces the possibility of market distortions, including crowding and illiquidity. Exchange-traded funds, in particular, are worth watching closely because of their explosive growth and high trading volume. There is evidence that passive investing has had an influence on valuations, correlations, and liquidity.
• How efficiently inefficient markets are determines the appropriate balance between active and passive. More active management can lead to more efficiency and an inducement to go passive. More passive investors and noise traders may create more inefficiency and hence opportunity for active managers.
• Four drivers have led to the development of the mutual fund industry and, more recently, to the shift toward passive investing. These include regulation, the market environment, technology, and the balance between informed and uninformed investors. In particular, technology has contributed a great deal to informational efficiency as a result of advances in the speed and cost of information dissemination, computing, trading, and communication.
• Active money managers need to seek easy games. These include competing against individuals, investors who buy and sell without regard for fundamental value, and investors who use simple decision rules. Wealth transfers are another potential source of excess returns.
• Small and unsophisticated investors should build passive portfolios, with an emphasis on asset allocation and low cost. Sophisticated investors should seek active managers in asset classes with high dispersion. There are ways to assess money managers beyond past performance that may shade the odds in your favor.
• Active managers must constantly consider who is on the other side of the trade. Research shows that fundamental money managers who take a long view and are truly active can deliver excess returns. It is essential to identify a repeatable source of edge and to align the investment process to capture that edge.
• There is an academic case for indexing, which is based on the work by Nobel Laureates Harry Markowitz and William Sharpe. They developed a way to understand the trade-off between risk and reward and emphasized the importance of thinking about portfolios. Subsequent to their work, researchers identified factors associated with returns beyond risk, measured as variance, which has led to factor investing (“smart beta”).

Introduction

Say that I invite you to my house for a game of poker on Friday night. If you play to make money, your first question should be, “Who else will be there?” If I tell you that some rich players who have poor skills will attend, you will put the date on your calendar. If I say that the other players are better than you are, you will make alternative plans.

Let’s make this a little more interesting. Rather than providing you with an assessment of each player’s skill, I’ll tell you about some scenarios for the outcomes of the evening. I will invite 5 players, each of whom will bring $200.

In the first scenario, I tell you that the expected winning of each player is zero. While money will move around because of normal variance, the players are anticipated to gain or lose nothing by the end of the night. In the second scenario, I tell you that one player is expected to leave with the same $200 he or she walked in with, two are expected to lose $100 each and thus depart with only $100, and the final pair is expected to gain from those losses and exit with $300. The standard deviation is $100.

In the final scenario, one player is expected to leave with $200, two are going to lose all of their money, and two are going to take home $400. The standard deviation doubles to $200.

How much would you be willing to pay to access each scenario?

In the first case, the answer is nothing. In the second and third cases, your answer depends on an assessment of your skill. If you think you are one of the top two players, you should be willing to offer something less than your expected profits. If you think you are below the average, or do not know where you stand, you are better off not playing.

As simple as it is, our poker game reveals three important lessons for investors. First, for every winner there has to be a loser. The money coming in the room at the beginning of the evening is the same as the money going out. Second, the players end up with less money than they started with if there is some cost to play. Finally, randomness ensures that some players will win or lose more than their underlying skill justifies. Skill is revealed only over a large sample of games.

One of the biggest issues in the investment management industry today is the shift from active management, where a portfolio manager selects securities in an attempt to deliver higher returns than a benchmark index, to passive management, where a fund mirrors an index or operates according to set rules. Since the end of 2006, investors have withdrawn nearly $1.2 trillion from actively managed U.S. equity mutual funds and have allocated roughly $1.4 trillion to U.S. equity index funds and exchange-traded funds (ETFs). See exhibit 1.

In this report, we will try to explain why this shift has happened, what the impact is on markets, how to think about how much more there is to go, and what to do about it.

Let’s establish some important points right away. Active management promotes price discovery. A market that is close to efficient, where prices accurately reflect available information, is a positive externality that benefits society.2 Think of the classic arbitrageur. He or she buys what’s cheap, sells what’s dear, and leaves efficient prices in the wake. Our arbitrageur enjoys an excess return and delivers a proper price. Markets must be inefficient enough to encourage active managers to participate. At the same time, the participation of active managers creates efficiency.3

Index investors benefit from this externality. There is nothing wrong with that. We all benefit from prices every day. A corollary is that the market cannot be made up solely of passive investors: we need some investors to collect information and to reflect it in prices.

Active investors also create liquidity in markets. Liquidity is the ability to turn assets into cash, and vice versa, in a timely fashion without suffering large transaction costs or a sizable price impact. Because buyers and sellers do not always seek to transact at the same time, investors have to compensate market makers to create a liquid market. Research shows that liquidity has an impact on asset prices, and assets with low liquidity are susceptible to large price reversals.4

The questions relate to how many active investors we need to approximate this efficiency and how much our society should be willing to pay for price discovery and liquidity.5

In 1991, William Sharpe, a professor of finance and winner of the Nobel Prize, described what he called “the arithmetic of active management.”6 He argued that the return on the average dollar managed actively will equal that of a dollar managed passively before costs, and that the return on the actively managed dollar will be less than that of a passively managed dollar after costs.7

Here’s the way to think about it. Say you define the market as the stocks that comprise the S&P 500. The index and the passive funds that mirror it will generate the same return before costs. The return for the active managers must, then, also equal the S&P 500’s returns as well because the parts, passive plus active, must equal the whole. Since the fees of 81 basis points for active funds, weighted by assets under management, exceed the 21 basis points that passive funds charge, active management will underperform the index as well as passive funds tracking the index over time.8

Studies going back as far as the 1930s have consistently shown that active managers generate net returns less than that of the market.9 Exhibit 2 shows that 42 percent of all U.S. equity funds outperformed the S&P Composite 1500 Index, on average, in each individual year from 2000-2015. This average rate of outperformance has a standard deviation of about 15 percent. It also shows that only about 1 in 8 funds outperformed the S&P Composite 1500 Index over the past 3 and 10 years, and only 1 in 20 did so for the trailing 5 years. The percentage of outperformance varies by fund category, but most of the annual averages are in the range of 30-40 percent.

The intuition behind these results is straightforward. If my 5 pokers players each walk in with $200 and agree to pay me to play, the net amount that walks out will be less than $1,000. The same math applies to passive funds. Almost all passive funds underperform their relevant indexes after fees.10 For example, the compound annual total shareholder return for the Vanguard 500 Index Fund Investor (VFINX) shares was 17 basis points less than that of the S&P 500 Index, an amount comparable to the fund’s fee, for the five years ended December 31, 2016.

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