From all of the rationalizing we’ve been seeing recently, it seems like active equity managers have been having lots of uncomfortable conversations with their clients. The latest comes from Neil Constable, who leads quantitative research for GMO’s global equity team, and Matt Kadnar, a member of GMO’s asset allocation team, in their aptly named white paper ‘Is Skill Dead?’

“In today’s increasingly short-term-oriented investment culture, winning stock pickers are deemed to have exhibited superior foresight and brilliance while the losers have suddenly become idiots and are often shown the door. Reality is something quite different,” they write.

While they make a good case that active management underperformance has more to do with last year’s investing environment than competence, they don’t make a great case for active management in general.

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Active managers: Underperformance can be explained with cash, small caps, and international stocks

To explain how so many active managers can fall behind the index (instead of cancelling each other out as you might expect with sector or style biases), Constable and Kadnar find that they can explain a lot of manager outperformance (or underperformance) with just three factors: the relative performance of international stocks (using the MSCI ACWI ex-US index), small caps (using the Russell 2000), and USD against the S&P 500. Simply counting how many of those three factors are doing well against the S&P 500 gives a good estimate of how well active managers are doing. Last year, all three asset classes lagged behind the S&P 500, which Constable and Kadnar figure gives a typical manager a 120 bp deficit before they start picking stocks.

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Using a regression to predict managers’ relative performance with the same three factors does an even better job of explaining last year’s unimpressive results.

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Three-factor model explains underperformance, but not why you should keep paying fees

“For active management as a whole, 2014 was a year when the forces in our three-factor model were aligned in such a way as to make it an especially difficult environment for active managers to outperform. U.S. equities trounced non-U.S. equities, large cap stocks trounced small cap stocks, and equities trounced cash. That was a lot of trouncing going on,” write Constable and Kadnar.

But investors pay for active management because they believe they’re getting some alpha – excess return beyond what the market would give. Instead, it looks like most people are paying a lot for straightforward diversification that they could probably get more cheaply through well-chosen ETFs.

See full PDF below.

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