Is Active Management Broken?

Jun 26, 2019
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SMI’s first investing strategy was Just-the-Basics, a passive strategy built on index funds. This may surprise some readers, given that all of SMI’s strategies since then have been actively managed — meaning investment decisions are regularly being made in an effort to beat the market’s return, or at least produce a better risk/return tradeoff than index funds alone would provide.

It’s been our contention that if an investor is willing to diligently follow these active strategies, he or she has a good chance of outperforming the market. Up until the financial crisis a decade ago, the returns of SMI’s strategies consistently backed up that assertion.

However, the past decade has been a different story. SMI’s Sector Rotation strategy has continued to amaze, with annualized returns of +17.8% over the past decade. But Stock Upgrading and the newer Dynamic Asset Allocation strategy (launched in 2013) have lagged during this long bull market. DAA’s struggles are somewhat understandable, given its “defense-first” orientation. But Stock Upgrading had always outperformed during past bull markets.

It’s not just SMI’s Upgrading strategy that has struggled. The underperformance of all types of active management approaches throughout this bull market has been a topic of frequent discussion in the financial media. Although there have been other contributing factors, poor relative performance has surely played a key role in the huge number of investors leaving the active fold and shifting to indexing over the past decade. When this bull market began in 2009, the split of U.S. equity investments was roughly 75% active, 25% passive. This year, the share of U.S. investments passively invested will top 50% for the first time. There are many new passengers on the indexing train that have never before ridden it through a bear market.

Two separate issues

In assessing the reasons behind the relative underperformance of active strategies over the past decade, there are two issues to consider. Before we can consider what’s happening at the active/passive level, we first must consider the impact of diversification on returns.

  1. Diversification
    The simplest way to illustrate the impact of diversification on returns during this 10-year bull market is to compare the returns of the S&P 500 index with the returns of SMI’s Just-the-Basics strategy. Both are passive indexing approaches, so this strips out the active management element. The difference is simply a matter of diversification. The S&P 500 index measures the performance of the largest 500 U.S. stocks. JtB is comprised 40% of an S&P 500 index fund, 40% of a U.S. extended market index fund (measuring the performance of medium- and smaller-company stocks), and 20% of an international index fund.

    When this bull market was getting started in March 2009, a review of the prior 10 years (1999-2009) would have shown the S&P 500 losing -3.0% annualized, while JtB had lost less at -0.9%. Again, this difference simply reflects the impact of adding smaller and foreign companies to the allocation mix. While it’s likely shocking to some that both approaches lost money over that full decade, adding small and foreign companies via JtB produced returns that were +2.1% better per year than simply owning the S&P 500.

    Fast forward to today. The same comparison over the past 10 years produces the opposite result: the S&P 500 has compounded at +13.9% annualized, while JtB trails at +12.5%, a gap of 1.4% per year in favor of the S&P 500.

    Clearly, diversification has hurt performance over the past decade, just as it boosted performance over the decade before that. Of course, most passive investors don’t buy only the S&P 500 index, they also own some type of diversified mix, as JtB investors do. But many active investors compare the returns of their active strategies to a single benchmark figure like the S&P 500 index. As these numbers illustrate, that’s been a recipe for growing dissatisfaction throughout this bull market.

    But is diversification a bad idea, even if it has led to lower returns during this bull market? Of course not. SMI readers are reminded every month that it’s a biblical investing principle (the theme verse of our Level 3 column each month is Ecclesiastes 11:2 — "Divide your portion to seven, or even to eight, for you do not know what misfortune may occur upon the earth."), and any investment advisor worth their salt diversifies their client’s holdings.

  2. Active/Passive
    Having isolated the impact of diversification on investing returns during this bull market, we can now better tackle the current status of actively managed investment strategies.

    Morningstar’s John Rekenthaler recently wrote an article on Yale’s endowment fund, which for 25 years under manager David Swensen has been “its industry’s shining city on a hill, demonstrating to the masses the brilliance of institutional investing.” That’s not hyperbole — apart from Warren Buffett, Swensen may be the closest thing to a superhero left in the industry, and the Yale endowment fund has long been viewed as the ultimate in institutional investing.

    Given that, it’s surprising that over the most recent decade (using performance data through mid-2018), the Yale fund gained just +7.4% annualized while the S&P 500 gained +10.0% (Upgrading gained +8.0%). Extend that period out to the past 20 years however, and the numbers flip: Yale +12%, S&P 500 +7%. This despite the Yale endowment rarely allocating much of its portfolio to U.S. stocks. The point here is simple: the S&P has crushed the competition over the past decade. But the S&P 500 doesn’t always lead.

    Pivoting to Upgrading, we see a dynamic similar to the Yale fund in that both attribute their long-term success to finding the best managers within their peer groups, which allows these strategies to “win” within the individual allocations of the broader portfolio. Last year, for example, Upgrading’s fund choices outperformed the average fund in all five of SMI’s risk categories — yet Upgrading still lagged the S&P 500 index by 3.5%.

    These examples aren’t failures of active management, per se. It’s simply that the S&P 500 is dominated by large growth stocks, whereas Upgrading, the Yale endowment fund, and most other active strategies are diversified across other stock types and/or asset classes. Many active strategies continue to do what they’ve always done, which is to identify superior investments within their assigned parameters. They just aren’t being rewarded because large growth stocks have been so dominant during this bull market.

Past as prologue?

Morningstar’s Rekenthaler ends his article this way: “The last time Yale’s endowment fund looked this out of sorts was the late 1990s, and it promptly posted outstanding relative results. Perhaps history will not repeat. But I would not bet against such an occurrence.”

Neither would we. We’ve also pointed to the late-1990s as a parallel of sorts to the current market. The investor exuberance of that era isn’t present today, but the incredible outperformance of the S&P 500 relative to other stock types and investing approaches is similar. So, too, is the feeling among investors today, similar to 20 years ago, that the Fed is waiting in the wings to rescue them should the market falter at the end of a similarly extended economic expansion and bull market.

We know how that turned out last time. After its last period of similar relative outperformance in the late 1990s, the S&P 500 fell a total of -26% over the following decade. Meanwhile, Upgrading gained +65%, creating a stunning 91% performance gap between the two approaches.

But 10 years is a long time and many SMI members weren’t around for that 1999-2008 period. So when they see Upgrading lagging the S&P 500 over the past decade, it’s understandable they may be tempted to think an S&P 500-only approach is a better way to invest. We’ve shown the false implication there. Any responsible investor would diversify beyond the S&P 500, and the return gap erodes rapidly as diversification is added. But even more important is recognizing that market leadership doesn’t last forever. The S&P 500 has been on a great run, and its +2.6% annualized performance edge over the past decade is impressive. But it pales beside the -10.1% annual performance deficit the S&P 500 experienced relative to Upgrading during the decade before this bull began!

There’s an old market saying: “Trees don’t grow to the sky.” The point is simply that while investors have a strong tendency to extrapolate the recent past indefinitely into the future, real life doesn’t turn out that way. “Reversion to the mean” (the tendency for asset classes to gravitate toward their long-term averages) kicks in, pulling prior winners down and boosting the former losers back up. Over this bull market’s 10-year run, indexing — and specifically the large growth stocks that dominate within the S&P 500 index — have been the most impressive trees in the investing forest. But we don’t have to look far into the past for a vivid reminder that one decade’s leader is often the next decade’s laggard.

Written by

Mark Biller

Mark Biller

Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark also serves as Senior Portfolio Manager to SMI Advisory Service’s Private Client managed-account program and the SMI Funds.

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