Frontier Focus 4Q16
Gary A. Miller, CFA
Founding Principal &
Chief Investment Officer
Active Fund Management: Dead or Alive?
Rob Miller wrote in last month’s Frontier Focus about some of the processes Frontier uses to find active fund managers that can add value over indexes. Well, I guess the joke’s on us. Earlier last week, on October 17th, the Wall Street Journal published a complete series of articles describing the dramatic movement out of active investment strategies and into passive ones, “The Passivists.” The subtitle read, “A series exploring the rise of passive investing.” The opening salvo comes from Dennis K. Berman and Jamie Heller in “Wall Street’s “Do-Nothing” Investing Revolution” in which they write, “there is a simple, destructive idea taking over Wall Street: that stock pickers can’t pick stocks well—or at least well enough for the fees they charge. And even those who do can’t sustain it year after year. In short, the idea of the “active manager” is rapidly losing its intellectual legitimacy to the primacy of the “passive investor” who merely buys an index of shares.” They add, “People have largely given up on the quest, which used to be so common, for “the next Peter Lynch” or “the next Warren Buffett.””. The next article in the series, “The Dying Business of Picking Stocks,” by Anne Tergesen and Jason Zweig, describes “aha” moments when institutional investors realize their portfolios would be doing much better if they simply employed indexing strategies. And, of course, there are also the University of Chicago Booth School of Business grads, such as John D. Skjervem, the 54-year-old, chief investment officer of the Oregon State Treasury, which oversees $90 billion in public assets and trust funds, who said, “What’s going on is a generational shift. Guys like me are moving in, and we had education that was empirically more rigorous than the prior generation’s.” Wow! Empirically more rigorous! Passive must be the way to go!
Actually, this is getting to be old news. The debate has been profoundly in favor of the idea that active fund managers that add value cannot be found beforehand for some time now. An October 2010 paper published in the Journal of Finance written by Eugene F. Fama and Kenneth R. French, “Luck versus Skill in the Cross-Section of Mutual Fund Returns” is considered by many investment professionals to be the nail in the coffin for active fund managers. In an interview with Bloomberg News in November 2010, Eugene Fama said, “The research shows that it is impossible to pick people who can beat the market.” Investors certainly seem to believe that and have been abandoning active fund managers en masse and placing their dollars with passive investment options for over ten years. Sorry, Wall Street Journal. You are at least six years late with your “news flash.”
I will admit I have flippantly addressed the active versus passive debate in the past by saying that “Eugene Fama has never been to the offices of Frontier Asset Management.” He hasn’t, but even so, that is not a serious response to a serious issue. Most studies evaluate whether or not fund managers are skillful (and not just lucky) by comparing their performance to a single index benchmark like the S&P 500®. The chart to the left, “Tough to Beat”, which appeared in the WSJ article on October 17th, “The Dying Business of Picking Stocks,” shows that U.S. large company mutual funds have had a dismal time outperforming the Vanguard Index 500 fund. Over the 5 years ending June 30, 2016, only 11.2% of US large company stocks funds were able to do it. Yikes! No wonder investors are moving in droves out of active funds and into better returning index funds.
But there is more to the story. Although many funds, are “closet indexers” or “index huggers,” and the likelihood they will outperform index funds in the future is slim, there are many good managers that might have trailed the S&P 500® the last five years simply by following their normal investment strategies. For example, let’s look at the performance of a “U.S. large cap” fund that we will call Fund Good for the purposes of this illustration. Like many U.S. large cap funds, particularly the good ones that do not just hold stocks in their “style box”, Fund Good tends to own more than just U.S. large cap stocks. Besides averaging about 70% in U.S. large cap stocks, Fund Good also tends to hold about 10% in cash on average, tends to hold about 10% of its portfolio in small stocks, and tends to hold about 10% in international stocks. Like the GEICO commercials, it is what Fund Good does. It is Fund Good’s “style.” Now, during the five years ending June 30, the S&P 500® Index outperformed the Russell 2000 Index of small cap stocks by 4% per year, the MSCI All-Country World ex-US Index by 12% per year, and 3-month T-bills by 12% per year. That means Fund Good, just doing what it does, would have trailed the S&P 500® Index by 2.8% annually, 9.3% annualized versus 12.1% annualized, even if its performance after fees was index-matching. It could have done extremely well and returned 2% more than its “style” every year, but still trailed the S&P 500® by 0.8% per year. And it still would have been fired by some disappointed investors. Just by doing what it does. And doing it well.
But here’s the kicker. The odds that the S&P 500® Index will outperform small cap U.S. stocks by 4% per year, international stocks by 12% per year, and 3-month T-bills by 12% a year, over the next five years are pretty slim. Investors who sold Fund Good to buy the Vanguard Index 500 fund in early July could very well be disappointed. But I digress. The Fama and French paper I referred to earlier does not compare funds to a single index benchmark. Fama and French use the Fama-French 3-factor model (market beta, market capitalization, market to book value) and the 4-factor model (adding momentum) and still discover that very few (perhaps 3%) U.S. stock managers are skillful. Using the 3 and 4 factor models makes the Fama and French paper much more robust than earlier studies that use a single index benchmark. However, the analysis is still not nearly as comprehensive as Frontier’s methodology. In last month’s Focus, Rob highlighted Frontier’s use of a technique called style analysis that we use for our quantitative evaluation of fund managers’ abilities. Style analysis, as practiced by Frontier, uses many more factors that might impact the performance of a fund than the Fama and French models. That’s helpful, but the qualitative factors in our fund selection process may be just as important or more so. Studies that rely on reams of quantitative data forget that actively managed funds are managed by people. And people are harder to evaluate than performance histories are. Fund manager experience, fund ownership levels, independence, ethics, passion, focus, discipline, smarts, and other factors are not considered in the return numbers. Nor do the studies consider fund manager changes, or performance of fund managers at other funds and institutional accounts.
All of the discussion above evaluates funds in isolation. The most important aspect of Frontier’s search for skillful managers considers how a fund fits within an entire strategy. The logic is fairly straight forward. If we can find a set of fund managers that as a group always or nearly always outperformed in the past the asset allocation mix we want to implement, then that strategy only includes fund managers who are individually doing something better within their unique style than any of the other fund managers; if they were not, they would be replaced by others who are. At the strategy level, we end up with a set of skillful fund managers (and index funds, too). The requirement that the strategy of funds outperformed the target asset allocation over nearly all periods removes all of the biases that might be inherent in the strategy. Remember Fund Good? It has a bias that it will do better than the S&P 500® when international stocks, small stocks and/or cash are outperforming the S&P 500®. Of course, it will probably trail the S&P 500® when the opposite is true. We also end up with a strategy that often includes funds that are very eclectic and do not invest in a single asset class or style. We find that most of the skillful managers are not so-called style box managers; they tend to be fund managers who have a particular investment discipline that is more intent on making money at a reasonable risk then only owning stocks within a specific style box. The table below shows how a strategy can hold a 21% allocation to U.S. large cap stocks despite owning a small allocation to just 2 so-called large cap funds. The list on the following page shows the holdings of Frontier’s Balanced strategy as of September 30, 2016.
There are only two funds in the strategy that have more than 50% of their holdings in U.S. large cap stocks. The majority of the holdings in U.S. large cap stocks comes from seven other funds, only one of which is categorized as a large cap stock fund – the Castle fund, which is mis-categorized and has only a 32% allocation to large cap stocks. As you read through the list above, it is clear that most of the funds in the Balanced strategy are eclectic funds with unique styles. These tend to be managed by the skillful managers. Style box managers need not apply. This example raises another interesting point. Of all of the U.S. large cap funds available to investors, this strategy only owns two. Maybe there aren’t very many large cap fund managers who are skillful enough to cover their expenses. That’s okay. We don’t have to own all of them. We only need a few skillful ones.
The studies and analysts who tout passive investing over active fund management cite “empirical” evidence to justify their claim. I am guessing you realize after reading this month’s Focus that the studies are correct in their assertion that the average fund manager does trail indices (Fama and French determined the shortfall was about equal to their expenses). But I also hope you realize that investors do not have to own “average” funds and that a better question than, “is passive better than active?” might be, “is there a way to identify skillful active fund managers who beat index funds?” And as for “empirical” evidence, the graph on page 5 shows the rolling 3-year annualized added value of the funds in Frontier’s Balanced strategy over the target asset allocation mix, using indices (with no expenses), not index funds, as the bogey.
Added Value from fund selection and how we put them together
Frontier’s Balanced Strategy 3-year rolling annual added value
(Oct-07 thru Sep-16)
Past performance is no guarantee of future returns. Please refer to important information in the Notes.
We believe that we can select managers and put them together in strategies in such a way that their performance mimics the asset allocation mix we desire, but adds one percent or more to the total return. Passive investors are happy with returns slightly below indices, or in the chart above, slightly below the “0.0%” solid black line. Although it may be true that active fund managers may be struggling against index funds lately, you would never know it by looking at the graph above depicting the added value from the funds Frontier uses in its Balanced strategy; they have added nearly 2% per year, (after their expenses, by the way) over the last three years. No shortfall from using active managers here.
Past performance is no guarantee of future returns. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types of securities and no investment decision should be made based solely on information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor's financial situation or risk tolerance. Diversification does not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated.
Information provided herein reflects Frontier's views as of the date of this newsletter and can change at any time without notice. Exclusive reliance on the above is not advised. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types of securities and no investment decision should be made based solely on information provided herein. Frontier is not responsible for any trading decisions, damages or other losses resulting from this information, data, analyses, opinions or their use.
For the Mutual Funds mentioned herein, a complete description of their investment objectives, along with details of the risks and fees involved is contained in their respective prospectus and statement of additional information, which is available on their websites and should be read fully.
Any forward looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. All calculations of performance are by Frontier.
Calculation of "Added Value"
Asset Allocation added value is the performance of Frontier’s strategic asset allocation mix relative to the benchmark performance. The strategic asset allocation mix’s performance is calculated in a similar fashion to the benchmark but uses each month’s strategic asset allocation mix to set the asset class weights. The monthly returns are linked to calculate the returns for time periods longer than one month.
Manager Selection added value compares the composite performance of each strategy to the performance of the strategic asset allocation mix each month. The composite performance tracks the weighted average performance of the funds closely, but can lag slightly due to implementation of the strategy. The monthly returns are linked to calculate the returns for time periods longer than one month.
It is generally not possible to invest directly in an index. Exposure to an asset class or trading strategy or other category represented by an index is only available through third party investable instruments (if any) based on that index therefore they do not experience frictional costs or fees.
|S&P 500||Represents US large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ.|
|MSCI All Country World Ex US||The MSCI ACWI ex-USA is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI ex-USA consists of 44 country indices comprising 23 developed and 21 emerging market country indices. The developed market country indices included are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom excluding the United States. The emerging market country indices included are: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.|
|Citigroup 3-Month T-Bill||Represents the monthly return equivalents of yield averages for the last three 90-day T-Bill issues.|
|Vanguard Index 500||The fund invests in 500 of the largest U.S. companies, which span many different industries and account for about three-fourths of the U.S. stock market’s value.|
Frontier obtained some of the information provided herein from third party sources believed to be reliable but it is not guaranteed and Frontier does not warrant or guarantee the accuracy or completeness of such information. The use of such sources does not constitute an endorsement. Data source for indices is Morningstar.
Frontier’s performance is available on our website – www.frontierasset.com.
Frontier’s ADV Brochure is available by request at firstname.lastname@example.org or 307.673.5675.
Berman D. and Heller J. (2016) Wall Street’s “Do-Nothing” Investing Revolution. The Wall Street Journal.
Tergesen, A. Zweig, J. (2016) The Dying Business of Picking Stocks. The Wall Street Journal.
Stein, C. (2013) Fama’s Nobel Work Shows Active Managers Fated to Lose. Bloomberg.
Fama, E. and French K. (2010) Luck versus Skill in the Cross-Section of Mutual Fund Returns. The Journal of Finance.