We have all noticed that active investors such as mutual funds and hedge funds are struggling. It doesn’t even stop there. Famous investors like Warren Buffet and Charlie Munger are no longer generating remarkable excess returns. Nevertheless, there was a time in history when superstar managers created great wealth for their investors. So, how was this possible? Why are many of those managers currently struggling? Will they continue to struggle? Let’s examine those questions.
Per prior posts, we established that outperforming the market is a zero-sum game. For someone to generate excess returns over the market, there has to be someone who underperforms the market (Passive vs Active). Alpha works the same way—i.e., for every manager that has produced positive alpha, there has to be someone that ends up with negative alpha (How much alpha exists). So, how does one actually achieve superior performance compare to peers?
How does an active investor outperform?
The chart below, which summarizes the change in US common stock ownership, is key to understanding how excess returns are generated and why they have diminished.
For an investor to outperform, he or she has to have an edge or some advantage. The edge could be educational, cognitive or informational, among others. For example, insiders have always had an advantage since they possess non-public information that can assist them in timing their purchases and sales. Of course, this is an unfair advantage, so the Securities and Exchange Act of 1934 outlawed it. In addition, those who knew how to read financial statements had a distinct advantage in the early 20th century. Imagine a well-versed financial statement expert trading securities with those who have a poor understanding of how to measure the profitability of a company or the value of its assets (e.g., Benjamin Graham versus your average 1930s individual). Now imagine someone who not only knows how to analyze financials, but who is also able to evaluate managerial talent and is aware of his or her own cognitive biases (e.g., Warren Buffett and Charlie Munger versus an accountant). In reviewing the chart above, we can see that up until 1945, over 90% of stock ownership was direct— meaning regular investors owned and traded stocks. Many of those individuals were “average Joes” who were neither full-time investors nor good evaluators of financial statements. Further, most were not gifted judges of managerial talent and probably did not possess any other critical investment skills. Because of their lack of expertise, these individuals were easy prey for the skilled investors. This allowed the skilled/professional investors to outperform and produce alpha. Over time, rational individual investors began hiring professional money managers to improve their performance. With the rise of the mutual fund and other pooled investment vehicles, the percentage of direct stock ownership began to slowly decline, as more and more money began to be professionally managed. In the US stock market, a climax was reached in the 1990s as professional investors surpassed individual investors.
The rise of professional investment management had some significant market implications:
- Ever-increasing competition. The professional managers undertake investing full time and are much more skilled. As we know, in a market for every buyer, there has to be a seller. The rising talent level meant that it will become harder to find fools to buy a great stock cheap or fools to whom to sell a bad stock.
- Securities started trading closer to “intrinsic value.” Most of these managers went to the same Ivy League schools, learned from the same professors or investors (Benjamin Graham, Fisher, Buffet, etc.), used similar models, and arrived with similar “intrinsic values.” The decline in standard deviation of excess returns over time (Exhibit 3) and the link between an individual’s stock ownership reduction and excess return standard deviation (Exhibit 4) display the trend’s effects perfectly.
In a way, active management has been a victim of its own success. Initially, more sophisticated investors were lured to the market because they could exceed the returns earned by all the other individuals who own and traded stocks. Eventually, the “average Joes” realized that they were better off just hiring those sophisticated investors to manage their money for a handsome fee. The handsome fees resulted in huge profits and margins for the professional investors (mutual funds, hedge funds, etc.), in turn attracting many of the brightest talent in the country (PhDs, CFAs, etc.). The influx of additional talent, combined with the move towards professional money management and the ability to learn from the top investors, made markets more “efficient” (and by “efficient”, I mean fewer discrepancies among participants’ intrinsic values, and not necessarily that these values are correct). This increased level of competition and thought-bounded reasoning has slowly eroded the ability of investment managers to find alpha and produce excess returns. Warren Buffett himself has recently warned Berkshire Hathaway investors not to expect outperformance like the 1960s and 1970s. Yes, part of the reason is the sheer size of Berkshire. But the ignored reason is the much higher level of competition. Thanks to his generosity and that of other top investors who have shared their knowledge and skill, many current professional managers use those same techniques to select stocks. Unfortunately or fortunately, outperforming the market has become harder, and it will continue to become more difficult.
“The high margins of active management have attracted many of the most talented people”
To illustrate further, consider the game of chess. Take two people who have never played chess and who have the same intelligence. If provided with the same chess training, do you think their games will be competitive? Will one dominate the other? Logically, we would expect their games to be extremely competitive with a fairly even distribution of wins and losses. At the end of the day, they received the same training. Now, if you were playing chess for cash, would you seek to play weaker or stronger competition?
Passive management further escalates the skill level:
On top of institutionalization of investing over the last 100 years, we are currently going through another rotation of a similar kind—the switch from professional money management to passive investing. As I have expressed earlier, truly passive investing is just a copy of all the active managers’ valuations. The passive management growth will have similar implications for the markets (How passive investing makes markets more efficient). As more actively managed assets move towards being passively managed, the level of competition and skill will rise even more. The switch will first push out the bad/unlucky active managers (the underperformers), leaving the most skilled. To get the point across, take a look at the below analogy:
“Imagine you and other people were offered the opportunity to participate in a multi-round basketball free throw shooting competition. During each round you will have two options:
- Shoot 10 free throws and earn a dollar for each throw made (taking the active approach).
- Sit it out and take the average score of the remaining competitors (taking the passive approach).
What will you do?
If you think you are better than other participants, you will compete. If you are not very good at free throw shooting, you will sit out and collect the average score.
Let’s assume you are better than the others. In such case, you will compete while several participants who don’t think they can score above the average will sit it out. The first round plays out with the remaining participants. What happens to the average skill level after the first set of below-average participants drops out? The average skill level increases. What will happen after the second round? What about the third round and so on?
Thanks to the law of competitive markets:
- Weaker players will be forced to drop out. In this case, these are the participants underperforming the average.
- The skill of the remaining competitors will continue to increase during each round; as the less skilled dropout, more skilled players remain.
Notice the law of competition holds up in most skilled games. Do you think we will see another person in baseball batting above the .400 mark? Do you think another player will score 100 points in one basketball game as did Wilt Chamberlain? Neither is likely to occur since the competition in both those sports has risen.”
The trends of (a) a decline in direct stock ownership and (b) an increase in passively managed assets will continue to reduce opportunities for active managers to produce outperforming returns.
“Looking for Easy Games”, Credit Suisse, Michael J. Mauboussin, Dan Callahan, Darius Majd. January 4, 2017
“Trends in Institutional Stock Ownership and Some Implications.” Marshall E. Blume* and Donald B. Keim**. March 12, 2008.