Does long-only active management add any value??

Undergrad interested in LO as a career path. LO asset management looks great on paper; significantly lighter workload than IB/PE, more intellectually stimulating, similar career / comp progression. However, I can't get past this idea that traditional long only investing adds no value at all.

First of all, there's the empirical observation that most funds fail to beat their benchmarks. EMH proponents say this is because the market is efficient. I don't believe the market is completely efficient, but based on the research I've done it seems like traditional mutual fund investing is one of the primary causes of market inefficiency, due to the structural incentive misalignments associated with it. I know many mutual fund PMs are very good investors, but the institutions whose money they're tasked with investing are much less sophisticated. The principles of fundamental value investing generally point toward investing in securities that are disfavored by the market, but the short-termism and backwards-looking nature of institutional capital allocators means that LO investors face a constant pressure to invest in the most favored securities. If domestic has outperformed over the last 5 years, for example, institutions will allocate toward domestic even if investors expect international to have a higher return. You can see this in the contemporary rush to allocate more to alternatives. Cliff Asness wrote of his experience investing during the dotcom era: "At the nadir of our performance, a typical comment from our clients after hearing our case was something along the lines of  'I hear what you guys are saying, and I agree: These prices seem crazy. But you guys have to understand, I report to a board, and if this keeps going on, it doesn't matter what I think, I'm going to have to fire you.'" The structure of LO AM incentivizes procyclical, anticontrarian investing. Career risk compels PMs to invest in what is safe, not what they believe is best, and asset managers face the same compulsion in order to maintain their aum. Hence, closet indexing. 

In other words, my perception is that most of the long-only asset management industry is structurally predestined to fail and is pretty much just pretending to be seriously pursuing alpha. If this is the case, I would have a hard time entering an industry like this, even if the career path looks pretty cushy on paper. Is my understanding of the industry wrong? Can someone make a compelling argument that traditional long only asset management actually does add value?

Comments (30)

Most Helpful
  • Intern in AM - Equities
Jan 13, 2022 - 4:55pm

I'm an undergraduate entering long-only asset management, so I can try and speak to some of your points. TBH, I don't have a response to the assertion that long-only asset management as an entire industry is structurally a farce; that's a hefty statement, and answering it is beyond my knowledge/capabilities.

However, as you pointed out, there are nonetheless a ton of issues and inefficiencies within the industry. On a more individual level, it highlights the importance of joining the right firm out of school. The future of AM has been discussed ad nauseam on this forum. A key point in this discussion is that the "middle" will get squeezed, leaving the industry dominated by a handful of large players (think Fido/Well/TRowe/Cap) as well as high-quality smaller players that occupy a specific niche. To maximize comp and career stability, if you're in it for the long run, you'll want to focus your recruiting efforts on these kinds of funds. Based on your post, it doesn't seem like you'd enjoy yourself at a large active manager, obviously. The downside to focusing on niche, boutique managers, however, is the lack of structured recruiting and the tiny number of seats, especially for undergraduates. Even at the largest active managers, class sizes at the entry level are often less than 10 associates total, sometimes less than 5. Another option is to take a look at MM HFs

Hope this helps! As someone who went through the LO recruitment process not knowing anything, I'm frustrated by the lack of information available online as opposed to banking/PE, so I want to try and help demystify some aspects of the industry as best as I can.

  • Prospect in IB - Gen
Jan 15, 2022 - 12:31am

To add specific numbers for those reading, a couple years ago Fidelity hired exactly 3 associates in equity research. So <5 is not an exaggeration by any means, Point72 alone probably hires as many associates a year as all of the large LO AMs combined.

Jan 15, 2022 - 1:46pm
marketMergerMaddie, what's your opinion? Comment below:

Currently working for one of the "large players" you mentioned. I think you are exactly right, and I'll even go to the extent to say that those currently at one of top LOs will see a significantly easier career path as they over the next several years continue to dominate. All of public markets (LO, L/S, Alt. Credit & Distressed, etc.) will see a serious degree of consolidation, and T. Rowe Price's recent acquisition of Oak Hill (in addition to Wellington's continued acquisitions of smaller LOs) makes me believe that being at one of the bigger players does make a huge difference in career outlook for the medium term. 

A few thoughts on LO: 

  • The EMH is fairly flawed in nature and this enables many of the large funds you listed to be successful in the intermediate term, by beating out their LO competitors who are less resource rich. This will continue in the medium term, but as the space becomes more consolidated into the top four players in equity, we will likely see each firm only barely being able to edge out the other. 
    • I'm curious if this will have significant effects in the revenues of these businesses as they continue to cut fees, and if the compensation of those who work in the industry in the future will keep up with previous growth. I just don't know. Fee compression is a real thing and may significantly change this industry as we see it moved to a business dominated by efficiency rather than performance. 
  • Doing LO out of college is super rare and now I see why having worked at an LO myself. To join this industry, you better really love public equity and not have FOMO. I live in a T2 city and make COL-adjusted a bit more than my T1 city friends. But the FOMO for IB, PE, VC, and other high finance roles is real. I keep my head up with confidence knowing that I have a great job, but I definitely think from time to time if I would have made a better career choice by sticking with IB at first, even if LO is what I wanted to do in the long run
    • Additionally, I definitely believe the recent wave toward IB is due to the availability of roles compared to LO which has very, very few. You're just not going to hear much about a space that only has a couple of seats. It's great for those interested in LO right away, since competition isn't horrific, but you better be prepared for the roles and know that you want this specifically.
    • For reference, my cohort at a large LO is 8 people
  • dickthesellsider has a great guide for interviewing on the buy-side; read it if you want a job in this space
    • I've also read a lot of his reading list. Bought a lot of books based on it. Thanks Dick!
  • Do any of these above points mean that LO is value accretive to society or not? I have no idea. I can tell you that we think that we have to beat our competitors to be successful, and that for every winner there must be a loser. Does this make the industry structurally a farce prima facie? No. Does it mean that everyone benefits from it though, also no. Funds have to invest right and be very thoughtful about their choices. This encourages conservatism for sure, but does not necessarily encourage anti-contrarianism. Funds that are closet indexers won't outperform, and since many of the top players consistently outperform, there must be some contrarianism at these firms in their investing approach. 
    • Now, I definitely have my agreements and disagreements with this method, especially considering that this viewpoint is considered as blessed as it is (basically, value investing on the whole, which has worked for just about everyone in the past, but the reverence that exists for it feels so counterintuitive to the contrarian views affiliated with the rest of the job). But I don't think that these companies are faking pursuing alpha. They're picking a tried-and-true method that has worked for many in the past and works for them too. 

Those are my thoughts. I'm sure they're a bit rambling, but that's what I've learned so far since graduating from undergrad

Jan 16, 2022 - 5:26pm
boom12345, what's your opinion? Comment below:

Curious to hear about the post-MBA route at your larger LO shop. Are there more roles post MBA (or are they equally as competitive in entering the industry) and how many summers do you see get return offers back? Would you expand on your thought process on those in LO shops having easier path going forward - is this more of a reference to more assets moving towards beta managed so more opportunities for asset price discovery?

  • Analyst 2 in HF - Event
Jan 13, 2022 - 5:05pm

IMO, Active management on the FI side offers MUCH more value-add than the LO equity side. Of course, there are consistent top stock pickers at shops Wellington/Fidelity/T Rowe but like OP said, many equity funds at those shops still underperform their benchmarks. However, if you look at a shop like PIMCO, which is the gold standard in the AM industry for active FI.. 93% of their funds have beaten their benchmarks for the past 5 years. But if you can land a research role at any of the firms mentioned above and make it to the PM/Analyst level... you will have a very comfortable and lucrative career. 

  • Research Analyst in HF - Other
Jan 15, 2022 - 8:50pm

a few thoughts:

LO AM's job is to pick good companies. If they are able to do that, it doesn't matter if they invest in securities that, as you say, are disfavored by the market. As long as they can stay solvent longer than the market can stay irrational (which most AM's can), they just need to hold. In the long term, these disfavored stocks will have their prices reflect EPS. So that shouldn't be a hindrance. 

I think the bigger issue at hand here is that LO AM's, unlike a hedge fund, must beat the market in order to appear like they are a positive value add. A L/S fund can return 6% annualized and still be considered an amazing asset that LP's gobble up if the fund's net market exposure is 0. Having these 0 beta assets is very valuable from the portfolio theory perspective. A LO AM, however, obviously cannot hedge positions and short stocks to achieve 0 beta so they have no excuse for underperforming benchmarks. This is what results in that highly defensive and anticontrarian investing. 

Also, Buffett talks a lot about the problems that plague large mutual funds (asset elephantiasis, moving in lockstep, etc) and I think these still apply in today's market.

Jan 15, 2022 - 11:19pm
xyzESG, what's your opinion? Comment below:

Some really good points in here. One that I think is widely under appreciated here, it's a lot harder to generate significant alpha on a $150 billion fund than a $1 billion fund.

  • Intern in IB - Cov
Jan 16, 2022 - 3:44pm

Disagree with the first point. That's how it's supposed to work, but do things actually play out that way? Say you go long value in 1996. You know it's the right call, and you know you'll outperform over the long run. But it turns out you have to wait 4 years for this to actually pay off. How many redemptions will your fund have faced by then? Will you still have your job? Everyone knows you have to invest for the long term, but myopia is institutionalized in the structure of the asset management industry. It's far safer to just buy what everyone else is buying, to overweight growth in 1996. On the way up, your clients won't complain. And on the way down, your career will survive because the same thing happened to everyone else, too. Good career risk management, bad investing.

  • Research Analyst in HF - Other
Jan 16, 2022 - 7:02pm

to clarify my first point-- I'm not referring to entire categories of stocks like "growth" or "value" (and by the way... is there really a difference now? There are some tiger cubs / equivalents that call themselves value investors and have 80+% of their portfolios in SaaS tech).

I'm talking about any particular stock. If you do the fundamental research and believe it's gonna do X in earnings in 1-2 years equating to an EPS of Y, if your research is actually correct, the company's price will adjust to reflect it when it starts earning that much. Doesn't happen instantaneously because the market's sometimes got slow reflexes but give it a few quarters and sell-side is bound to pick it up. 

Jan 16, 2022 - 12:15pm
ke18sb, what's your opinion? Comment below:

The argument against LO at the institutional investor level is largely academic and does not consider many of the realities of allocation. This isn't something you'd be aware of unless you're in the system. Without getting into a long counter post to various points, at the core LO is being paid to deploy capital, its not merely about beating the market. Large pensions, endowments, sovereign wealth funds aren't going to drop 100mm, 500mm, 1bn, 5bn, or whatever into ETFs. There are tons of other reasons why LO exists as well but capital deployment is a big one. 

  • Intern in IB - Cov
Jan 16, 2022 - 1:47pm

I'm interested in hearing more about this. Why would an institution prefer to allocate capital to a US equity mutual fund that benchmarks off the S&P but underperforms it by 50bps net of fees each year with similar vol? Wouldn't a passive fund be strictly better? I'm not in the industry so I'm not saying I'm right, I just don't understand this.

Jan 17, 2022 - 3:24am
whatsgucci, what's your opinion? Comment below:

Just to touch on the "why", many clients have requirements and constraints on how their capital is allocated. On the a FI side it's common to see guidelines such as x% IG, no Bank Loans, x% agency MBS, etc. Not sure about equities, but the value add for FI AM institutional clients is beating the benchmark while maintaining their portfolio guidelines 

Jan 16, 2022 - 2:04pm
marketMergerMaddie, what's your opinion? Comment below:

I very much agree with this. Something that I didn't touch on above is the distribution piece of the business (sales and client service). A huge reason why most people invest in my company's funds is the client service piece. Distribution staff make up 80% of my company's staff in total. I think it is possible in the future that distribution will be a significant driver of the business, especially in areas where LO AM has not been as present previously

Feb 10, 2022 - 11:09am
Addinator, what's your opinion? Comment below:

They absolutely do - but they aren't like you or I. Investment policies play a big role in this, risk parameters and constrains. Limits on allocation to a specific issuer, specific fund, etc. Counterparty risk is largely irrelevant to you and I - but it starts to really matter when you take a position of a few hundred million dollars. 

A note on investment policies - this is one of the most underrated, and under appreciated, variable in the markets. The amount of activity driven, rightly or wrongly, by these policies is incredible. Policies sometimes limit the amount of ETF or mutual fund exposure you can buy - so, as an example, you might be structurally limited and be forced to use a separately managed account. Conversely - some can't buy the underlying (say equities) or, their size would actually take them over an individual issuer limit that's in place - where you can't have more than 5% of an issuer, etc. 

This commonly happens with issuers and in the fixed income world can create some odd challenges - i.e. you'll see an entity come to market, trade at a discount to where they might normally simply because they are so widely held, large institutions can't buy more due to policy, risk, etc. so they have to find incremental buyers. 

Another is functional - these intuitions are large enough to do things you, I and most others can't. Rather than buying an ETF - you might find more pickup from replicating it, and engaging in securities lending to pickup yield. Just an example - but you get my point. 

The other one is politics. Don't discount this. When Wells Fargo was tied up in scandal - there are places that simply said 'no thanks' and punted any holdings they had. Don't think this can't, won't or doesn't happen with other entities. There's also the issue of stakeholders. Passively indexing large portions of the money might, academically, make sense but it doesn't get you re-appointed or re-elected if you underperform. Add in all kinds of other issues - blowback on private equity or hedge fund fees, suddenly the Yale model looks a bit less 'attractive'. Board politics, optics, etc. are all real and have tangible impacts on how they invest. Rational investors they often are not. 

Jan 16, 2022 - 4:49pm
ronwesley, what's your opinion? Comment below:

feel like there are a few high quality lo shops that have consistently beaten the markets. i find ron baron in particular very interesting since his long book is so tesla heavy with other growthy names like penn national. what allows him to outperform is how long term he is. there are stocks he's been invested in since the 90's and just let them ride which is crazy. 

Jan 17, 2022 - 9:17am
rickle, what's your opinion? Comment below:

One of the issues with passive management (maybe more in the FI world but I think applies to EQ as well) is you get exposed to whatever is in the index, good or bad. You don't have the flexibility to go heavy or light in an asset class or an asset. Say you're in a "core fixed income" fund. If you're pegged to an index you get a lot of crap in there. But if you're active, you can find sectors within IG, HY, MBS that provide alpha. You can use leverage to juice performance. Probably why you find many more mgrs beating their respective indexes in the FI space.

Feb 10, 2022 - 10:22am
Master of Prospects, what's your opinion? Comment below:

The value proposition for active mutual funds is nothing less than purely abysmal. Given that there have been decades of consistent evidence dating back to the 1960s, we have reached the point where it is undebatable that mutual funds, regardless of tier or the skilled manager behind them, will underperform their benchmark net of fees over long-term investment horizons (e.g. 10 years and up). Anyone who argues different is advocating for their own agenda/bias.

Nowadays, the only compelling reason that long-only active funds still boast ~$19 trillion of capital is due to investor inertia. The first mutual fund was invented back in 1928, whereas the first ETF was invented in 1993. Therefore, the mutual fund industry has had a 65-year advantage for marketing to investors and raising capital. Before the 90s, you're only way (as an average net worth individual) to get access to a diversified portfolio of equities/bonds was through a mutual fund. For this reason, mutual funds have historically been the bridge that have brought people to saving for retirement. They have been granted access to manage millions of people's 401k and savings accounts. The largest mutual funds employ thousands of salesman to promote their portfolios to the average Joe and local financial advisor. Again, this has all been happening long before passive indexing was created.

We currently sit in a world where a lot of the capital in mutual funds has been tied up. It becomes a tricky situation to renovate the 401k system and allow ETFs to overtake all responsibilities held by mutual funds. However, we have seen more wealth managers opt to put their clients' capital into passive indexes over active management -- hence, the recent capital inflows into ETS, away from mutual funds. The internet has also made information much more accessible to the average Joe so a few Google clicks can show regular individuals the advantages ETF investing has over mutual funds. The time it will take for mutual funds to lose most of their capital will take much longer expected due to the fact that they've been the historically preferred framework for mass-retirement savings. However, as the boomer financial advisors and money managers retire, the younger and more aware-with-the-times professionals will quickly reshape the way long-term investors deploy capital into the public markets.

All this to say, I almost personally wish mutual funds added more value than they actually do. The industry has been quite lucrative, especially for the better work-life balance than other finance fields like investment banking or alternative investments. Also, your literal job is to pick stocks which can be very rewarding and exciting in itself. However, it is clear the glory days of the industry are well behind us and all I can do now is look for a better opportunity in a different finance field.

Twisting your mind and smashing your dreams
  • 3
Mar 18, 2022 - 9:40am
Patrick Bateman's Videotapes, what's your opinion? Comment below:

In my opinion, the funds with the highest positive active exposure will likely be the only ones who could potentially add any value.

The funds that operate with a long-term Buffet-approach and only hold 5-10 companies in their portfolio have the opportunity to offer clearly differentiated returns to the market (for better or worse). Large stakes in a few firms are much better than small stakes in many firms. If you believe yourself to be such a sophisticated and savvy investor, you should be confident in knowing that there are only a very small amount of compelling investment opportunities in the market (since after all, markets are relatively efficient). Big stakes and a small portfolio guarantee that you will be able to outperform or underperform the market by a much larger degree, potentially allowing you to justify your higher fees relative to passive funds.

When you think about it from an institutional perspective, what is the need for active investors to offer diversification? Most institutional investors already are invested in a multitude of ETFs and passive instruments so they are already well diversified. The only reason why investors will put their money into active funds is for the possibility of outperformance. They understand its an uphill battle to achieve alpha so they are only allocating a smaller portion of their AuM to this unlikely cause.

When these investors gamble on active management, they're looking for quality over quantity in assets. There is virtually no reason to pay an active manager to hold 30 stocks long-term, their performance is guaranteed to essentially match the S&P minus the fees paid out. Studies show after holding about 18-25 stocks, you are diversified almost to the same degree as the market.

Dorsey Asset Management is a great example of a fund that prioritizes large active exposure over dreadful diversified asset-aggregation strategies that the Fidelity's and T. Rowe Price's use

Mar 18, 2022 - 10:02am
marketMergerMaddie, what's your opinion? Comment below:

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