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?
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.
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.
And P72 fires as many associates as all large LO AMs combined too.
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:
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
Thanks! The aforementioned articles are in my signature.
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?
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.
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.
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.
Can you please explain?
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.
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.
A LO AM may underperform the SP500 for a bit, but won’t investors be happier IF the beta of the portfolio is less than the stock market? That would be mean that downturns in the market wouldn’t affect them as much. Obviously, if the fund engages in closet indexing that means the beta will be the same but I thought retirement accounts need wealth preservation?
No, since all types of beta are cheap and available through passive instruments.
It’s as simple as buying the utilities (XLU) or staples (XLP) index, given both offer large-cap low beta exposure at a fraction of the cost of active management.
Many L/S hedge funds try to produce “uncorrelated”zero beta portfolios but that is a whole other can of worms and not on the agenda for long-only’s
Active management definitely makes sense for small caps, illiquids and emerging markets.
Whether it works for developed large caps without insider trading, etc, only the finance gods know.
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.
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.
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
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
Do you mind elaborating on this? I’m curious what you mean by areas LO AM wasn’t in previously.
Why wouldn’t pensions dump their money into ETFs?
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.
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.
Russia sanctions earlier this year effect on Global funds is a perfect example of this
Exactly.
To take it a level deeper, an active FI manager looks at the whole debt structure of a company and can partake in specific offerings vs. a stock. A stock is a stock (yes I get there are options and leverage). But within FI, company X may have 10 different bond offerings (different durations, yields, terms, etc.). Being active lets you get far more granular than a passive index say in HY, IG, EM, etc. You can get overweight duration, country, credit, agency, etc.
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.
What are your thoughts on working at a more boutique AM that can deliver more value on fewer but more concentrated high conviction bets?
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
What are your thoughts on the sticky assets that are stuck in the Fidelity's and T. Rowe Price's? Both of those companies are largely built on managing the 401(k) plans, 529 plans, and institutional retirement plans. These assets are unlikely to leave large active managers any time soon, although I think some trends within this space are emerging (for example, a shift away from target-date funds).
What I'm trying to say is, despite the efficiency that could exist by having large institutions move their money to passive, this has yet to happen for the firms you list. Do you think there is a point where these firms really will be left behind, or do you think the client service teams and sales' forces of these businesses alone will keep them strong? Or do you think something else entirely?
That’s an awesome question. In short, I’d say that the mutual fund industry has been so far ingrained in retirement accounts that it seems impossible to be wiped out entirely — however, I personally wouldn’t bet my career on it.
Given that fidelity and the like have thousands of salesmen aimed to push their products down the throats of 401k plans, they definitely have an upper leg to maintain these relationships. It is likely that the mutual funds have made sweetheart deals with each employer to ensure that it’s employees exclusively use their mutual fund products.
This puts us as employees in a tough situation: we know low-cost ETFs are much better investments but we also want to invest in our 401ks for tax deferrals and company-match policies. Therefore, most of us know investing in fidelity-conspired 401ks are still better than nothing. I feel this is how fidelity makes its bread and butter. Most employees (besides people on this site) literally have no idea wtf the difference is between an ETF and mutual fund, or how they’re getting ripped off. Even the ones who do and tell their employers will face a brick wall — since your employer very well has an incentive to upkeep the mutual fund plans.
It looks like a never-ending cycle of high fees in my opinion. However, there’s no telling what happens in 20-30 years if there’s more government scrutiny or a widespread awareness amongst individuals. In either scenario, I would expect fees even for the mutual funds to drop to be more competitive with Vanguard. This possibility, coupled with the fact that you add quite literally no form of value working at a mutual fund, is all the reason why I have no interest going into the industry.
Your understanding is more or less correct IMHO. A few things though.
1. Few professions aren't some sort of shell game where you are trying to piss on the customer's head and telling them its raining so you can sell them an umbrella. IB, consulting, law, much of corporate . . . very high degree of bullshit in these fields.
2. Even medicine, a field many consider to be an example of real value add, is overflowing with waste and people being paid multiples of what they've created for others. The American Medical Association's primary function is to serve as a cartel to keep doctors under-supplied and expensive. Not to pick on medicine, just pointing out that the least bullshit field out there is still full of it.
3. Since you quoted Asness, worth pointing out that fundamental long-only will never be remotelythe snake oil industry that factor-based investing is. AQR, DFA, and others like them are selling essentially index funds for multiples of what Vanguard/iShares charges. The mental gymnastics they do to convince you that somehow you should pay for "risk exposure" via "factors" is IMHO the biggest scam in the industry. That's why they need all those academics to be the face of the firm. Only the most trusted presenter imaginable - an old man standing at a chalkboard - could get away with selling something so ridiculous.
4. So at least as a long-only, you're trying to achieve alpha for your clients, which is more than many can say. Sure it doesn't work out on average, but so what? Is the goal to be average?
Nonetheless your point is well taken that its a zero sum game. You can't go into it with a mindset of "my industry creates X amount of pie and some of it will be mine." Mentality needs to be more of, it's a game designed for most people to fail and few people to benefit greatly at their expense.
1) EMH is an hypothesis
2) Most acquisition destroys value so IB isn’t that value adding either
3) without fundamental investors the capital market can’t function
I think the question is how many active investors are needed to maintain efficient markets; Jack Bogle did research theorizing that only 10% of current trading volume needs to be active for efficient markets.
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