Why Active Managers Can't Beat the Market Benchmark
These are my thoughts, please comment yours.
The idea is collective wisdom.
Let's call the market a collective. Here, the sum of investor expectations are aggregated and a net vector or final expectation is given. Law of large numbers. If the aggregate collective has sufficient size, the net expectation will be far more accurate than taking a subset of the investors and comparing it to the mean. So, since bechmarks have so many participants, there is so much knowledge being aggregated into a "best estimate" that it becomes very accurate. It's almost as if we flip a coin 10 vs 100 times. The chances of heads / tails are the same, but to which can we be more confident in to equate to the expected value? In other words, sampling error becomes larger when samples are smaller. In bechmarks, the samples are huge and therefore "the market" relays more accurate information than it's average participant. Why? Because the "market" takes all participant's expectations into account which makes them very accurate. Active managers may be smart, but they don't have the advantage that markets do which is the power of large sample aggregation. These active managers usually underpreform because they can't take as many opinions into account. Very similar to Hayek's economic calculation problem which critiques socialist economies by arguing that you can't plan economies since markets account for so many subjective preferences that they can output efficient levels of price and quantity. If any one planner were to try and guess supply and demand, no matter how smart they were, they wouldn't be able to out-plan the market. To me, these ideas are very similar. Afterall, the past 2 years have shown us that both retail and hedge funds can really struggle to beat the alternative of parking their money in an index and chilling out for a while. The more you try, the less you'll have.
Although it does seem to be the case in EQ, how do you account for FI active mgmt typically outperforming benchmarks? As an example, PIMCO outperforms their relevant benchmarks 92% of the time over a 5 yr period. I've read that most active FI managers outperform their benchmarks routinely (industry something like 80% over 5 yrs). This has always interested me as the FI markets are far more complex then the EQ market. Perhaps that's the overarching reason. My assumption is there are many alpha plays that are missed /lost when mimicking indexes in FI. Not sure why the same isn't true in EQ. I've heard it explaind in FI that the challenge with passive is PM is required to hold certain asset classes and very little leverage so they have to just own all the crap vs. picking winners and levering alpha. Of course that requires tremendous research strength. Thoughts?
Thanks for your reply. Excellent point about fixed income asset managers, and here’s what’s more. Why on Earth do non-central bank buyers purchase negative yielding debt? The market for this is in the trillions. 2 answers come to mind. 1) if rates decline even further you can profit off of price increases of bonds, so even if your principal is being chipped away by the negative coupon, you can still profit, and 2) To fulfill portfolio diversification or other mandates. I think also it comes from the fact that central banks are buying most of bond issuances and that yields are so much less attractive, the markets for FI are more predictable with a macro view. So there will be profit opportunity because the “benchmarks” aren’t really people trading information as much, but yields are nowhere close to what an efficient market would price them at without CBs massive QE programs. This doesn’t fully answer the question though. Largely, I suppose bond markets will be trying to guesstimate what J Pow will say every meeting, so if you have some people even in the know how, like PIMCO has Bernanke on their board, it might leave room for excess knowledge to generate profit. Bottom line: bond markets may have excess profits because if you understand central banking, it becomes easier to predict, but because yields are so low, most investors may not see those profit opportunities as worth taking since putting your time and knowledge into equities would be worth more. Ironically, you’d still be better off putting your equities in SPY rather than giving it any time and knowledge.
> Why on Earth do non-central bank buyers purchase negative yielding debt?
Liquidity management or something of the like? Not everyone wants or needs to speculate
Isn't what you've just described basically the semi-strong efficient markets hypothesis?
Yes and no. The hypothesis states that markets give prices at optimal levels, but doesn’t explain why active managers lag, because if active managers simply chose a random bag of stocks, those stocks would be perfectly priced and if they were part of the underlying benchmark, it would be 50/50 if they’d go up or down comparatively. In reality most hedge funds and retailers lose compared to the market, but given this theory, I think we’d expect to see it not matter if you go active or passive since both will be priced with equal efficiency.
I think it needs to be considered in the active vs passive sense, that the entire market is owned by active and passive investors, so even if it was a perfect split, the fees and transaction costs of active investors lowers their net returns when comapred to passive investors. So in a sense, even making choices that result in the same gain, the end result of these active investors is they are already at a disadvantage. Then again, past data doesn't dictate future outcomes so who can really speculate? That being said I haven't broken into the industry yet so take my thoughts with less than a grain of salt.
OP you are over thinking it
Active managers will usually underperform in bull market because the vast majority of the real money community are not momentum traders & they are not chasing or don't own the high flyers in the index e.g. TSLA / NVDA / MRNA / mid-cap E&Ps, etc. last year, so they will underperform when there is exuberance in the market. There are also biases to take profit and lock in gains / bonuses for the year early which also leads to U/P in a bull market.
And vice versa, active managers tend to outperform in a bear market for the exact opposite reasons. Active managers are more risk averse and have an incentive to limit losses / protect AUM and fees, so in a down market they tend to O/P.
It is easier for fixed income active managers to outperform the market because they can take more risk vs. the index. The benchmark fixed income index for example (LQD) consists of 1.7% AAA, 8.0% AA, 40.2% A, and 49.4% BBB-rated bonds (balance is in crossover & other). By simply owning a larger proportion of lower-rated / higher yielding bonds, you will outperform over the long run (because you are taking more risk).
Allocators care as much about performance vs. peers as they do about performance vs. the market. And at the end of the day, no matter what, 50% will outperform the group average and 50% will underperform.
I think it is possible that the risk premium will have a bit of impact here? Institutions and funds might have more consideration and awareness in risk management, so their risk premium is different from less skilled individual investors. Also, under the government regulation and the supervision of compliance department, they might have less degree of freedom than individual investors? It's just my personal opinion and I am not sure how wrong my opinion is. Thoughts?
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