The Only Post About Active Investing You Will Ever Need To Read

All You'll Ever Need To Know About Active InvestingActive vs Passive. Science vs Religion. Republicans vs Democrats. Luke Skywalker vs Darth Vader. Jordan vs LeBron. Cobra Kai vs Miyagi Do. The age-old debate. Although each party has credible points behind its beliefs, they often disregard the opposition's - thanks to confirmation bias. The more comfortable they feel about their actions, the more they discredit the opposing side.I always found it interesting that some of the most educated people in finance with CFAs, MBAs, and PhDs have continued to disagree on a simple question: is it worth it to pay a professional to pick stocks/bonds for you?

In order to reach clarity on this issue, I found it necessary to scour the internet and academic studies to understand both sides of the argument. By doing this, I've learned more than I ever could about the different strategies, as well as when certain media outlets may be bending the truth to fit their own agenda. When it comes to investing, it is certainty true that the news headlines cater more towards individuals than institutions when making arguments -- which is probably why there is more coverage into passive investing than active investing. In order to figure out why, and to build a genuinely wholistic understanding of the industry, here is everything you need to know about active investing.

Who and What Is Active Investing?If there's anything to be learned about finance, it's that active investing has consistently attracted many of the brightest and most talented investment bankers, equity research analysts, sales & trading analysts, and other professionals on Wall Street - mainly because it offers both the highest levels of autonomy and the highest ceilings for total compensation (for those who reach the senior levels). It is one of the few roles where industry experts can prioritize using their business acumen to generate attractive investment returns instead of capital raising (a.k.a. selling), or marketing/catering to potential client needs or mandates.

As with most careers, active investing comes in all shapes and sizes and it often is tailored to the industry expert/individual. Active investors include but are not limited to the following: mutual funds, hedge funds (long-only, macro, event-driven, arbitrage, long-short, credit, quantitative, etc.), private equity firms, and real estate funds. In other words, any type of investment fund that employs individuals to make individual investment decisions is considered active; any type of fund that is indexed to a specific benchmark and does not deviate from that exposure is considered passive.Although the flavors may vary from fund to fund, each active fund's performance is measured relative to a benchmark. It is the active investors' goal to deliver a better risk/return ratio than its benchmark, net of fees. For the sake of simplicity, this post will focus mainly on the topic of public market returns (i.e., performance that can be measured in real-time that consists of publicly traded companies and REITs). However, the following core concepts are still fully applicable to private equity, credit, and real estate firms as well, except their asset classes/benchmarks are materially different than, say, the large-cap S&P 500.Active Investors Will Always Underperform. Given that the best talent flows to the active investing space, you would expect their returns to be greater than that of any average (passive) fund. However, as many know, rather than outperforming, the majority of active investors underperform over long-term horizons.

Ever since the 1960s, evidence has continued to confirm that 85-95% of active funds will underperform the S&P 500 over 10 years.To fully understand this occurrence, here are the main explanations:Theory of Reflexivity: When thousands of experts set out to seek compelling investment opportunities, it becomes incrementally more difficult to find them. George Soros is credited with this idea, as it basically hints that when one finds a successful investing strategy, many will catch on and try to replicate it. Once it has been replicated enough, it no longer works. A great example of this is how Ben Graham's once successful strategy to find companies trading below their liquidity values (net cash balances + short-term assets) is now merely impossible to follow. Today, all companies' market caps are greater than their net cash balances, thanks to the thousands of experts who've read Ben Graham and understand why those companies would be blatantly undervalued and poised for a price appreciation if they were to ever come across them. Now, since the "no-brainer" investment opportunities like Ben Graham's have washed away, the modern strategies rely more (though not all the time) on subjective valuation than objective certainty it's undervalued (which is still fine in the active space but clearly less easy to find alpha). The other issue arises when a fund has a successful strategy, many of the portfolio managers and other employees may become tempted to leave the fund and start their own funds; which will dampen the competitive advantage that the mothership fund once had in the market.

Asset Elephantiasis: Assuming that a fund is able to keep its investment strategies inside its walls, and is consistently successful, the next issue becomes the effect of too much capital. It is well documented that whenever a mutual fund or hedge fund experiences exceptional performance for a given time, many investors will flock to hand over as much money as they can to the fund. Initially, this may appear favorable for the fund managers since they will be able to incur higher fees from the assets they manage but it has a dampening effect (in fact, nearly inverse relationship) on performance. Even in the most liquid asset classes like public equities, there is a limit to entering and exiting positions in the market. To any Ozark fans, think about how much more difficult it would be for Marty Byrde to launder $500 MM of cash through the casino rather than only $50 MM. The same is true with investing into stocks, especially smaller-cap ones where a size-able investment could materially increase the purchase price (hence, reducing the fund's cumulative returns when they exit). This occurrence is also partly why Jim Simon's Medallion Fund has been able to maintain its excess returns: they refuse to accept more capital and keep their assets under management below a certain threshold.

Benchmarks Will Always Include The Winners: In the U.S., many active funds, by their own desire or someone else's, have been benchmarked to the S&P 500. The problem with the S&P 500 is that it includes the largest cap firms in the U.S. Empirical evidence shows that the top 5 companies (AAPL, MSFT, AMZN, FB, GOOGL) account for 20% of the index, and drive even a larger percentage of the index's annual performance. These companies have had experienced incredible growth through the past decade, making it more difficult for active funds that do not hold these companies in their portfolio to outperform them. Essentially, many funds need to find investment returns that are more size-able than some of the world's most profitable companies. Of course, they can always add active exposure to FAAMG to mitigate this issue but not all active fund strategies benchmarked to the S&P 500 are aligned with investing in high-growth blue-chip stocks.

Changing Trends/Popularity: As mentioned above, large-cap growth stocks, especially in the information technology sector have been the most popular among investors in recent memory. Some of these same firms have been, at worst, avoided entirely and, at best, tolerated by value investors, a group that had seen rampant success during the 1930s - 1980s. Is value investing no longer productive in today's market or will it become more favorable in the years to come as the market environment shifts? The only certain answer to questions like this is: markets continuously change. A simple look back to the Fortune 100 companies of the 1960s would show that it would've been more beneficial to be a industrials/utilities large-cap investor than a small-cap healthcare investor. All this to say, a common challenge for the long-term performance of active investors is how will their strategies perform in the market 10 years from now? What about 20 years? Will their strategies still be as effective in an entirely new environment, and if not, how will they adapt to the market to ensure they are beating their respective benchmark?

The Other Side of the Trade (Efficient Markets): Assuming that a fund is able to maintain its secret sauce in an ever-changing environment, they are still essentially taking on a bet with the other side. As learned in many finance courses, the efficient market hypothesis suggests that stock prices are trading at a market equilibrium where 50% are buying and 50% are selling. This price reflects the market's best guess into the underlying value of the company at the given time and any changes in price from therein after are a result of new information flows. Although the efficient market hypothesis is a valuable framework for asset managers and personal investors, it is not true in practice. There are various reasons that confirm markets are not entirely efficient but rather relatively efficient (Dot-com bubble, Gamestop meme 2021, 2008 financial crisis, CUBA fund, Ben Graham net liquidation value). Moreover, a stock's price may not always reflect its true value, provided that all strategies baked into the price are not effective. For instance, a stock's price is at a crossroads with all sorts of investors such as high frequency traders, fundamental value investors, growth investors, momentum traders, day traders, and other alternative strategies. Therefore, the price could deviate from the intrinsic value of a company for a given time due to increased trading volume from quantitative or momentum traders, or misjudgment from fundamental investors themselves. As an example, many mutual funds are required to maintain certain levels of exposure for each holding so whenever a holding appreciates "too much" in value, they are forced to shave their holding to recalibrate to their mandated weighting. This action may cause the stock price to fall regardless of whether the fund believes the company to be at its true value. However, even so, it still remains difficult to beat the other side of the trade consistently. As Warren Buffet says, "the markets can stay irrational longer than you can stay solvent" so even if you know with 100% certainty that the other side of the trade is wrong, there is no guarantee they will realize they are wrong before the time you need to exit your position. A great example of this occurrence is Dr. Michael Burry's investment into short-selling credit default swaps on subprime mortgages in 2005-2007. The Big Short novel gives a great description of this challenge as well as the movie. Fortunately, it worked out for Burry but it did strain his relationship with many of his investors and he faced worries of insolvency before his thesis came into fruition.

Fees: By far, this can be the most detrimental to returns, especially if pre-fee performance for an active fund was the same as it's respective index. For an active fund, typical fee structure has been 2% of assets under management and 20% of annual performance (usually above a certain hurdle rate). If an active fund does not handsomely outperform the benchmark on a raw basis, it can eat heavily into net returns for the limited partners (LPs) relative to the passive alternative. Because of this underperformance, fee compression has ramped up and the 2-20 model has been becoming less popular than it once was when A.W. Jones created the first 2-20 fee investment fund back in the late 1940s (when there was nothing like it's kind and now accessible passive alternatives)

Why Does Active Investing Still Exist Today?
Up until this point in the post, the outlook for active investing may seem more pessimistic than it actually is. In fact, most institutions with billions of dollars of capital to deploy already know everything that was mentioned above (at least the competent ones) so why is it that we continue to see headline after headline about the overwhelming shift from active to passive investing? Or why would investors want to invest in funds that are essentially guaranteed to underperform their less-expensive passive counterparts? Here's the core reasons we still see active investing today:

Risk-Neutral Strategies: Given that the grand majority of limited partners (customers) for active funds are either pension funds, insurance companies, ultra high net worth individuals, or other large institutional investors, their appetite for risk and return is vastly different from the average American citizen setting aside 20-30% of their income for retirement. Many of these LPs (pension funds & insurance firms) have long-term obligations/liabilities on their balance sheets. They need to preserve capital more so (and take less risk) than a traditional "long-term" individual investor but wouldn't like this capital preservation to be at the expense of capital appreciation. In other words, these LPs want access to a product where risk is not mutually exclusive to return; a product that offers a diverse portfolio which both protects against market volatility while still being able to capitalize on positive trends. Considering the demand for such a risk-neutral product, it should be no surprise that hedge funds (one of the most common active funds) underperform the market: they are designed to. Many hedge funds practice strategies where they take on both long and short positions in the market to mitigate market volatility. Ultimately, this may allow them to increase their "Sharpe ratios" (better returns for less risk). As with any investment strategy, hedging can come in all shapes and sizes and it can often vary for each customer and their own objectives. The largest hedge funds such as Citadel, Millennium, and Point72 offer multi-manager strategies that use several different styles with various asset classes in hopes to offer better diversification in any given market environment. Other funds go so far as to offer an absolute return mandate that aims to return a positive % regardless of any market condition (recession or expansion).

Marketing: Because many hedge funds practice risk-neutral and absolute return strategies, they are not permitted to market to the average household or individual. The U.S. government has set restrictions on the total net worth needed to invest in a hedge fund. Therefore, most average net worth individuals do not have access to hedge funds, and even if they did have access, it would not be the most effective use of capital to reach their long-term retirement goals. Instead, if a common investor wants exposure to an actively managed fund, they are permitted to invest their capital into a mutual fund. Mutual funds, unlike hedge funds, are more highly regulated by the government in order to essentially protect common investors from themselves. The greatest difference between mutual funds and hedge funds is the fact that mutual funds cannot use derivatives or short-selling instruments; rather, they must only have "long-only" exposure. The biggest mutual funds today, such as Fidelity, Vanguard, and T. Rowe Price, market heavily to household investors. They employ thousands of sales reps in effort to manage a household's money. They are more transparent to investors with their methodologies and they usually do not have a lock-up period, meaning an investor can withdraw their capital at any point in time that they desire (hedge funds usually have lock-up periods).

Where is Active Investing Headed Tomorrow?Thanks to the internet and innovations like the ETF (exchange-traded-fund), common investors now have better access to information, as well as more investment options, than they did merely two decades ago. As a result, the landscape for investing has continued to change - most notably with household individuals. Given that capital can only flow to an active or passive fund, the investing style environment has become a zero game. A dollar that flows into passive funds is a dollar taken away from active funds. In recent years, there has been an overwhelming flow from active to passive. Here are some of the key points that are driving this shift, as well as what can be expected in the future:Mutual Fund Industry: Since passive funds merely track an index, they are able to offer significantly lower expense ratios than their active counterparts. Given that active funds underperform passive funds, the value proposition for active mutual funds does not look as favorable to the common investor. If your goal is to retire and save the maximum amount of money (without taking on extra risks), why not place you're money into an ETF that is virtually guaranteed to outperform any money manger's fund (that you have access to)? As a result, the industry that has been hit the hardest by this trend has been the mutual fund industry. Before the advent of ETFs, the only way for an average investor to gain exposure to a broadly diversified portfolio was through mutual funds. Nowadays, it's as easy as downloading a brokerage app onto your iPhone and buying the S&P 500 ETF in real-time. It is likely that capital will continue to flow from the mutual fund industry into the passive/ETF industry as households wisen up. In order to maintain some form of a value proposition for their largest customers, mutual funds have undergone three courses of action (and time will only tell which are successful):Fee compression: most of the actively managed long-only portfolios have reduced their fees to be more competitive with their passive counterparts. The fees are certainly still at a premium to ETFs but within a range where investors may be convinced active could still make sense (in certain circumstances)Active exposure: previously, many mutual funds practiced "closet-indexing" strategies where they would essentially mimic an index and only take small stances on individual investments so that they could never greatly underperform or outperform their benchmark - all while collecting fees as if they are a true actively managed portfolio. Today, with strong access to passive funds, mutual funds that will remain in the game are the ones who prioritize positive active exposure (i.e., the funds who take large active stances on individual companies). By nature the greater the active exposure of the portfolio (the lower amount of holdings), the less correlated the fund's performance may be with the index. In other words, investors are getting more value for their higher fees since these funds are actually taking stances on companies and their performance could more greatly outperform (or underperform) their passive counterpartsPrivate Investments: Lastly, many mutual funds have begun to deploy more capital into private investments like private equity or real estate firms. Their goal here is to convey to the investor that they are more diversified and sophisticated than a traditional long-only public equity portfolio. However, academic studies (Jeff Hooke, Johns Hopkins) have shown that private equity and real estate funds have more or less returned the same as their public counterparts. The only difference is that these private funds are not marked to market but rather only have to release their valuations on a quarterly basis (which is usually done by either themselves or a trusted third-party). The end result is that at times private funds can appear as less correlated to public funds in the short-term (not long-term) and they look and sound more sophisticated to the common investor.

Hedge Fund Industry: As for the more sophisticated investors, hedge funds will likely remain a strong alternative investment choice. Large institutional investors are certainly deploying more capital to passive funds but they will always demand exposure to active funds as well. In some ways, active funds may serve as insurance policies to institutional investors that protect them from strange market environments - and in other ways, these hedge funds merely add to the overall diversification benefits of the institutional investor's portfolio. As far as alternatives for hedge funds go, the studies show mixed results. Specifically, MIT analyzed whether hedge fund risk/returns could be replicated by a mix of stocks/bonds. The results demonstrated that hedge fund returns were often superior to the cloned portfolio mix. However, the research also suggested that the cloned portfolio mix did a relatively "good enough" job of capturing similar risk exposure to that of many hedge funds - so much to the point that they "warrant serious consideration as passive, transparent, scalable, and lower-cost alternatives to hedge funds." Therefore, the value proposition of the hedge funds is very contingent upon the investors' preferences and how they value the premium to be paid for hedge funds. An important note is that it's evidently easier to mimic historic hedge fund returns using a clone portfolio looking backwards than it is looking forwards. Maybe the last decade required 30% bonds to match the risk profile but the next might need 40%.

Passive Is Not The Enemy: In recent years, there have been growing concerns (mainly from active investing proponents) over the possibility that too much capital into passive funds will produce greater market inefficiencies. In theory, this belief is true but it might be over-exaggerated. Jack Bogle, founder of Vanguard, cited that even if active trading only represented 10% of trading volume, markets would be able to function (relatively) efficiently. For many reasons, it is impossible for passive to ever fully reach 100% of trading volume. Therefore, an influx in passive funds will likely coexist with an active market. Currently, the trading volume associated with passive funds purchasing more holdings is anywhere from 5-10%. Another 50-60% of trading volume is from high frequency traders which would leave pure active trading in the 30-45% range. At this volume, it is likely that active will continue to influence the equilibrium of every stock price; albeit periods or moments where prices could appear to move solely based on index buying. Additionally, over time, the "closet indexers" and other incompetent active investors will be weeded out in favor of their cheaper passive counterparts. The active investors who remain in the market will possess greater active exposure and more differentiated strategies. Overall, many outlooks may be unclear into the dynamic between active and passive but the evident truth is that neither will destroy the other. Passive is dependent upon active. Even with greater passive weightings, the battle will mostly be active versus active (albeit different active strategies which could lead to mis-pricings in itself).

Conclusion: It is clear that passive funds have taken market share from many of their active counterparts. Markets will continue to be relatively efficient and it will forever serve difficult to consistently beat an index over a given period of time. Nevertheless, emphasis for active funds should be placed on their risk/return profiles rather than just simply net returns. Hedge funds will continue to generate demand from institutional investors looking for an insurance policy to mitigate against market volatility.  The active funds that could face the most pressure are long-only mutual funds, as their risk/return profiles are easier to replicate with passive funds. The greater the active exposure, the more compelling the value proposition (and less correlated risk/return profile to the market). In the coming years, investors will likely pay greater attention to active exposure before they decide to invest their capital into a mutual fund over its cheaper passive alternative.