Wealth Manager

Results, in other words, may vary when
it comes to analyzing active and passive
funds. That’s the message in a research
study co-authored earlier this year by
Matthew Rice and Geoffrey Strotman of
the Chicago investment consultant DiMeo
Schneider & Associates. “The Next Chapter
in the Active vs. Passive Management Debate”
(available at DimeoSchneider.com)
crunches the numbers in a way that may
surprise even the most dedicated fans of
indexing or active management.

Consider, for instance, one of the bedrock
arguments in support of indexing:
The benchmark beats the average active
manager over the long run. Yes, but as the
DiMeo Schneider paper reminds, that’s the
opening statement to a longer story. True,
over the past 10 years, indices have generally
enjoyed superior performance over
the median active manager during bull
markets. But during the periods when the
bears held sway, the median active manager
outperformed the respective indices
on a relative basis, the study finds.

Rice and Strotman also report that over
the past decade, 90 percent of top-quartile
active mutual funds suffered at least one
three-year period in the bottom half of
their peer-group performance ranking.
Meanwhile, the overall break-even point
for active versus passive funds for 17 investment
strategies is the 48th percentile,
lending support to the idea that indices
are tough to beat. But looking at the 17
strategies individually shows that the
break-even point varies quite a bit, implying
that indexing holds more—or less—
promise, depending on the market under
discussion.

The point is that weighing active versus
passive management isn’t always cut and
dried. Yes, index funds are sometimes the
superior choice, Rice told Wealth Manager in
a recent interview. No wonder, then, that
DiMeo Schneider uses passive management
in its oversight of some $25 billion
of assets for its institutional and highnet-
worth clients. But the passive choice
isn’t exclusive. Indexing, for all its power,
isn’t always and everywhere the compelling
choice, Rice adds. Deciding when it’s
better, and when it’s not, he explains, is a
function of several factors, including the
fund choices, the fees and the dynamics
and challenges of the target market.

Pre-emptively choosing active or passive
may make portfolio management easier,
but smart investing implies keeping an
open mind, the firm’s study suggests. For
some thoughts on why, we recently talked
with Rice, a principal at DiMeo Schneider
who holds a CFA.

Q: Your research finds that active managers
typically underperform their respective
indices during bull markets and outperform
in bear markets. Why?

A: There are various reasons. One is that active
managers hold cash, and so they’re
buying and selling stocks. The cash position
might be 3 percent cash, it might be 10
percent. But holding cash when markets
are rising is a problem. Conversely, when
markets go down, holding cash helps outperform
the index.

Another reason: Indices tend to be momentum
driven. The bigger get bigger in
cap-weighted indices. At one point, ExxonMobil
was a massive holding in the
Russell 1000 Value—I think it was as much
as 8 or 9 percent, if not more. A manager
who underweighted Exxon was at a higher
risk of underperforming when the stock is
going gangbusters.

Q: Your study finds that the trend of active
outperformance in bear markets and
underperformance in bull markets held
across various asset classes, including
domestic and foreign stocks, bonds,
REITs, and so on.

A: It did, although we’re talking here of
the median manager. If we break it out for
top-quartile managers, you might not see
underperformance against the index. Even
so, the trend is still true in terms of relative
performance in that the top managers
tend to do better in down markets than in
up markets.

Q: What lessons does your study offer for
designing and managing multi-assetclass
portfolios?

A: One is that the active/passive debate
shouldn’t focus on active managers versus
indices. Rather, it should be active managers
versus index funds. The reason is that
index portfolios have trading costs, management
fees and cash flows. Depending
on the target market, indexing may be
relatively easy and cheap—large-cap U.S.
equity, for instance. However, some categories
can be implicitly or explicitly expensive
to index, such as emerging markets and
U.S. intermediate bonds. In 2002, for example,
the Vanguard Total Market Index Fund
underperformed its bogey, the Lehman Aggregate
Bond Index, by 200 basis points because
there was a shortage of liquid energy
and telecom bonds at the time.

If the only choice for an index fund
is one with an expense ratio of 50 basis
points or higher, paying an active management
fee might be worth considering.
The bigger factor is finding good active
managers. But if you’re looking for managers
who will outperform an index, and
you’re defining outperformance in terms
of three to five years, you’re going to fail.
Our study shows that 90 percent of tenyear,
top-quartile managers across 17 asset
classes fell below the median return over
an interim three-year period.

Q: And that suggests...

A: You’ll end up hiring managers when
they’re hot and firing them when they’re
not. The key is understanding your manager
and the investing process. Before you
hire a manager, you should know when
he’s likely to outperform and underperform.
Sometimes people blame the rooster
for the sun coming up, or they give the
rooster credit for the sun coming up. For
example, some managers avoid certain
sectors, like energy or utilities. It’s important
to know such things. If you know
your managers and understand what
they’re doing, you’re more likely to stick
with them during those inevitable lulls.
Virtually every manager will have lulls—
it’s when, not if.

Q: Your study identifies the general breakeven
point for index-based versus active
manager-based portfolios across various
asset classes at the 48th percentile.
The implication: Use index funds unless
you’re confident you can find active managers
who will perform better than the
48th percentile.

A: That’s been the case if you look at the last
10 years without adjusting for survivorship
bias. Of course, it varies from category to
category. For example, for midcap value
and large- cap value the median manager
struggled [compared to the index]. In other
cases, like large-cap growth, the median
manager did well. But if you look at the
next 10 years, these numbers will not repeat;
it could be the exact opposite.

Ultimately, chasing alpha is a zero sum
game around the market’s return. For every
alpha taker in active management, there’s
an alpha giver. The extraordinarily bad
managers are providing the alpha opportunities
for the takers. The one thing that
makes me feel pretty good about active
management is that there have been, historically,
extremely bad managers and that
means that someone else is making money
around the market. If there are enough extremely
bad managers, and you can avoid
them, you’ll increase your probability of
success [for picking good managers].

As important as it is to find good managers,
it’s more important to avoid bad
managers. If you’re hiring an active manager,
you must think there’s at least a 50
percent probability that he’ll outperform.
The problem is that you need to have a
higher confidence than 50 percent—you
need 75 percent, 85 percent, 95 percent.
And that confidence doesn’t come from
just looking at historical numbers. You
have to understand the reasons why you
think a manager will do well going forward.
Does the manager have some proprietary
capability? Does he have access to
information that others don’t have? Is the
manager simply smarter?

Q: What do you make of the various studies
that find that active managers have a
tough time beating the market?

A: The probabilities are that the longer the
time period, the lower the probability that
the active manager will add value. Over the
long haul, it’s about 50/50—half of active
managers outperform, half underperform.
If you factor in a 1 percent fee over time,
the outperformance ratio slips further. In
fact, adding 1 percent of outperformance
over the market [in the long run] requires
skill. If you factor in a 1 percent fee, and the
expected alpha’s 1 percent, you’ll need that
skillful manager just to break even.

Past performance is a poor predictor
of future performance, but past fees are a
great predictor of future fees. You should
seek out those managers with low average
fees because the probability of success
dramatically increases with lower fees.

Q: Sounds like an argument for index funds.

A: Index funds, or low-cost active managers.
Another option: Enhanced index funds
with low tracking error to the benchmark
with relatively low fees and a high information
ratio.

The bottom line: If you’re paying a sizable
fee every year, it’s a tough road to hoe
over longer periods.
But we don’t worship at the altar of
passive managers. This is all about trying
to maximize your probability of success.
First and foremost is getting the asset
allocation right. Second, make sure you
don’t bleed alpha by selecting the wrong
managers. It’s more important to avoid
the mistakes than it is to pick the very best
managers.