Active management deserves all the criticism it gets. After all, over 80% of equity managers underperform their benchmarks over the long-term and active managers charge vastly higher fees compared to passive indices.
But active management also gets a bad rap. There are many active strategies that perform very well over time, and justify the fees they charge.
How can both of these conflicting statements simultaneously be true? The answer lies of the definition of the term “active management” and the many ways that active decisions can be applied to equity investing.
But before we talk about the different types of active management, it is first important to look at its opposite and define the market portfolio. A true passive equity investor would hold the global market portfolio. They would invest in all equity markets around the world in relation to their size, and own individual positions within those markets in proportion to their market capitalizations. From a practical standpoint, this is very difficult to do, but there are funds out there that can get you very close.
Although the true market portfolio is a global one, for the purposes of this article I am just going to focus on the US market to simplify things. The true US equity market portfolio would follow the same principles, though. It would hold all US companies, weighted based on their market capitalizations.
If I asked your average investor how I could invest in the US market portfolio, the vast majority of them would tell me that the best way to do that would be via an S&P 500 index fund. And that wouldn’t be a bad suggestion given that the S&P 500 tracks the overall US market fairly well and it has beaten the vast majority of active managers . But the S&P 500 isn’t the market portfolio.
Despite popular belief, it turns out that the S&P 500 is an active strategy itself. It is constructed using a specific set of active investing decisions, filters and rules.
If we define active management as any strategy that deviates from the true market portfolio I mentioned previously, then the S&P 500, and many other strategies widely considered passive indexes, meet that test. To understand why, I think it is helpful to examine the various types of active management that exist and how each deviates from a true passive portfolio.
Here is a look at the different types of active management ranked from least active to most active, and the pros and cons of each.
[1] The Mostly Passive Portfolio
Despite the fact that most investors consider the major market indices to be passive, all of them are created using active decisions.
Let’s look at the criteria for inclusion in the S&P 500. Here is how S&P’s website describes it.
To be eligible for S&P 500 index inclusion, a company should be a U.S. company, have a market capitalization of at least USD 8.2 billion, be highly liquid, have a public float of at least 50% of its shares outstanding, and its most recent quarter’s earnings and the sum of its trailing four consecutive quarters’ earnings must be positive.
Once those criteria are met, the S&P 500 index committee looks at each company and makes a final decision as to whether it will be included.
So to be included in the S&P 500, a company has to be a certain size, it has to make money, it has to be liquid, and it has to have a sufficient float. And meeting those criteria doesn’t guarantee inclusion. A committee of individuals makes the final decision.
Each of those factors results in some deviation from a true market portfolio. The size requirement eliminates about 15%-20% of total US market cap. The profitability requirement has kept firms like Tesla out. And the committee has the right to keep firms out even if they meet the other requirements (as it may do with Tesla).
None of these are necessarily bad things. As I mentioned before, the S&P 500 beats the vast majority of traditional active strategies over time. And it tracks the true US market portfolio fairly closely since it is market cap weighted and accounts for the majority of US market cap. But given the way the index is constructed, it does practice forms of active management, even if they are very watered down relative to what a true active manager would do.
[2] The Index Reweighting
One of the main criticisms of market-cap weighting is that it results in owning more and more of individual names as they go up. Although this approach has worked very well in the past decade, over the long-term there have been other weighting schemes that work better.
For investors who want a slightly active strategy, but also want to stay reasonably close to standard indexes, utilizing these alternative weighting schemes can be a good option. Some funds within this category take an index like the S&P 500 and just equally weight the positions. Fundamental index providers like Research Affiliates use things like sales, which allows companies to be weighted more based on their economic footprint rather than their market price. Still others use things like value to try to overweight the cheapest stocks within the index. Either way, this type of active management tries to strike a balance between generating excess returns and limiting deviation from the overall market.
[3] The Closet Indexer
Thankfully, this type of active management is falling in popularity as more and more investors focus on fees and net returns. It offers a combination of high active management fees and a portfolio that looks a lot like the passive indexes. Either one of those attributes on their own are not a problem, but when combined they essentially eliminate any chance of generating an excess return.
[4] The Factor-Based Approach
This is the approach utilized by many quantitative investors, including us. The goal of this approach is to maintain the systematic, rules-based approach of indexes, but to use academic research and other time-tested strategies to select stocks that have the potential to generate an excess return over the index. Instead of reweighting an index, these strategies will select different stocks. The advantage of these types of strategies is that they limit the impact of emotions and biases and follow factors that have proven themselves over time. The disadvantage is they deviate further from the index than the reweighting approach, which can lead to poor investor behavior when they inevitably struggle. There is also no guarantee that the factors that have worked in the past will work in the future, so the excess returns that these strategies have generated in academic research may not translate into the real world.
[5] The Human Active Manager
The days of the star manager are largely behind us due to the rise of passive and quantitative strategies, but human stock pickers will likely be around forever. The long-term data tells us that this type of investing fails to beat the market after fees more often than not, but despite those statistics, there still are some great managers out there who add value for investors. The one thing most of them have in common is they are willing to be different than the market, and suffer the periods of underperformance that come with that, in order to generate long-term alpha.
The Elusive Definition of Active
Active management has a terrible reputation these days. And many of these criticisms are well-founded . The record of active managers as a whole certainly is poor, especially when its higher fees are considered relative to more passive strategies. But in reality, almost all the strategies and funds we invest in have an element of active in them. They all have some set of rules they follow that allow them to deviate from the true market portfolio. Understanding what those rules are and the types of deviations they lead to is an important part of understanding any investment strategy. So next time you hear that all active management is bad, keep in mind that all portfolios have elements of active. They just vary in the degree to which they use it.
Originally Posted on September 2, 2020 – The Different Shades of Active Management
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