Do these new factors make actively managed funds more compelling?
Today the index fund debate continues with two posts: One clearly pro-index -- and this from Fidelity Observer -- asking pro-indexers for their response to new factors that make managed funds more compelling. Any takers?
THESE NEW FACTORS MAKE ACTIVELY MANAGED FUNDS MORE COMPELLING
Submitted by: Fidelity Observer
While I recognize the logic that the pro-Indexers have used to support their case, I believe that the fact that index funds generally beat actively managed funds over time does not address the following issues:
Factors Affecting Fund Managers
1) Regulatory changes have transformed U.S. and international financial markets in the past three years. They force the executives of publicly listed companies to abide by real accounting practices and submit honest appraisals of their performance. This allows fund managers to more accurately evaluate company stocks, and avoid buying into potential Enrons.
2) Recent technological changes in the form of better software and trading tools allow some fund managers to more efficiently and accurately identify stocks that have the potential to perform well (as well as laggards) and execute successful trading strategies.
Factors Affecting Individual Investors
A) Unlike the common strategy of index fund investors, those who invest in actively managed funds don't always do so for decades. Many will rationally re-allocate their holdings based on changes in financial markets and certain sectors of the market, the poor performance of certain funds and fund managers, and the better performance of other funds and fund managers.
B) Technological changes have enabled individual investors to select better funds and asset allocations. "Better" funds may include outperforming actively managed funds, or even index funds. The investor of the mid-1990s relied on magazine articles, mutual fund advertisements, and word of mouth to make investing decisions; the investor of today can use sophisticated tools and research to make decisions about which funds or sectors of the market to invest in.
I'd like to make a couple of follow-up points. First, not every fund manager has taken advantage of the factors listed in the first section, nor have all investors pursued a sensible asset allocation and investing strategy that hedges risk while maximizing returns. There are a lot of bad funds, and investors who are lured to them, or are reluctant to leave them.
Second, I believe that this debate is framed in an unrealistic way. Indexers tend to compare performance against a single fund over a long period of time, all funds in a sector to the corresponding index in a short period of time (usually a year), or the average performance of index investors vs. the average performance of active investors. Are these realistic comparisons? Do people buy pieces of all actively managed funds? How many hold onto a single actively managed fund for decades? And should strategies for successful actively managed fund investing be discounted because of the poor performance of certain funds, and lackluster portfolios of certain investors?
I'd like to hear responses from the pro-Index camp that addresses the points I have made above, rather than simply repeating a Bogle essay from five years ago. I believe the new factors listed above warrant an updated response.
I look forward to a healthy and civil debate!
Fidelity Observer
Read more from Fidelity Observer at http://fidelityobserver.com
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To address your points...
1) SOX - this impacts all publicly traded companies equally. The market will respond to SOX disclosures in the same manner it has always dealt w/ impactfull news. I do not believe that active portfolio managers get any advantage based on SOX... unless, of course, it's an Accounting Industry focused fund.
2) New technologies, if they provide a true competitive advantage, are very quickly adopted by the market and their impact is negated.
A few active funds will beat the market over a long time period... most will not. Here is your choice:
- Passive Investing: Always attain the market return.
- Active Investing: Rarely beat the market... underperform the market often... deal with untimely capital gains distributions... constantly monitor performance so you don't get stuck with a bad fund
Full Disclosure - I enjoy picking stocks and some of my investment $'s are in individual stocks. I do this willingly and I know I'll probably underperform the market... it's my hobby, however, and I get better odds than a casino.
I agree with JP. Every one of the points brought up above actually reinforce the logic of indexing. New technologies simply make the market that much more efficient. Now if a manager had a technology that nobody else had, that would be a different matter altogether. If a manager were somehow smarter than the rest of the market combined, he might have an edge. But competitive advantages cannot be sustained and exploited profitably over the long term. Thus in a drive to beat the market, the trader underperforms.
When individuals "re-allocate" their holdings and begin using new technologies all it does is make their hot money even hotter. It increases their expenses and ultimately drives their profits down. Again: in trying to beat the market they underperform.
Also, don't be so quick to knock a 5 year old essay on indexing. The arguments are the same today as they were 5 or even 25 years ago. That's because it's a viable strategy for the long-term. Value investors still read Ben Graham don't they? It's because his work has stood the test of time. Don't judge an essay by it's age. Judge it by it's content.
Given the points outlined above, I don't see how they strengthen the case for active management in the least. If anything, it makes the case for a DIVERSIFIED buy-n-hold portfolio more plausible.
Remember, indexing is not simply buying the S&P500. That's not what we're advocating. It's indexing various asset classes: large, small, bonds, stocks, growth, value, developed, emerging, REIT's, etc...
Thanks for your comments, jc and jp. I'll respond to your points in the order that they were stated:
Jp: "I do not believe that active portfolio managers get any advantage based on SOX ..."
I have to disagree. SOX and other regulations force publicly listed companies in the U.S. to be more upfront about problems and avoid illegal and deceptive practices, and senior executives to certify financial statements. Five years ago, Enron and many other companies created the illusion of profitability, and a lot of fund managers believed them. The smoke and mirrors have been removed, to a certain extent. Bad stocks can be more effectively eliminated from consideration, or sold if financial reports indicate problems. How can portfolio managers *not* benefit from this?
jp: "A few active funds will beat the market over a long time period... most will not."
I agree that a majority of actively managed funds will not beat the market. The question is how many will be able to beat the market, now that new tools and regulations are in place? My point of view is that the number of funds outperforming the market as a percentage of all funds will show an increase relative to the index benchmark, even as the efficiencies I have named are factored into the benchmark.
Let's say 200 out of 2000 large-cap funds outperformed the corresponding index for a five-year period ending in 1995. I believe that the factors I have named in my essay will result in more than 10% of large-cap funds outperforming the index in the five-year period ending in 2010. Fund managers will be more likely to stay away from tainted companies, while the index will not (as long as they are still included in the index).
jc: "... But competitive advantages cannot be sustained and exploited profitably over the long term. Thus in a drive to beat the market, the trader underperforms."
I believe that some managers (and individual investors) won't take advantage of the new tools and regulations that can help them weed out duds, and will continue to rely on rumors, company PR departments, and "gut instinct" to make choices. However, a growing number of fund managers (and individual investors) *will* have a competitive advantage over them.
jc: "When individuals 're-allocate' their holdings and begin using new technologies all it does is make their hot money even hotter. It increases their expenses and ultimately drives their profits down. Again: in trying to beat the market they underperform."
This statement does not apply to everyone. It is well known that actively managed funds have higher transaction costs. But that doesn't make an outperforming fund underperform, unless the degree of outperformance is less than expense levels.
jc: "Also, don't be so quick to knock a 5 year old essay on indexing. The arguments are the same today as they were 5 or even 25 years ago. ... Don't judge an essay by it's age. Judge it by it's content."
I am simply pointing out that a five-year old essay does not take into account factors that I believe must be addressed by Bogle et al. If I wrote an essay on the state of the auto industry based on information from five years ago, it would likely be viewed as out-of-date if I didn't take into consideration factors like $3/gallon gas prices and the introduction of new technologies such as hybrid engines.
jc: "Given the points outlined above, I don't see how they strengthen the case for active management in the least"
Everyone is entitled to his or her opinion, and in this case I think it's safe to say that ours are divergent. Thanks for taking the time to respond, though!
Fido,
I think you misunderstand our objection to the idea of SOX giving traders an edge. The point is that the information is public knowledge. Thus, the data is already factored into the price of the stock. Something that everybody knows isn't worth knowing and can't give you a competitive advantage. SOX and other regulations cannot give investors any edge whatsoever. If that is true, then there's no reason to believe that "new tools & regulations" are going to result in more funds outperforming. We'll have business as usual (with the vast majority of active managers underperforming and no way to pick the winning managers in advance...)
You said, " some managers (and individual investors) won't take advantage of the new tools and regulations that can help them weed out duds, and will continue to rely on rumors, company PR departments, and "gut instinct" to make choices." So in other words, you plan on outsized profits in the market by exploiting the chumps who fail to take advantage of new technologies? I hate to break this to you, but those guys get fleeced real fast. The vast majority of the volume on ALL of the major exchanges is represented by large institutions and pension funds who have access to the best and brightest armed with the latest technologies. And you're going head-to-head with them! Good luck with that! You think you're going to be competitive from home with Metastock & eSignal and Etrade? Isn't that sort of like my local high school team playing NFL Pro Bowlers in a game of tackle football. I think I already know who is going to get creamed...
You also said something about the degree of outperformance by active managers needs to exceed expense levels. Yeah. That's just the trick...
As far as the 5 year old essay thing goes, I just mentioned above how new technologies are irrelevant. No, it's NOT different this time. The tried and true principles of MPT, efficient markets, and indexing haven't changed a bit.
You said, "Everyone is entitled to his or her opinion, and in this case I think it's safe to say that ours are divergent." Agreed!
Good luck! You'll need it!
JC
