Devon Miller: Although there are good reasons to invest with active management, investors need to have the facts up front.
In this podcast, we’ll look at some of the more common active management myths and the reality of these frequent misconceptions.
Hello, and welcome to Vanguard’s Investment Commentary podcast series. I’m Devon Miller. In this month’s episode, which we’re taping on December 17, 2018, we’re going to give listeners a framework for better understanding active management. I’m joined by Chris Tidmore, a senior investment strategist in Vanguard Investment Strategy Group, where he leads the team that conducts research and provides thought leadership on issues related to active management.
Hello, Chris, and thanks for joining us.
Chris Tidmore: Thank you for having me.
Devon Miller: So I’m going to kick off with a pretty bold question. Why should our audience listen to someone from Vanguard talk about active?
Chris Tidmore: Sure. The first thing almost everyone thinks about when they think about Vanguard is passive investing. I think they don’t realize that we got our start with active management. We have over a trillion in actively managed dollars, and we firmly believe in it.
Devon Miller: But we continue to hear that “active is dead” and “passive is the future.” True or false?
Chris Tidmore: Really, what is happening is, you’re seeing high-cost investing dying, and you’re seeing a move into lower-cost products. It just happens to be that the legacy, high-cost products, a majority of those are active.
Devon Miller: So I want to be clear. Vanguard believes in both active and passive. We have products in both of those areas, but we still hear terms passive, indexing, and active. How are these related?
Chris Tidmore: At Vanguard, we define passive as broad market-cap-weighted investing. If it’s global, that’d be even better. When we then move on to active, that is essentially everything else.
What we’ve seen, though, is, historically, indexing has been broad market-cap-weighted in passive; active has been your traditional active mutual funds and, say, individual security selection.
Devon Miller: Can you elaborate on that just a little bit?
Chris Tidmore: What you’re essentially now seeing is, index-based products are being created that are no longer just broad market-cap-weighted products. You’re seeing those being nonmarket-cap-weighted or being weighted in a different way or they’re being utilized, the broad market-cap-weighted products, in a certain way.
Devon Miller: Interesting, now when we’re looking at traditional active managers, one thing we’ve heard is that high active-share funds typically outperform their benchmarks. Any truth to that?
Chris Tidmore: No, there’s not. What you see is, a high active share just telling you how different it is than the underlying benchmark. And it doesn’t mean you’re going to get outperformance. What you’re going to get is your different returns than the benchmark; sometimes better and sometimes worse.
We also see a lot of times an excuse to charge a higher fee. We see a clear relationship between the higher the active share, the higher the cost of the fund.
Devon Miller: But, Chris, there’s also long been a belief that it’s easy to find a talented active manager that can outperform its peers and the market. Any thoughts on that?
Chris Tidmore: What we used to actually see was that a majority of the market was individual investors. And those individual investors had less access to information; they weren’t as talented. And so the professional investors, because they were a small segment of the market, they could take advantage of the individual investors. And what we’ve seen through time is, the amount of individual investors have gone down considerably, and so most of the market out there is made up of professionals. So what we’ve seen is this concept known as the paradox of skill.
Devon Miller: So, paradox of skill is a really interesting term. Can you tell us more about that?
Chris Tidmore: Sure. I think a good real-world example is in sports. I have three daughters. My youngest daughter, her absolute skill in field hockey is not all that great, but her relative skill to her competition is quite good, so she might score a few goals a game.
My eldest daughter, on the other hand, her absolute skill is significantly better, but her relative skill to her competition is not that much different, so maybe she scores a goal every game or so.
So what we see there is, as absolute skill starts to increase, we start seeing relative skill between the competition shrink. And luck is always playing a part in who outperforms and who underperforms. And so, as absolute skill increases, luck plays a larger part in who outperforms from one period to the next. And we see the same thing take place in the investment management arena. As absolute skill has increased, as it’s become more and more professionally managed, what’s happening is, you see less and less persistence of outperformance from one time period to the next.
Devon Miller: So as things become more equal, it becomes more difficult for active managers to consistently outperform. However, does active perform better in one type of market or economic environment? For example, does it perform better in a bear market?
Chris Tidmore: So the concept of the zero-sum game, where half [the] dollars outperform and half [the] dollars underperform for a given market, that holds no matter what monetary or what market environment. And in the case of what you asked about, the bear markets, it holds true for that.
If you want to think about one bear market to the next, during the dot-com crash, we saw tech stocks and we saw utility stocks significantly underperform. We saw value and REITs do significantly better. During the global financial crisis, the exact opposite took place. Tech stocks and utilities performed well, REITs and value stocks relatively poorly.
So while bear markets tend to have uncertainty and fear, what we see is, certain parts of the market underperform and different parts of the market underperform in, say, the next bear market.
Devon Miller: So no two bear markets are identical.
Chris Tidmore: No. In fact, we looked at how did active managers do during one bear market and then how did those same active managers do in the next bear market? And we actually saw not very much overlap between the managers who outperformed during one bear market and those that outperformed during the next bear market.
Devon Miller: Then what about in specific segments of the market? We often hear this notion that active will outperform in these less efficient markets.
Chris Tidmore: Probably the question we get asked the most: Are there parts or segments of the market to be active and parts and segments of the market to be passive? And the typical places you hear are emerging markets and small-caps. And while those markets may be informationally inefficient, what we should see then is that active managers should be able to capture persistently those informational inefficiencies. And we just don’t see a persistence in active managers outperforming from one period to the next.
Devon Miller: So investors may attribute the success or failure of an active manager to whether the manager’s investment style is in or out of favor. Is that a good approach?
Chris Tidmore: Yes, but not in the way most would think. It comes from a concept known as style purity. If you want to invest in large-cap growth, the purest way to invest in large-cap growth would be a market-cap-weighted passive product that is targeting that.
What we see in active managers is that they tend to be less style pure. What they do is, a large-cap growth manager, if that’s what they’re targeting, they may have some mid-cap, they may be in developed non-U.S., maybe they have some value stocks in their portfolio. And so what you’ll see happen is that when the bets outside of their target are doing better than their target investment, you’ll see that being a tailwind to performance. You’ll see that they’ll do better during that time period.
When those bets outside of their target are doing relatively poorly, that ends up being a headwind to performance. And so you need to understand whether or not your active manager is making those bets or not.
Devon Miller: How does an investor better understand that?
Chris Tidmore: It’s not easy. Sometimes, I guess, it could be easy if the manager explicitly says, “We also have an exposure outside of our style benchmark.” The other thing would be to look at the holdings of the portfolio, and you’d be able to see that they systematically are underweight or overweight a part of the market relative to their target benchmark.
Devon Miller: So then, as a final takeaway, what factors should we keep in mind about active to be successful?
Chris Tidmore: We think it comes down to really three things. One is talent. Now, talent is hard to put your hands around, but if you believe that you have access to that talent, you need to also believe that it will persist into the future. Second, [the] lower the cost the better. And, third, and probably the most important, is to have patience.
We’ve done work, what we call the bumpy road to outperformance. And what that has shown is that even for funds’ managers that do well, who outperform over a period of time, they will go through periods of significant underperformance. So either you or your client needs to have the patience to stick with those inevitable periods of underperformance.
Devon Miller: Aren’t there any shortcuts, Chris?
Chris Tidmore: No, there really [are] no shortcuts. Instead, it’s important to focus on what you can control. Things like keeping investment costs low, staying diversified, saving more, of course, if you can, and making sure that you work with investment partners that you can trust.
Devon Miller: Great insights. Thank you so much for being with us today.
Chris Tidmore: Thank you, Devon.
Devon Miller: Thanks for joining us on this Investment Commentary podcast series.
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