Robin writes:
I don't like talking about the active versus passive "debate". Anyone who has read the evidence will know that there isn't one. Statistically, you are far more likely to enjoy superior cost- and risk- adjusted returns by investing passively. However that's not to say that active management is all bad. As a new study by David Nanigian at San Diego State University shows, active management does have some advantages, but also a huge disadvantage, namely the greater cost involved. If — and it's a big if — active managers could reduce the cost substantially, there may be a case for using them. LARRY SWEDROE has been running the rule over Dr Nanigian's paper.
The question of active versus passive investing is tackled in an interesting new paper by David Nanigian, published in the April 2022 issue of The Journal of Investing. In it he adopts a different approach to the traditional one, examining the risk-adjusted performance of actively managed versus passively managed mutual funds and also considering the performance of lower-cost actively managed funds versus comparable index funds. His database covered the period 1991-2019.
Many will find Nanigian’s main result surprising: “There is no statistically significant difference in performance between the two types of funds when the passively managed funds are compared to competitively priced actively managed funds.” Nanigian also found that the combination of high active share and lower costs improved the odds of success. His findings led him to conclude: “The practical implication of this study is that, setting tax considerations aside, as long as investors are cost-conscious in their fund selection process, investing in passively managed funds does not meaningfully improve investor outcomes.”
Let’s address the main finding. That active management has been a loser’s game is not because active managers don’t have skill. In fact, there is a large body of work (including Russ Wermer’s Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses, and Jonathan Berk and Jules van Binsbergen’s Measuring Skill in the Mutual Fund Industry demonstrating that they do have skill, as the stocks active mutual fund managers purchase outperform.
The reason they underperform, as John Bogle noted, is that while the market is not perfectly efficient, it is sufficiently efficient (there are not enough naive retail investors and anomalies to exploit), and that , they generate net negative alphas for investors. What economists call the “economic rent” goes to the scarce resource (the ability to generate alpha), not the plentiful resource (investor capital). That occurs just as economic theory predicts it should.
Active managers also have some advantages over index funds, especially those whose main objective is replicating the results of their benchmark index. For example:
The forced turnover of index funds can allow actively managed funds to exploit that turnover by “front-running” the trades of index funds. For instance, the lack of opaqueness has historically created problems for index funds that replicated the Russell 2000 Index. An active fund can also trade patiently, minimising trading costs, including market impact costs.
There are many well-documented anomalies in the academic literature that long-only actively managed funds can exploit by excluding from their portfolios the stocks in the short side of the anomaly, while replicating index funds must include all the stocks in an index. This not only avoids the negative side of the anomaly but allows them to overweight the positive side. Among the anomalies are poor risk/return characteristics of stocks in bankruptcy, very low-priced stocks, IPOs and extreme small growth stocks with low profitability and high investment.
Active funds can also provide more exposure to the well-documented factors of size, value, momentum, profitability and quality than popular indices. This could allow them to earn higher returns, possibly more than offsetting higher expenses.
These advantages of actively managed funds can help them overcome potentially higher trading costs related to their generally greater trading activity. It’s also important to note that passively managed (systematic) funds that are not indexed can also exploit these advantages and minimise or avoid the negatives facing replicating index funds — strategies employed by fund families such as AQR, Avantis, Bridgeway and Dimensional that use systematic construction rules to gain exposure to factors that have premiums that have been persistent, pervasive, robust to various definitions, survive transactions costs and have risk- or behavioral-based explanations for believing the premiums will persist.
We now turn to Nanigian’s finding that the combination of high active share and low expenses improve the likelihood of success. This should not be surprising because the greater the r-squared (lower active share) of a fund, the higher the hurdle it is for active management to overcome the burden of its higher expenses — they are fully borne by a smaller percentage of the portfolio. However, it is important to note that Martijn Cremers, Jon Fulkerson and Timothy Riley, authors of the study Active Share and the Predictability of the Performance of Separate Accounts, published in the first quarter 2022 issue of the Financial Analysts Journal, found no evidence that active share is a predictor of mutual fund outperformance, even when combining it with past performance.
We will now address Nanigian’s conclusion: “The practical implication of this study is that, setting tax considerations aside, as long as investors are cost-conscious in their fund selection process, investing in passively managed funds does not meaningfully improve investor outcomes.” I suggest that this is not the right conclusion to draw because it fails to consider several issues. For example:
Indexed and other systematic strategies provide greater control of the risk exposures in a portfolio, allowing you to target the factor exposures you desire while also avoiding the problem of style drift that can occur with active managers.
Index funds typically are more diversified than actively managed funds, reducing the dispersion of potential outcomes.
For taxable investors, index funds are typically more tax efficient due to their lower turnover. In addition, index funds and other systematic strategies typically have ETF (exchange-traded funds) versions that are highly tax efficient (note that there are an increasing number of actively managed ETFs).
Investor takeaways
There’s plenty of good news here for investors on both sides of the active versus passive divide. First, if you choose actively managed funds that have similar costs to index funds, your returns should be similar on average. That’s because of the high degree of market efficiency, which greatly limits the ability of active managers to generate true alpha. That same high level of efficiency also limits the possibility of the funds underperforming by much more than their total expenses (assuming they are broadly diversified).
Active investors can also benefit from using low-cost active funds that provide higher loadings on factors than popular index funds. However, the same objective can be accomplished by using lower-cost, passively managed but non-indexed systematic funds. My own firm, Buckingham Strategic Wealth, uses the systematic, structured portfolios of AQR, Avantis, Bridgeway and Dimensional. In addition to constructing their portfolios in ways that minimise or eliminate the negatives of indexing, they also provide the benefit of broad diversification and full control over the risks of a portfolio, eliminating the style drift risk of active managers.
Second, competition is driving expense ratios down across the board, both for actively managed and passively managed funds.
Third, the cost of trading has come down greatly as commissions and bid-offer spreads have fallen sharply over the past several decades. Note that lower trading costs are best captured by those who can trade patiently and avoid the forced trading that index funds incur and the market impact costs that actively managed funds incur if they are buyers of liquidity due to a perceived need to trade quickly to take advantage of “mispricings”.
The bottom line is that if you still believe active management can be a winner’s game, the evidence demonstrates that you should limit your choices to active funds that have “index-like” costs (e.g., the active funds of Vanguard), high active share and relatively low turnover (limiting trading costs).
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