Do Averages Point to Active Management?
There’s a fairly common way to explain why active investors/managers tend to underperform the index: all investors as a whole will earn the index return as an average, and index investors will also get the index return, so the average performance of all active investors is also the index return. However active managers take higher fees so their average falls below the index return.
It turns out that there may be a catch though, which comes in the form of another common active management complaint. I just saw this today thanks to the latest post in a Million Dollar Journey series about identifying good managers. If you follow the averages a bit further it looks different because, as we all know, a lot of fund managers are really just tracking the index to varying degrees. Some are virtually identical while others looks different but have similar performance.
If the average active manager underperforms the index after fees, and a large percentage of funds track the index closely and end up falling in the same range or below, they may be counter-balanced by a category of funds that look different and have better performance. The blog post linked above cites a study which appears to identify such a group, saying “Of the funds that had only 0-20% of their holdings in common with the index, the average fund beat the index.”
This may make sense and might even hold together if there is a large enough group of funds outside this category that counterbalance it with worse returns to maintain the average. However one study is not enough to demonstrate this; it could just be a coincidence in a certain time period or region. It seems more likely that the closet-index funds stay close to the average under-performance and funds that deviate further from the index have a wider range from losing it all to winning big.
As Jeremy Grantham frequently points out under the name of “career risk” this is exactly why there are so many closet-index funds; as long as the manager doesn’t fall too far behind the market their job is safe. The only ones that have a hope of delivering real value are just a few unlucky years away from getting kicked out unless they protect themselves. The series does point to some other ways to identify good fund managers including looking at whether they are committed to their strategy for the long term, but it’s no easy task (in fact it sounds like more work than stock picking). As a simple measure, looking for a fund manager that’s different from the index hasn’t been proven to be enough yet.