Active Managers Are About To Outperform The Index
Active mutual fund managers always seem to find a reason for their collective failure to beat the index (other than the simple fact that it is mathematically impossible). First they say that they provide protection during bear markets. Then when a bear market comes along and they lose more than the index, they say they can find the stocks that will grow in the recovery. All too often those turn out to be companies that never recover. Recently they have taken to claiming that the rise in indexed assets is making their job harder, when index investors should be an easy target for a smart active manager – I have already announced what I will buy next year!
But I may have found the most creative and hilarious excuse yet. Doug Cronk’s fine blog links to a piece by a manager at AllianceBernstein who takes the idea of mean reversion, commonly used by indexers, and applies it to active managers:
Performance probably falls into the cyclical camp, as it tends to be mean-reverting – bad performance is often followed by good and vice versa. […] the fact many typical active managers’ strategies have underperformed passive strategies for the last five years means the odds are very good that performance in the next few years will be much better.
While this might sound good if you only look at it superficially, it fails to account for things like fees that will most likely not revert to the mean. Unless active managers cut their salaries by 90%, they will continue to have a major drag that keeps their returns lower than the index. Most amusingly it ignores the reality that the index used by passive strategies is simply the average of the largest active investors, so they can never outperform themselves.
There is a small element of truth in this. There may be active managers who consistently outperform the market. If they do so it’s only because they sometimes have a few years where they look very bad, only to come back later (some of them never recover though; hope you picked the right ones!). This fact is blown into something much bigger here which is ultimately impossible.
Active managers as a whole cannot revert to the mean. They seem to have underperformed the index for just about as long as there has been a reliable index to measure against. Unlike bonds, which have experienced a 30-year bull market that probably is about to revert, I don’t think this history of pain (which is much longer than the last 5 years) is about to stop any time soon.
Even if they make major improvements they can’t deviate much from their past performance where 60-90% of active managers have under-performed the index and last year’s winners tend to be this year’s biggest losers, creating a constant rotation in the top funds that leads many individual investors to lose money. But on the plus side they can be entertaining!