In a recent article published in Financial Analysts Journal, Charles Ellis makes an excellent case for the death of active management. Ellis asserts that the efficiency of a market is a function of the number and quality of active, informed investors at work at any time. As more investors with increasingly deep educational backgrounds, and armed with mountains of data and significant computational horsepower, enter the market seeking inefficiencies, they will eventually eliminate all inefficiencies.
Plenty of literature supports this view. Two recent studies by Blake et al., sponsored by the Pensions Institute at Cass Business School in London, compared actual mutual fund returns to a distribution of returns, which might have been expected as a result of random chance. The authors conclude that, on average, investors would accrue an extra 1.44% per year in alpha from investing in passive benchmarks.
The authors also studied the impact of mutual fund size on performance, and found that smaller funds outperform larger funds. In fact, this is an economically significant effect. Specifically, Blake et. al found that a doubling in fund assets results in an average 0.9% per year reduction in fund alpha.
And while some managers will inevitably outperform purely as a result of good luck, it is virtually impossible to identify these managers in advance. Worse, traditional methods of selecting managers based on three- to five-year track records are a near certain recipe for disaster. Figure 1 below describes the proportion of institutions that evaluate and terminate managers at various horizons. While most institutions evaluate managers on a quarterly basis, they base termination decisions on three- to five-year evaluation periods. Yet, as Figure 2 makes clear, managers who are fired, presumably because of poor three- to five-year performance, go on to outperform replacement managers over the next one-, two-, and three-year periods.
Whatever method these institutions are using to evaluate, terminate and hire managers, it doesn’t appear to work on a three- to five-year evaluation period. The vast majority of active managers underperform, exacerbated by the fact that the managers who are expected to outperform typically go on to underperform the managers who are expected to underperform. Fortunately, the vast majority of investable assets for both private individuals and institutions have time horizons in excess of five years. That kind of capital will generally benefit from full exposure to a diversified portfolio of risky assets in order to maximize the opportunity for returns above what might be earned from cash.
Figure 1: Proportion of institutions that evaluate and terminate managers
Figure 2: Excess returns to terminated and newly hired managers in the three
years prior to, and subsequent to, termination
The only true passive benchmark: The Global Market Portfolio
In 1964, Bill Sharpe demonstrated that, at equilibrium, the portfolio that promises the greatest excess return per unit of risk is the Global Market Portfolio, which is composed of all risky assets in proportion to their market capitalizations. Since the Global Market Portfolio represents the aggregate holdings of all investors, it is the only true passive strategy. All other portfolios, including the ubiquitous 60/40 portfolio of (mostly domestic) stocks and bonds, represent very substantial active bets relative to this global passive benchmark.
Figure 3: The Global Market Portfolio, 2012
Doeswijk et. al. recently published a paper on the evolution of the global multi-asset portfolio, where they examined the relative dollar proportions of all financial assets around the world from 1959 through 2012. There were roughly $90.6 trillion in tradeable financial assets globally as of the end of 2012 (see Figure 3, below). Bonds represent about 55% of total financial assets, while equity-like assets represent 45%. It’s well-documented that private equity is just equity and real estate with a lag factor; furthermore, most investors can’t access quality private equity, so you might as well assume it doesn’t exist. We also wondered whether the authors include infrastructure investments under equity, and whether there is a place for commodities, though they aren’t strictly financial assets. But, in our opinion, this framework is 99% complete. We recreated the proportional exposures described in Figure 3 with liquid ETFs (see Figure 4, below).
Figure 4: ETF proxy global liquid market porfolio
It should be simple to link the allocations in Figure 4 with the allocations in Figure 3. The one exception relates to private equity, which we have subsumed into roughly equal allocations to equities and real estate. The total annual MER for this portfolio on a weighted-average basis is under 0.3%.
It’s interesting to note that this portfolio requires no rebalancing, because the weights will drift according to the relative performance of each asset class. However, a passive investment in these ETFs will not account for relative issuance and retirement of securities.
This has a large impact on weights over longer periods, so investors will need to consult the literature periodically to ensure weights are still aligned. That said, this portfolio has the lowest theoretical turnover of any portfolio.
While the Global Market Portfolio is the only true passive benchmark, there are some simple ways to improve on the concept without introducing traditional forms of active management.
by Adam Butler, Michael Philbrick and Rodrigo Gordillo, advisors at Butler|Philbrick|Gordillo & Associates with Dundee Goodman Private Wealth.