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Miracle Saves Active Investment Management

Numerous studies by S&P, Vanguard, Morningstar and others prove that active investment management fails to outperform passive, especially after fees and expenses.
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"Move to passive likely to build more steam" is a front page story in the September 15 issue of Pensions & Investments, the newspaper for pension consultants and fiduciaries. The sub-heading for the article reads "But any paradigm shift is seen as a long way off." In other words, active investment management is dying a slow death, and for good reasons. In this blog, I explore the shortcomings of active investment management and offer a miracle that could save it. It's not too late.
Why Active Management Deserves to Die

Numerous studies by S&P, Vanguard, Morningstar and others prove that active investment management fails to outperform passive, especially after fees and expenses. Furthermore it is now well understood that, in the hierarchy of performance sources, asset allocation is king, explaining more than 100% of actual performance results. The other aspects of performance, namely timing and manager selection, tend to subtract value.

Bottom line, studies show that investment portfolios perform better when all underlying assets are passive. This result is attributed to efficient markets. It's very difficult to beat the consensus, the market, especially a market that is dominated by professionals.

Why Active Management Has Survived (At least so far)

In his popular book, What Investors Really Want, Professor Meir Statman, a behavioral scientist, tells us that investors like and want the entertainment and bragging rights that come with active management. He compares the choice between active and passive to the choice between fine dining in restaurants and eating health food at home. Fine dining is more fun, but not so good for our health. Investors want to play the investment game, and they want to win. They believe their investment adviser can make that happen.

Some investors know that the odds of winning are less than 50/50 - the odds are against them. But they believe that, together with their adviser, they can outwit everyone else. Just as fancy restaurants don't discourage patrons, advisers don't discourage active management, even though it would take a miracle to actually deliver skillful management.
The Miracle

Hunter S Thompson, author, says "Anything worth doing is worth doing right." The miracle that could save active investment management is contemporary due diligence that actually identifies skill, even though it is much more work than the antiquated approaches advisers have used for the past 40 years. Indexes and peer groups do not work - never have and never will. Consequently, investors hire losers, and are constantly disappointed. "Always change a losing game" advises Dr. David Posen, speaker and author.
Active managers should pray for this miracle but they fear what it might show.

Advisers won't accept the miracle until clients become frustrated enough to fire them. Change comes hard, but clients deserve better.

Survival of the Fittest

In a June 5, 2014 research post, "There are too many active managers", Towers Watson asserts that active managers should be only 30% of all managers rather than the current 80%. This realignment would be more cost effective for investors and would continue to keep markets efficient. In other words, active management should mostly fade away, but not die altogether. The "Miracle" will make this happen.

A reduction in the number of active managers will happen naturally if intermediaries (consultants and fund-of-funds) figure out who's good and who's not. Then Darwinian principles will prevail so only the fittest will survive. Clients hire intermediaries to perform a talent search, but it fails because the processes remain in the dark ages, and include golf (pay to play). Contemporary manager due diligence could change all that and consolidate the active manager pool down to just the most worthy.

Article originally posted on Paladin Registry has been updated for Huffington Post.

About the Author: Ron Surz is president of PPCA Inc and its wholly owned subsidiary Target Date Solutions. He is a pension consulting veteran, having started with A.G. Becker in the 1970's. He holds a CIMA (Certified Investment Management Analyst) designation. He has published regularly in such publications as The Journal of Wealth Management, The Journal of Investing, Journal of Portfolio Management, Pensions & Investments, Senior Consultant, HorsesMouth and the IMCA Monitor, as well as contributed to and edited several books. Ron's most recent co-authored book is the "Fiduciary Handbook for Understanding and Selecting Target Date Funds."
Follow Ron on Twitter @RonSurz.