consistently over time in the US large cap space, closer to one in two managers outperform in niche sector markets or markets outside the US. It is important to understand what an average performance will achieve, but equally important to strive and prepare to be above average.
If I subscribed to the efficient market theory I would still be delivering papers.
—Warren Buffett, investor
Espousing the theory of efficient markets and moving capital to passive alternatives has an additional benefit to capital allocators: job security. No capital allocator ever underperformed the market by being in passive alternatives. From a career perspective moving to passive investing is a very low risk decision, especially when everyone else is moving the same direction. Expectations and the pressure to outperform are lower for chief investment officers if clients and fiduciaries believe that active investing cannot produce alpha. Past failures to produce alpha through active manager selection can be written off as an industry failure, not an individual capital allocation firm failure. A move to passive investing will drop expectations to a level that will always be met. No alpha expectations from clients, constituents, and board members will mean no underperformance (hence no stress) by the chief investment officer and investment team. The outcome, of course, is that they have now, also, given up any chance of outperforming.
It is very clear from my own investing and watching other active managers that outperforming the market, although difficult, is possible. Unfortunately, the 2010s were particularly difficult, and many of the best managers in the world have struggled to produce returns. Large established hedge funds have closed their doors in frustration. Efficient market theorists may point to enhanced communication via the internet, quantitative models, and fair disclosure laws as limiting factors, but there is another answer behind the recent alpha degradation.
Self-reinforcing cycle driving poor performance
The challenges created by the confluence of global central bank intervention and the accelerating pace of technology have created a negative self-reinforcing cycle for active managers The investment decision process and the core tenets of outperformance are challenged, which hurts investment returns. Poor returns drive money flows out of actively managed funds and into passive alternatives. These negative fund flows create more pressure on active investment managers to perform, which drives short-term decision making. Of course, short-term focus and chasing returns leads to more poor performance and more flows into passive alternatives. Once started, this is a tough cycle to stop.
Why do these forces pressure investment decisions?
Massive central bank intervention creates a market driven by macro issues. The focus is on central bank statements and interviews of bureaucrats on how they foresee the next six months. Central bank–driven low rates push all investors into riskier assets, because traditional low-risk investment alternatives provide uncompelling returns. When capital allocators cannot achieve their defined investment return goals due to low bond yields, they have little choice but to take on more risk in the form of higher equity exposure to achieve objectives. This demand for equity and risk capital creates high valuations and enables weak companies to flourish. Allocators believe the central banks will act as support to markets making the additional risk more palatable. The central banks try to fulfill the need for low volatility and market stability for the good of the markets and the economy. Another dangerous cycle is created as global central banks manipulate investors into pushing asset prices higher to spur the economy, but in doing so have increased the risk profile of the investment community, which, of course, could lead to potential losses negatively affecting the economy. This means central banks must go to even greater lengths to maintain low levels of volatility and support the financial markets. Easy access to capital, low rates, and low volatility cause another headwind for hedge fund managers, which is the dispersion of stock returns among companies. Good companies and bad companies alike do well in upward-trending macro-driven markets. Successful investment managers achieve outperformance by selecting the strong companies and shorting the weak companies. When there is very little difference in returns, it is hard to create alpha. An analysis produced by the BoA Merrill Lynch Quantitative Strategy team in Figure 1.4 illustrates the level of dispersion in the returns of the top-performing quintile and bottom-performing quintile of stocks in the S&P 500. High dispersion is a positive environment for alpha creation, because there are more distinct winners and losers for a manager to choose in the security selection process. Low dispersion (more stocks moving in unison) is a headwind to alpha creation. It is clear from the analysis that dispersion has been below average since 2010, when central bank intervention began.
FIGURE 1.4 S&P 500 dispersion of the top and bottom decile from 1986 to June 2019
Source: Adapted from BoA Merrill Lynch US Equity & Quantitative Strategy Group (August 2019).
The central bank low rate–driven environment pushes investors into risk assets, which often equates to investment in high-growth, no-earnings companies. This increased willingness to invest in companies without earnings amplifies the already accelerating pace of technology. Combined the two forces of easy money and an increased pace of technology innovation create disruption in industries and a major challenge to the core investment tenets that have driven outperformance historically. The following diagram illustrates the different ways high demand for risk assets affect active investment manager decisions creating headwinds for alpha creation. To be clear, this artificially driven demand for risk assets is not all bad for society or the economy. It does create the potential for financial bubbles, which can be problematic.
We will dig deeper into central bank intervention and the accelerated pace of technology in chapters 2 and 3, but first we need to briefly introduce the key investment tenets that are coming under magnified pressure. Although there is no one right way to be a successful active investment manager, the following investment tenets, to be developed fully in Part II, are central to the majority of successful fundamentally based equity investment firms.
Key investment tenets
In order to discuss the unique challenges of today's environment in relation to history, it is worth quickly defining the key investment tenets in question.
Goal congruence and fiduciary responsibility
This is the investment tenet that will never change. Very simply, if you do not have goal congruence in an investment or with an investment manager nothing else matters. If a management team or investment manager causes you to question his or her integrity as a fiduciary of your capital, you should investigate your concerns, and if they are not completely alleviated simply move onto other opportunities. The rest of the investment decision process means nothing without trust in the people and numbers you are analyzing. The great thing about the investment industry, in general,
