A little crystal-ball gazing into the future: how do you think investing is going to evolve over the next few years? After all, it is increasingly becoming difficult for active fund managers to beat the market…
There are two parts to investing. One part doesn’t change at all over time and that is the essential objective of buying assets at much less than they are worth. The value of assets are dictated by the present value of their cash flows. So there are certain principles that are going to be immutable and consistent over time.
But coming to your point that active managers find it difficult to deliver excess returns, I talk about this in The Success Equation and it is an idea I call “the paradox of skill”. It says that as skill increases in an activity, luck actually becomes more important. We see this in sports. As training methods and coaching techniques become uniform, the performance of athletes becomes uniform too.
From an investing point of view, it means a couple of things. One is that there should be recognition of that basic reality. We have seen the standard deviation of excess returns in the US mutual fund industry decline fairly steadily since 1960. So this has been borne out. The second thing is that where you can really get an edge as an active manager is in asset classes where there is more diversity of skill. There are certain pockets where that is true. So there are areas where active managers will continue to do well. So there is an immutable part to investing, and a changing part.
You mentioned there could be pockets where active investing could do well. What pockets would that be?
There have been some classic studies. One case that continues to be true in the US is spinoffs. Large corporations have multiple businesses and when they decide to spin off a troublesome business, it becomes almost an orphan that no one wants to own. It turns out, buying those spinoffs has been a very lucrative strategy. Buying stocks where expectations are quite low is a good strategy because that is when valuations are cheap. We have data now for 90 years that shows value investing tends to work quite well. So the simplest way to say it is to repeat a Warren Buffett quote: “Be fearful when others are greedy and greedy when others are fearful.”
Active fund managers don’t deliver but they keep getting assets to manage. Why? Is it simply greed, or that the fund sales guys are doing a great job of lying?
In the aggregate if you say active fund managers roughly approximate the market and they charge fees, just by definition they can’t deliver excess returns. According to the US mutual fund data, over the last 50 years active fund managers have outperformed by an average of 40%. To state it differently, 40% of active fund managers have beaten the benchmark in an average year. But that has a standard deviation of 17%, which is a very wide range. In some years only very few do it; in other years a majority will do it. So the key is it is difficult to beat the market. But there are a couple of factors why index investing is not sustainable. One is that while indexing and passive fund management makes a lot of sense for people, there is a logical limit to doing this because passive managers are piggybacking on the research and trading of active managers. They are leveraging the information that has been reflected in prices. There is a very famous paper by Joseph Stiglitz and Sanford Grossman that says you need active fund managers who go out, seek information and reflect that in prices, and they will be compensated by way of excess returns in order to do that. Markets aren’t miraculously informationally efficient without somebody doing the work. That is the first point.
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