Being a Stock-Picker Is Just So Hard
Forget the higher costs of active investing; the real problem is achieving the desired goals
Bloomberg, August 11, 2017
The rise of passive investing, which its advocates prefer to call low-cost investing 1 , is the most dominant trend in the markets during the past decade. Sure, exchange-traded funds (ETFs); smart beta; factor investing; environmental, social and governance(ESG); impact investing; and other themes have all attracted adherents. But if we were forced to select the single biggest stylistic change in investing since the financial crisis, the embrace of low-cost indexing would likely be the one.
The problem that confronts us is the criticism that indexing is worse than Marxism, is devouring capitalism, is a lobotomised investing style that creates a “frightening” riskto markets. Or so we are told. Mostly what the articles I have linked to show is the risks not to investors but to the people who earn a living selling high-cost, underperforming investment products. 2
Today, we shall apply Charlie Munger’s aphorism of “invert, always invert” to the active-versus-passive management debate. Set aside your biases (I’ll try as well), and assume that these folks are correct, that indexing is evil, and that investors should embrace active management for at least part of their portfolios.
What might that look like?
Active management offers the promise of several desirable goals versus passive, including:
- Alpha: outperformance versus a benchmark or market rate of return
- Expressive: investing toward a specific goal that isn’t primarily financial in nature
- Risk management: controlling results by managing around market, sector, stylistic and other risks
- Behavioral: affecting decision-making by investors
Let’s consider each in turn.
Of all the reasons to be an active investor, alpha may be the most difficult to achieve. Someone is going to beat the market every year, and the challenge is identifying whether you can be that person — or identify the fund managers who will be — in advance. Picking the stocks that beat the benchmark, or alternatively, finding the stock-picker who can beat their benchmark, is no easy task. 3 If you invest actively to achieve alpha, the latest studies suggest that the most of you will be disappointed over the long run.
Investing in order to express a particular nonfinancial viewpoint is the entire basis of ESG investing. Meir Statman of Santa Clara University, author “What Investors Really Want,” has explained that this is typically an unstated desire of many market participants. Sure, they want decent returns, but they also want to use their capital as an expression of their values and belief systems. My colleague Josh Brown has described this during the Trump presidency as “#Resisting with your portfolio,” and is a favorite with millennials. I expect this aspect of active investing is only going to grow over the next few decades.
Some have argued that a reason to go active is risk management: The idea of being fully invested throughout a significant correction, to say nothing of a huge crash like 2007-09, is an anathema to some. The problem with this reason is that most track records in market timing are pretty awful. There were too many people who bailed on stocks in 2008 only to become paralyzed, incapable of going back in after the bottom was reached in March 2009.
However, there are valid reasons from a behavioral perspective to be active in a portion of your holdings. I prefer a strictly rules-based quantitative approach to both buying and selling equities. The true purpose isn’t to beat the market, but rather to allow you to tolerate the more severe downturns in your core buy-and-hold portfolio when it’s being buffeted by a hurricane. If you can’t hold on to a diversified portfolio during a bear market, a rules-driven tactical portfolio that moves some of your holdings from stocks and their risks to bonds and their safety will allow you to sleep at night.
Higher costs aside, the problem active investors encounter is that all of these benefits are more difficult to achieve then most people believe. I am not a total curmudgeon advocating the death of active management. Indeed, I have even advised active managers on how to bring more value to their clients. But it should be recognized as a tool with specific uses toward even more specific goals.
Unfortunately, that isn’t how most people use active management.
1. Even passive funds are constructed via some small amount of active decision-making. See “Finding the Active in Low-Cost Passive Investing.”
2. Disclosure: My investment style/bias is to a mostly passive approach, with modest active participation geared toward a specific portfolio purpose. The bulk of my clients’ portfolios (and my own) are invested in a core, low-cost, global asset allocation model; however, we also include a tactical portfolio for behavioral purposes, and where appropriate, sleeves of aggressive small cap and/or municipal bonds (polar opposites for opposite reasons).
3. Some even hire an adviser to pick the fund managers who will pick the stocks that beat the market. This results in a wonderful regressive fractal of selecting the selectors of selections. This is a very nearly impossible task to do well.
Originally: Being a Stock-Picker Is Just So Hard