New Century Investment Management, Inc.Active Management White Paper By Jeffrey D. Modell, Esq. and Mark C. Lahti, Esq.Telephone: (248) 262-3140
October 26, 2016
As Cleared for Distribution November 1, 2016
Active managers have had a hard time since the 2008/2009 crash. Further, a report by S&P Global
concluded that 90.2% of the actively managed U.S. domestic equity mutual funds underperformed their
benchmarks for the twelve-month period ending June 30, 2016. Our category, large cap growth style,
was up 2.26% for 2016 through October 25 based on the Morningstar™ category (which is net of both
management fees and custodial fees) whereas the Standard and Poor’s 500™ Index, which includes both
growth and value elements but is a fair benchmark over a full market cycle, was up 6.70% and the
Russell 1000® Growth Index was up 4.94%. Some of this is fees, some is a lack of talent, some is the
True skill is rare. Most investment managers lack a rationale investment system. Some have a good
system but lack the discipline to implement it through thick and thin including multi-year periods of
underperformance. Sometimes flailing (typically demonstrated with unusually high trading activity) is
driven by client pressure. Sometimes there is an internal policy at the management shop that requires
underperforming managers to mimic their benchmarks to help prevent customer attrition. Some active
managers have a good system but attract so much money that their market impact during trading makes
it impossible to profit. A number of managers who grow out of their britches quietly modify their strategies
to add positions and increase market cap in the hope of being better able to cope with excessive pools of
assets instead of closing the product to new investment at a manageable level.
Studies have shown that emerging managers, which tend to be defined as shops with less than a few billion
funds with allocations specifically targeting emerging managers. The difficulty in the emerging manager
arena is identifying the small shops with talent, adequate controls and financial staying power. You can’t
do that by just screening a manager survey database or kicking out a rote RFP, you need a specialized
consultant with the intelligence and creativity to understand the strategy, know the people and kick the
tires. It is easier for a large shop to have established systems and staying power but it is still possible for
a larger manager to have just one person who actually understands the strategy and for that person to
True skill is rare but it does exist. It is statistically possible to rule out the possibility that a sufficiently
comprehensive stream of good investment performance is the result of luck. That is no guarantee that
markets will not change so the system ceases to work over a specific time period or ever again, or that
the investment product will not suffer one of the bad fates noted above. The SEC effectively requires
managers to state that past performance is not indicative of future performance. We do not disagree with
that but I find it more helpful to remember past performance is no guarantee of future performance. The
race does not always go to the fastest but that may be the smartest way to bet.
Active management depends on rational market environments. That means there is a correlation between
a company’s fundamentals, the broad economic environment and stock pricing, over a
reasonable measurement period. The post-2008/2009 markets have been characterized by hedge funds,
high frequency trading, and stock market behavior keyed off geopolitical and global events including
macroeconomic crises, reducing the degree to which stock price movements reflect general and company
specific reality. Our internal study using an aggregate of indices put out by the CBOE shows the price
correlation of all the stocks within the S&P 500 doubling from early 2007 to a post-crash high.
You may heard a market pundit say that active managers have difficulty picking good stocks when all
stocks move in tandem. We form our own opinions and see it differently. Most active managers lack
talent and have difficulty doing well regardless. It is the talented managers who have been suffering.
To add insult to injury low quality speculative stocks – companies at serious risk of going under and
which would flunk any reasonable due diligence – are a part of many benchmarks and thrive when sentiment
turns from doom to positive. Active managers are typically prohibited by their institutional clients from
investing in these stocks and/or have internal guidelines prohibiting owning them even if some limited
exposure would benefit the portfolio as a whole. Clients simply will not put up with an active manager
who regularly owns companies that go under even if overall performance is good.
If you look at an active manager during only that part of a market cycle when their system is ineffective
it will not be a good picture. Market cycles vary in length but must include sufficient time when the major
style boxes are in and out of vogue so that the aggregate measurement period is representative of normal
markets and a fair shake to all parties. Much of that relates to the economy in a direct or indirect fashion.
Market cycles are seldom an arbitrary fixed period however convenient. Even pension fund officials may
lack the patience to wait out a full market cycle and end up firing world-class managers at exactly the
wrong time. In our opinion we have not seen a full market cycle for the period commencing with the past
recession. The economy has yet to improve from tepid growth to strong or from fragile to solid.
Passive investments have a number of advantages. ETF’s and mutual funds have lower fees than active
Index vehicles can have hundreds or thousands of stocks including those speculative stocks that
fiduciaries find problematic should they appear on a portfolio inventory. Index based vehicles are far
more actively managed than most investors realize. One of the major index firms included Exxon Mobil
Corporation in its large cap “growth-style” index and it was nearly 4.5% of the index! No reasonable
fiduciary would have classified Exxon as a growth stock at the time. They later eliminated it in one day
cutting the energy sector precipitously. Periodic index “rebalancings” can have a material impact on
An index is a lot like a Frankfurter. It is a delightful meal so long as you do not know what goes into it.
Index investments are not the most risk efficient portfolios since nothing is done to alleviate systemic
risk though we hasten to add not all managers have the same philosophy and expertise on risk management
or target on the risk/reward spectrum. A risk efficient portfolio may have materially better or worse
absolute performance than its benchmark during any specific period of time. A good index fund should
avoid the stress of material underperformance versus its benchmark during all periods absent
Passive managers do their best to track their benchmark closely but there are differences in the quality
of those efforts. Index vehicle providers must conform their portfolios to benchmark changes, and also
experience cash inflows and outflows that require significant trading. The better passive managers use
futures and other complex instruments to minimize the cost of these transactions. If the market is
crashing, there are insufficient buyers for many of the stocks in the index because everyone is selling that
index that day, and a client decides to sell out, the passive fund manager will do his best under the
circumstances but there are consequences.
From the “Nifty Fifty” (in the 1960’s, 50 stocks you could buy and hold forever, until they got crushed)
to the internet boom (when page views mattered and earnings didn’t), from investments in collateralized
mortgage pools (how many AAA rated pools fell to zero I wonder) to high fee black box hedge funds
chosen by institutional investors with the mistaken idea that non-bond securities would actually provide
bond-like protection when the market collapsed, the one constant is the belief that there is a sure thing.
Investing is a lot like fashion. You can own clothes that are in style and clothes that are out of style but
you do not want to be the person wearing the Emperor’s New Clothes.
ETFs pose a systemic risk to the market and your pocket book but only when it really matters. When
hedge funds whip massive amounts of liquidity around these vehicles get wagged like the tail on a dog.“Portfolio Insurance” is also back by another name. For those of you too young to remember, the ideawas to dynamically use tiers of options to protect a long portfolio from a crash. It had the exact oppositeeffect during the 1987 crash; the insurance caused a downhill stock market snowball. When a calamity isso severe that the financial system is at risk, hedge funds have jettisoned their long holdings and gomassively short index futures, and high frequency traders accelerate the trend with their own trading andby scaring potential buyers out of the market, the corresponding ETFs will plummet soon followed by theindex mutual funds. Portfolios less correlated to these indices will at least stand a chance. That is apretty bad fate but it is not the worst potential wealth destruction outcome.No one talked about the possibility of a money market fund breaking the buck and gating redemptionswhen individuals poured out of banks into money markets. There could also be catastrophicconsequences to the operation of the passive investment vehicles during a meltdown. We call an illiquidmicro-cap stock a “roach motel” because you can get in but not out. You can easily get out of thosepopular index funds today or during a “normal” crash. What happens when index ownership is at a newhigh, the market is down so far every passive investor wants out of the exact same stocks at the samemoment, and all of the bad actors are accelerating prices lower with computer-generated programs andultra-high speed connections? What prices will be quoted for the stocks in the index or for an ETF? Whatprice will the actual fills come in at? Will index fund managers be able to timely dump the stock theymust, even at any price, to fill the redemptions? If it all goes south and their operations fail the only time
it really matters will these management firms be willing and able to dip into their own pockets like somebrokerage firms did after putting clients into problematic money funds?Do not ignore the systemic value-creation risk from too much passive investment. Think of the growth inthe U.S. economy during all those years before index funds became the thing. Back then the stockmarket was able to allocate capital where it could do the most good and that drove industry. The goodeconomy then pushed the indices up. The more money we invest on auto-pilot the poorer will be thereturn on the benchmarks and their corresponding passive investments. Perhaps this longer term issue
has already put drag on the economy.
In our opinion the best reason for staying with active managers is the timing. One of the greatest value
managers in the world decided to hang up his shingle after an extended streak of bad performance. That
was the year before value-style took off. Index funds have done so well everyone and their brother is
recommending them and piling in. Active managers have not done well. Investing is not a field where
you can buy high, sell low and make it up on volume.
The S&P 500 internal correlation has declined from its high but is not down to pre-crash levels. The latest
numbers are heading in the right direction but nothing decisive. Nor has the SEC shown an inclination to
enforce existing securities laws that would reduce the abuse of equity markets by hedge funds and high
frequency trading firms.
What would do see, however, is stock market behavior more reflective of the true measure of economic
affairs and a company’s outlook. There is a more realistic weighting of global events and a quicker
readjustment if the knee-jerk reaction was excessive. The Brexit dip is a great example; a modest
overreaction followed by a quick rethink rather than an accelerating cycle of international equity market
destruction. There are plenty of bad things happening in the world now that a few years back would have
decimated equity markets and perhaps resulted in another recession. That has not happened in 2016.
Consequently we anticipate more normal equity markets, the kind where talented active managers can