Tag Archives: Mankiel

Why do people use active managers?


The question about whether to use active managers or passive managers when it comes to the stock and bond markets is one that has been discussed over and over on out class blog.  A few weeks ago, I wrote about how some managers thought this was a good year for stock picking due to lower market correlation.  Such theories have no statistical weight behind them; most active managers are outperformed by simple index funds each year, even before their higher management fee are considered.  Despite the superior performance of passively managed funds, more people use active funds than passive funds.  While I think the active versus passive question has been thoroughly settled, not as much discussion has taken place about why people use actively managed funds.  This blog will provide a few theories for why people use actively managed funds rather than passively managed funds.

  1. Ignorance/Fear: The average American probably knows very little about the stock market and how it works.  Sure, many people track the DJIA or S&P500 and perhaps know how the market is doing on aggregate, but that doesn’t really qualify as understanding the market.  Thus, when they do want to invest their money into the stock market they feel like they have no other option than turning to the professionals for fear of losing everything that they invest.  These professionals, probably seeking a management fee for themselves, point them to an actively managed fund.
  2. Clever Marketing: Investment firms certainly work to perpetuate the idea that investing in the stock market requires a professional.  Such an idea is critically important for the health of their business. Every firm likes to tout how they beat their Lipper averages, which are a comparison to similar investments.  Unfortunately, comparing an actively managed fund to other actively managed funds doesn’t tell an investor anything about how well they do relative to other types of investment vehicles.  Especially with a market in 2013 where everyone brought in huge returns, brokers could easily advertise that their funds gained 25% in 2013, without their clients knowing they lost to the market by 7%
  3. People are willing to take the risk for higher return: Both Burton Mankiel and Professor Kimball recommended Vanguard Group for low cost index funds.  In fact, Vanguard invented the index mutual fund!  But even Vanguard offers actively managed funds in additional to passive index mutual funds.  They admit that, “while Vanguard believes there’s a very persuasive argument for index investing, that argument doesn’t rule out well-executed active management at a reasonable price.”  Some people may know that index funds generally outperform active funds, but they may be willing to take the risk that their active fund manager will hit it big one year.
  4. Not all markets are equally efficient: As a recent WSJ article suggests, some people believe that only some markets are efficient.  Namely, markets with extremely high volumes, like large cap companies and bond markets are generally quite efficient.  In recent years, even emerging markets have become quite efficient.  But some investors question whether smaller markets like small cap stocks might still leave opportunities to find undervalued stocks.  I personally believe that this theory may have a grain of truth behind it.

There is also one more important thing to consider: passive funds need active funds.  If everyone just bought stock indices and then did nothing, the market wouldn’t react to economic changes, and then would hardly produce any returns at all.  In order for a stock price to go up, there must be active managers willing to be a stock at a higher price than what the price is currently .

Some Claim Good Year for Stock-Picking

A recent WSJ article hailed the return of good performance for stock pickers.  The argument the article makes is that in recent years, stocks have mostly moved together for a variety of reasons, including strong signals from central banks.  The strength of how stocks move together, or their correlation can easily be measured.

Stock Correlation

As the graphic shows, during the recent recession, correlation between stocks was fairly high, but the correlation has trended lower in recent months.  Stock pickers argue that this is good for them, because when stocks are too strongly correlated it is hard for experts like themselves to differentiate themselves from a less advanced investor.  The article closes with an ironic statement from a stock-picking fund manager.  He states, “The sorting-out process has to return to fundamentals.”

The argument of stock-pickers makes a subtle but important observation:  Performance is relative.  Over spring break, a peer mentioned that his friend had given him a hot stock tip last year and made him some money.  I had to break it to him that his friend was no savant, but the entire market performed exceptionally last year. This story illustrates the point stock pickers make; since the whole market was moving up, it didn’t take skills to do well, or even get lucky.  Thus, doing well, compared to other investors, was difficult, because everyone did well.  This observation is accurate so we cannot, and should not judge how good a fund manager is based the nominals returns he/she brought in, but the returns relative to the market.  What does the evidence say about the performance of stock pickers, who are also known as “active” fund managers?

Unfortunately for stock-pickers this is where their confidence, some might call it arrogance, clashes with their results. The facts are simple:  “historically, active managers have tended to perform badly, even when dispersion was above average”.  Dispersion is another measure of how much stocks vary compared to one another, and has an inverse relationship to correlation. The very same feature of the market that stock-pickers were touting as beneficial for them has not helped them one bit!  The author of the article advocates for investing in passive funds or indexes to save on transaction costs.

Looking at the evidence, I will admit that my view lies somewhere in between these two articles, similar to those of Burton Mankiel. The overwhelming statistical evidence is very convincing that trying to pick the right stocks (or stock manager) is nearly impossible.  The silly arguments that active managers use while pointing at previous returns for their funds fall dead on the ears of managers who underperformed and are now looking for a job.  However, success investors can make a lot of money, Warren Buffet being an example.  As Burton Mankiel writes towards the end of his commentary on fundamental analysis in “Random Walk”, “if there are exceptional financial manager, they are very rare, and there is no way of telling in advance who they will be.”  Speaking of the 30+% rise in the S&P500 in 2013, Mr. Buffett “warned shareholders in his last annual letter he would be unlikely to beat [those returns]”.

I think an interesting line of investigation from here is determining why the general public entrusts so much money to active investors, when the results show that may not be the best investing strategy.  I suspect part of the reason is ignorance, that the general public doesn’t know what the statistics say or don’t understand the importance of relative gains.  Perhaps another reason is fear; the stock market has a reputation of being a tough place, and some people will turn to a professional out of fear.  Other reasons, like referrals, belief in stock -picking could also play a part in this trust, whether it is well founded or not.