Tag Archives: stock

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.

Pick Up Truck Market

After the stock market took a sharp turn for the worse at the end for January, some wonder if the economy is going to continue its recover from 2009. Much like the housing market, many view the pickup truck market as an indicator of the economies health. Pickup trucks generally start at a higher base than other vehicles like sedans or SUVs, and require a more substantial investment from the consumer. So what is the pickup truck market saying about the economies future?

Automotive Industry experts blamed some extremely cold weather as the reason automotive industry closed below projected sales for the month of January. Analysts also moved forecasts for 2014 from an increase to flat growth. Both Ford and GM posted negative sales growth year over year, with Chrysler being the only of the American “Big Three” posting positive growth when it comes to overall January sales. Ford’s F-series, or their pick up trucks, are not only one of Ford’s best seller but also the leader in the pickup truck market. The F-series specifically showed a 0.7% decrease in January versus last years sales. GM’s two pickups, the GMC Sierra and the Chevy Silverado, 13.5% and 18.3% decrease from January of last year, respectively. Chrysler’s Ram series was the only of the major trucks to show a positive growth, with a 22.5% increase since January of 2013. Further, GM started offering incentives up to $7,000 off the purchase of new pickup trucks or almost a 20% savings.

Chrysler was one of the automotive companies hardest hit during the recession, and before the take over for FIAT was known for having some of the poorest vehicles in quality. So it may be a natural that as the vehicles quality increased their sales rebounded to normal levels, and appear to be growing quicker than their competitors.

The Fed continuing on with their quantitative easing strategy is likely to begin hiking up interest rates from historically low levels. The interest rates in the foreseeable future are only suppose to rise on 30-year mortgages and not shorter term auto loans. It is possible that uneducated consumers are worried about a rise an interest rates and may have backed off big ticket purchases, like pick up trucks, but that seems unlikely. It is definitely more realistic to blame poor sales on the scare of the stock market declining and the extremely cold weather. Not many consumers, educated or not are comfortable spending big sums of money while the market is collapsing. The cold weather is also a reasonable explanation, as many people like to walk around car lots and test drive vehicles before purchasing, not something enjoyable in the future.

As for Chrysler’s Ram, it is likely that the created a superior new product and the high quality is preventing the negative growth that the other companies faced. Recently Ram was awarded the 2014 Motor Trend Truck of the Year award, and it was the first time any truck has ever won the award back to back. Further, the Silverado/Sierra both underwent major changed in the 2014 model year and still failed to dethrone Ram.

Facebook: Beginning of the End

Facebook had a big run in the tech industry. It was the original frontrunner for the social media industry and has been praised as one of the best place to work in the world. However, Zuckerberg’s recent signaling, the decline in its active user base, increased competition, and the ever growing outspokenness, make both the general public and investors question whether Facebook has been overvalued and is heading downhill.

Facebook’s stock has gone up two-fold this past year because of much better than predicted revenues due to an improvement in their mobile advertising model. Despite this, late last Decemeber, Mark Zuckerberg sold $2.3 billion worth of Facebook shares to “pay a tax bill” he inquired by change the class of his shares. Investors saw right through the company’s official statement, realizing this was a cash out when the stock price may have peaked. This clearly was not something Facebook needed to do out of necessity, making it seem suspect. Companies as popular as Facebook have easy avenues for spending money either from investors/banks or take on some debt as a growing company should.

Before getting recently acquired by Facebook, 22 year old Princeton drop-out, Josh Miller created a start-up Branch with 7 of his buddies. Before he made many bullish claims against Facebook with a large audience, citing his own personal experiences as well his little sisters.  He claims his statements will not be for naught and that Branch will live on.

Like Josh Miller I do see the issues with Facebook, and agree that Facebook may have an “irreversibly bad brand”. With the emergence of other popular social media, not only have the users been spread thin, but we see competitive advantages to using other services like Twitter, Snapchat, and Google (Google Plus recently had a integration with YouTube which will further spread the butter thin). Now a working for Facebook, Josh insists that a killer new products and re-branding is key for their long term success. These products need to reclaim the valuable standalone that Facebook once had. Smartphone apps now have access to a user’s contacts and photos providing some of the social networking niche that only Facebook use to fill.

Even when losing the spunk it once had, Facebook is still grossly popular, churning out ad revenues and attracting some of the best tech talent to Menlo Park. By no means is the end in sight just yet, only the beginning.