Active managers have no excuse for poor performance

As I have told readers of this column many times, active equity managers are having a horrible time. That is in part because the whole game of trying to beat the market is inherently difficult and expensive - which is why passive index-tracking has grown in popularity.

But there is also an argument that the conditions of the past few years have been especially bad for active managers. In the strange world of the QE-driven rally, stocks have tended to rise in unison, and the dispersion of their returns - the extent to which their performance varies - has dropped ever lower. The lower the dispersion, the harder it is, even if you choose the winners, to beat the index.

According to Standard & Poor's Spiva team, which takes a lead in benchmarking active managers, dispersion last year hit its lowest since it started measuring the concept. (And it has fallen even lower so far this year). It is a relative measure. In 2009, it reached 15 per cent; over the past 12 months it is down to 4.3 per cent.

That means even critics of active management, like me, give active managers something of a pass. Long-only equity fund managers, and also equity hedge fund managers armed with the ability to leverage up and sell short, (who gained only 1.85 per cent last year, according to Hedge Fund Research) have had a bad time of it for a while. But maybe this should be regarded as part of a long cycle, with anomalies building up that will lead to big dispersion, and great opportunities to outperform, once the market returns to its senses.

That at least was my attempt at a charitable and balanced view. Plenty of Wall Street sellside research departments will support it.

But feedback I received from one reader shows I was too charitable.

Even in a low-dispersion year, a simple analysis of the main stock indices shows there are ample opportunities to pick winners. Dispersion may have been low in relative terms, but in absolute terms there was plenty of it.

Take the Russell 1000 index of US large-cap stocks, and divide them into quintiles. The top 20 per cent of stocks by performance, measured this way, averaged a return of 44.3 per cent (and a median of 38.2 per cent). The fifth quintile (the 20 per cent with the worst returns) lost an average of 16 per cent, with a median loss of 13.8 per cent. The Russell 1000 gained 11 per cent.

This, remember, was in a historically low-dispersion year. So at any time, there is ample opportunity to beat the market, and to make good returns.

We need to be reasonable here. Mistakes will happen. They are more likely when managers go against the consensus - picking cheap value stocks that turn out to be cheap for good reason, or backing a company with good but risky growth prospects that comes a cropper. Nobody could possibly be expected to pick the top quintile stocks every year without fail.

But would a more realistic target of being right slightly more often than wrong allow you to beat the market? Very much so. Using the medians, an investor who put 60 per cent of their portfolio into top quintile stocks last year, and 40 per cent into bottom quintile stocks, would have logged a return of 17.4 per cent. That is meaningfully ahead of the index.

Within the energy sector, which suffered a uniform battering in 2014 as the oil price tanked, there was again an opportunity to make money. There were 13 US-based energy companies whose share prices rose during the year, six of which logged returns of more than 10 per cent. They were led by Cheniere Energy but also included names like Tesoro and Kinder Morgan - certainly not obscure and well known to investors.

Remember this was an abnormally bad year. Usually stocks are far more dispersed, offering a better chance to beat the benchmark.

What does this tell us about active management? First, it is difficult. Spotting top-quintile stocks 60 per cent of the time is hard. Second, they are not making the contrarian bets that need to be made, or using the kind of concentrated portfolios that give the best chance of outperformance. There are ways to run active managers better and provide a better chance of beating the market.

But the bottom line remains. Why should we pay fees for active management? Judged collectively (there are honourable exceptions), this analysis suggests the long-running poor results from active managers are indefensible.

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