Have Active Managers Given Active Management a Bad Name?

The Debate Two weeks back, Barry Ritholtz of Ritholtz Asset Management and Nir Kaissar, a Bloomberg columnist, discussed the merits of active versus passive investing. The debate's outcome was a foregone conclusion; these days, few if any investment writers wholeheartedly support active management. They either recommend passive investing fully or they advocate blending the two approaches, typically by starting with a core of passive investments and then adding active funds as desired.

Ritholtz and Kaissar each chose the latter path. Each also suggested that active management be mostly in the form of strategic beta. That is, they maintained that instead of trading securities freely, as active fund managers traditionally have done, managers should use investment strategies that follow mechanical, preset rules. The ideas are human, but the execution is a computer's.

The strategic-beta approach has the advantage of costing less than traditional active management. It's not clear to me that the underlying expenses are all that different between the two forms of management, because both traditional investment approaches and strategic beta require a qualified fund manager and both often use similar amounts of in-house research. But strategic beta is generally offered through exchange-traded funds, and the convention is that ETFs underprice mutual funds.

Self-Inflicted Damage This is all familiar, but what was different was Kaissar's comment that "active managers have given active management a bad name"--a phrase enthusiastically echoed by Ritholtz, who responded, "I may have to steal that for a column title." (Too slow, Barry. When it comes to intellectual larceny, you're competing with a master.)

Let's examine their claims. Kaissar and Ritholtz state that active management has done itself a disservice in two ways:

1. They charge "absurdly high fees."
2. They encourage bad shareholder behavior by "waving shiny objects" at prospective buyers.

I halfway agree.

Cost Controls There's no question that active mutual funds charge aggressively. Historically, the industry has combined lofty employee salaries with high profit margins. Unlike firms in most other industries, fund companies don't go bankrupt. (The rare exceptions being firms that suffered major regulatory problems.) Once they hit a certain size, they either make huge profits or--if things go badly--large profits. All major fund companies could slash their fees without endangering their survival.

However, there are a couple of rebuttals.

One is that mutual funds are far from the costliest form of active management. The typical actively managed U.S. stock mutual fund carries annual expenses of about 1% per year (somewhat less for the big funds that buy blue chips, somewhat more for smaller, specialized funds). Meanwhile, the conventional fees for hedge funds have been 2% of assets, along with an additional 20% of the year's profits. Funds-of-hedge-funds have cost even more, because of their additional layer of fees.

By hedge fund standards, then, mutual funds have been discounters. Indeed, although this no longer remains a problem, in the 1990s several of the most-successful mutual fund stock managers were poached by hedge funds, offering pay packages the fund companies could not match. Active mutual funds are aggressively priced when compared with ETFs, but conservatively so when compared with hedge funds.

The other counterargument is that even drastic fee cuts wouldn't have changed the story. During the trailing five years, through this past Friday, the average surviving large-cap blend mutual fund gained 13.41%. The investable version of the Wilshire 5000 Index, as represented by

Irresponsible Sales? On the shiny objects point, it is true that fund companies pander to investors. Rather than promote their funds consistently over time, so that each fund receives roughly the same share of the marketing budget from year to year, companies typically advertise what has performed recently well and keep quiet about what hasn't. In addition, most new launches follow the financial markets rather than attempt to lead them. By and large, fund companies sell what they believe the people want, rather than what they need.

However, this habit is not limited to active managers. Selling past performance means, for the most part, selling asset classes. Small-company stocks have been performing well: Let's promote our emerging-markets fund. Gold has rallied: Did you know that we offer a precious-metals fund? Energy has been sluggish: Let's hold off talking about that for now. Such news doesn't affect the handful of companies that run the giant passive funds, which invest very broadly, but it does drive the marketing of many secondary providers. Indexers pander, too.

Misguided Attacks Although I don't completely share the duo's views on active managers' costs and marketing plans, I do have an additional criticism to support their contention that active management has been its own worst enemy. Active managers have done themselves no favors by attacking passive managers. They would have more credibility had they just not said anything at all about the subject. Through the years, active management's jibes have ranged from silly ("indexing is anti-American") to empty ("by definition, index funds can be only average") to underhanded ("index funds are destabilizing the stock market").

The better approach would have been to take the threat of passive management seriously by investigating the numbers. Do some asset classes seem to benefit more than others from passive management? If so, why? Can we predict when market conditions will tend to favor passive management, and when active managers might fare better? Active managers have been conspicuously absent from such discussions. With a handful of exceptions, they have been content to disparage and have left the studies to index providers and third-party researchers.

In summary, I concur with Ritholtz and Kaissar, although we differ somewhat on the details. Active mutual funds have indeed charged too much and been marketed too haphazardly, although in their defense they are far from the worst offenders among investment managers. Perhaps their greatest error was dismissing the competition. By the time active managers took index funds seriously, the indexers were already eating their lunch and inquiring about breakfast.

Look at it this way: If active managers couldn’t spot the explosion in passive investing, should they be trusted to foretell other aspects of the financial markets?

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.