The Paradox of Skill

Vanguard recently published a short paper called “Myth: Active Management Performs Better in Certain Market Segments.”[1] Taken literally, that claim is untrue. Over any time period, some categories of active funds fare better than others. Thus, per Morningstar’s most recent Active/Passive Barometer research, three times as many actively run emerging-markets stock funds beat their benchmarks over the trailing 10 years as did active large-blend U.S. stock funds.[2]

The title isn’t fully accurate at the next level of abstraction, either. Not only do some categories of active funds outperform others over a single time period, but extending those studies also uncovers some persistence. Active emerging-markets funds routinely give indexers a stronger fight than do large-blend U.S. stock funds. Small-company stock funds have more relative winners than do blue-chip funds.

But I accept the thesis at its highest level: No matter what the investments, or where their location, active managers face similar issues. They must overcome their cost disadvantage by outsmarting other market participants.

However, today’s participants are better prepared than ever before, which means that active managers can no longer succeed by being very good, or even excellent. To succeed, they must be outstanding.

Getting Crowded The Vanguard paper supports that point with data that demonstrates the growth of investment assets managed professionally against the number of candidates registered for Chartered Financial Analyst exams. Since the 1980s, according to Vanguard, the percentage of investment assets managed professionally has grown steadily, about doubling to nearly 80%. Meanwhile, Vanguard says that the number of CFA candidates has increased dramatically, from less than 10,000 a year to more than 225,000.

To be sure, earning the CFA designation is but one way to attain investment training; it is not as if the industry was bereft of professionals before 1985. But without question, the field has become more crowded.

The CFA effect has been wide-ranging. When the program started, it only taught equity analysis exclusively to Americans. That raised the level of investment competition for U.S.-domiciled domestic-stock funds but left other investment categories untouched. Over time, though, the CFA Institute expanded the curriculum to cover bonds of all flavors, alternative investments, and asset allocation. It also went international. This year, 75% of CFA candidates live outside the United States. Wherever the financial market, it has plenty of local experts.

The question then becomes, what are all these trained investors doing, when indexing has become so popular? After all, index funds require few CFAs. They demand careful operational attention and a portfolio manager to oversee the results, but they need no research staff. As indexing has grown, the number of investment professionals should be shrinking.

Active Abounds Well, here's the thing: Indexing is not as prevalent as is commonly believed. Last week, my co-workers circulated a 2017 report from BlackRock that I had missed, "Index Investing Supports Vibrant Capital Markets."[3] Rather than look only at public U.S. funds, which is typically how active management versus indexing studies are conducted, BlackRock measured how all investment assets are deployed. And those numbers are remarkable.

The Vanguard paper showed that since the early 1980s, the percentage of U.S. assets managed professionally has nearly doubled. The pattern is similar outside the United States. One might think that development is linked to the boom in indexing. But that is not so. On the contrary, BlackRock’s paper demonstrates that most of it owes to growth in active management.

Within U.S. equities, BlackRock reports that 12.4% of the stock market’s capitalization is held by index mutual funds and exchange-traded funds. (Those figures are from December 2016; they are somewhat higher today.) Another 16.8% is possessed by active funds, which means that publicly registered funds hold just over 29% of the U.S. stock market. The remaining 71% operates largely in the dark, as there is only limited information about how those assets are invested. Pretty clearly, though, much if not most of those monies are actively run.

Active management is more prominent yet when viewed from the global perspective. Doing so required BlackRock to make a host of assumptions; therefore, its estimate may be off by a few percentage points. But even so, the conclusion is unmistakable. BlackRock finds that less than 17.5% of the world’s equities are indexed, either directly through funds or indirectly as part of an institution’s investment strategy. The vast majority are managed actively.

What’s more, those active assets affect the stock market’s pricing much more than do the indexed assets. Not only do the indexers take the quotes that the markets give them, rather than sway prices by buying those securities that the active manager finds appealing and selling those that she does not, but they are also much less likely to trade. Annual turnover for actively run U.S. equity accounts is 80%, writes BlackRock, as opposed to 7% for the indexing average.

Look Within Indexing, justifiably, commands the headlines. For many years now, index funds have dominated the sales charts, with their actively managed rivals in net redemptions—a pattern that shows no sign of slowing. But indexing is not yet large enough to distort the financial markets. The challenge for active managers is not from the outside. It comes from within. It comes from the many tens of thousands of investment professionals who have raised the level of skill required to succeed at active management—and from the tens of thousands of new entrants who join the industry each year.

The paradox: As a competition becomes fiercer, its winners appear less impressive than those of the past. Ted Williams secured the 1941 batting title by hitting .406. Last year’s American League champ, Jose Altuve, hit 60 points lower. The 1896 Olympic marathon winner finished seven minutes ahead of the silver medalist. The 2016 titleholder won by one minute. Where have all the good men gone?

The answer, of course, is that the good men are better than ever. The stopwatch definitively indicates that 2016’s marathoner, Eliud Kipchoge, is history’s best—he shattered the world record in September. No such proof exists for baseball, but it’s a fair assumption that with today’s game drawing from a larger population base, accompanied by improved training methods, that the 2018 version of Ted Williams would not bat .400.

The logic applies to money management as well as sports. More assets than ever before are run by certified professionals. What once was excellent is now only good.

The argument doesn’t stop there, though. The problem for active mutual fund managers is not just that there are more competitors, and those competitors are better trained, but also that the field has leveled. Four conditions that once permitted winning investment managers to stay ahead of the also-rans have been eroded, if not eliminated entirely.

Technology Matters One is technological advantage. Thirty years ago, only large companies could afford mainframe computers. Investment firms that had the scale to employ mainframes, the budget to buy the costliest databases, and the quantitative wherewithal to use their data findings successfully enjoyed a significant edge on their smaller rivals. They could supplement their traditional, fundamental analysis with insights that boutique firms could not match.

This opportunity faded as personal-computer networks ascended. The PC revolution had a twin effect. First, it boosted the boutiques’ processing power so that they could accomplish similar tasks. Second, it democratized the databases. Using PCs, data publishers lowered their costs and, thus, were able to make their products more widely available. Information that previously had been held closely was disseminated.

At the same time (and probably not coincidentally), hedge funds boomed. Many used quantitative techniques. These hedge fund tactics created additional competition for active mutual fund managers. So, too, did their habit of raiding fund companies for talent. The manager who moved from a conventional money-management firm to a hedge fund not only increased the amount of assets run in that fashion but also spread the quantitative word. Once again, that which once had been known only by a few became known by many.

Details, Details A similar process occurred with fundamental research. Back in the day, investment managers hunted for details that others overlooked. For example, somebody following shoe companies would survey store managers about their recent sales activities. Doing so might yield insights about shoe-industry trends that would only trickle down to income statements months later.

This activity could benefit both the giant investment managers and the small. The behemoths not only could afford to do their own work but also received the best service from Wall Street’s banks (which have since reduced their research efforts). Meanwhile, if the boutiques picked their spots, they could acquire in-depth, specialized knowledge on a handful of industries, and they could profit by investing heavily in those sectors.

Those opportunities have diminished. They have not disappeared—it is always possible, whether through intent or accident, to know something that hasn’t yet affected a stock’s price—but they have become much harder to come by. The Internet era flat-out destroyed Encyclopedia Britannica’s franchise. It hasn’t inflicted as much damage on investment sleuthing, but it certainly has not done that occupation any favors, either.

The Inside Scoop A third equalizer has been corporate communications. Once, corporate executives would commonly drop hints in institutional-investment meetings about the outlook for their company's next earnings report. Or, perhaps, the success of their new products. These comments might occur during conference calls with multiple parties, or within private sessions while visiting a major investment firm. Either way, they revealed helpful information that was not yet public.

These “whisper” comments were criticized for giving professional investors an unfair edge on Main Street buyers, a charge that was certainly true. Less discussed was that such guidance aided some money-management firms at the expense of others. Those organizations that were fortunate enough to be on the inside, whether through asset size or through personal connections, enjoyed informational superiority over those on the outside. Along with technology and specialized research, insider information was a competitive advantage.

That, too, is largely gone. Since the mid-1990s, the SEC has cast a stern eye on guidance. Not being in the room where it happens, I cannot personally testify how corporate communications have changed. Nor have portfolio managers directly confessed that they now receive fewer tips, since that would be tantamount to admitting their previous favors. Anecdotally, however, the practice seems to have been greatly reduced.

Wrapping Up The fourth and final item is IPO "flipping"— the practice of receiving an early allotment of an initial public offering from an investment banker and then selling it almost immediately. Historically, such tactics fueled the top-ranked performances of many small-company growth funds. However, with the IPO marketplace being less frenetic than in the past and (once again) the SEC increasing its scrutiny, the air has pretty much gone out of those tires.

There is one bright side to this otherwise unpleasant news: The leveling of the playing field works both ways. It is true that the relative results of the most skillful players have declined. But it is also true that those of the least skillful have improved. Today’s worst fund managers, relatively speaking, are better than those of the past.

[1] https://advisors.vanguard.com/iwe/pdf/FASAPMSM.pdf. [2] Johnson, B., Bryan, A., & McCullough, A. 2018. "Morningstar's Active/Passive Barometer." Morningstar Manager Research. August. [3] BlackRock. 2017. "Index Investing Supports Vibrant Capital Markets." October. https://www.blackrock.com/corporate/literature/whitepaper/viewpoint-index-investing-supports-vibrantcapital-markets-oct-2017.pdf.

This article originally appeared in the December/January 2019 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.