The asset management industry puts a lot of focus on identifying skilful managers who can beat the market. But skill alone is not enough, as investors were forced to realise in 2014 when most active managers failed to beat their benchmarks. Opportunity must also be present, and in 2014 this was certainly not the case.
"It is almost as if you are a star basketball player, but the coach won’t put you in the game; you are great, but you are not making any difference. Skill can be zero if the opportunities are not there", says Credit Suisse managing director and global market strategist Michael Mauboussin, who recently spoke at Morningstar's European Conference in Amsterdam.
For example, in 2014 large-cap stocks outperformed small caps in most markets as investors piled into large companies paying high and stable dividends. When most of the opportunities are in large caps, it's easy to see how small-cap managers are going to struggle to outperform. In 2014, US large-cap stocks beat US small caps by the largest margin since 1988, according to Mauboussin's calculations. Given that actively-managed funds typically overweight small-cap stocks—because it is difficult to overweight large caps when the common benchmarks are already heavily geared towards large companies—fund performances were dragged down by small-cap allocations compared to their benchmarks.
In a recent research paper in which Mauboussin and Credit Suisse strategist Dan Callahan looked at 45 years of stock market history to spot environments that have favoured active managers, they concluded that another prerequisite for active managers to do well is the existence of dispersion among stock returns. In 2014, dispersion was near 25-year lows in the example of the US stock market.
In the 45-year period that Mauboussin and Callahan looked at, active managers did best in the 1970s and 2000s despite markets performing better in the '80s and '90s. Thus the high dispersion required to provide a favourable investing environment for active managers is less present in a positive stock market.
Mauboussin thinks there may be something to the hotly-debated claim that the substantial increase in passive investing has made times tougher for active managers, but believes it is still too early to make strong statements for or against. There will remain "pockets of inefficiency", as Mauboussin calls them, which will enable active managers to earn their pay. Such situations include investors becoming overly optimistic or pessimistic, and thus driving stock prices to diverge from their fair values. In addition, when individual investors rush to the market en masse, as they did in the late 1990s, professional managers can in theory reap rewards from retail investors' inexperience.
For individual investors, Mauboussin thinks active funds remain a lucrative choice but warns individuals must put effort into selecting managers. Echoing the research on active share by Martijn Cremers and Antti Petäjistö, Mauboussin encourages investors to look for truly active funds that deviate substantially from their benchmark in terms of stock selection. According to his book The Success Equation, Mauboussin believes it is these funds that have the best chance of beating the market after costs. However, even if the most active stock-pickers outperform as a group, dispersion between them is also very high: there are very good and very poor managers among the most active ones. Thus, investors must do their homework and be patient.
