Value of Active Investment Management Part 2: Why hasn’t active management worked for [individual investors]?

“The mutual fund industry is not an investment management industry. It’s a marketing industry.”
– David Swensen (fmr. CIO of Yale & asset allocation pioneer)

Why hasn’t active management – and we mean specifically in mutual funds – worked for individual investors? We think there’s actually a very simple answer to this question:  It wasn’t designed to work for individual investors. Because if the active fund industry were designed to give investors good results, we think the industry would look much, much different than it does. But it doesn’t – as the quote above from a very influential investment strategist suggests, the industry is geared towards marketing, not necessarily managing investments. And that’s what we’ll get into next.

If we were to give it an analogy, the “actively managed” fund industry is designed a lot like a car with flat tires. While you can get to where you want to go with flat tires, it’s slow. It’s not optimal. It stinks.

NOTE:  The quotes around “actively managed” above are intentional. You’ll see why in a bit. Hang in there, please.

You might also notice the title has those little brackets “[]” above. There’s a reason for that: In fact, the fund industry has grown very large and made many people very wealthy. It’s just that it hasn’t always been as helpful as it could be for individual investors.

“Every system is perfectly designed to get the result that it does.”
― W. Edwards Deming.

The reason we’ve added this next quote here is to simply point out that, by design, the active management industry has gotten great results for itself. Namely, fund company executives, salespeople, fund managers, and investment consultants, to name a few.

How big is this industry, and how did it get so big?

Mutual funds first started with the Massachusetts Investors Trust fund a century ago. The fund structure, for most of its early few decades of existence, gave investors some nice benefits:

• Diversification – You could buy many companies (stocks) in a single fund, which wasn’t easy or affordable in an era of very high trading costs.
• Performance – Fund managers often had better information and investment skills than many individual investors.

Fast forward to 1978, when mutual fund companies had a huge new opportunity as the modern-day 401k was born. Hence, much of the 80s and 90s saw funds grow assets tremendously—in 1980, the US mutual fund industry managed around $150 billion, and today it stands at around $34 trillion! Along the way (in 2000, to be exact), a law known as Regulation Fair Disclosure (“Reg FD”) came about. The idea was that companies were no longer allowed to selectively disclose information to some investors before others—instead, they had to announce news widely. This meant that industry people were no longer allowed to have information before the general public. It turns out that was a really big deal.

There’s good evidence to suggest that, since Reg FD, fund performance just isn’t nearly as good as it was before it (Edward Nelling, 2018). In other words, it indicates that funds used to have better, more timely information than they did after the regulation was implemented. A skeptic might say you used to pay the management fee because fund managers were “in the know.” But Reg FD squeezed that out.

And yet, fund expense ratios (the price you pay for professional management) haven’t really come down. While it’s a little challenging to get perfect apples-to-apples data, in 1996, a random draw of any U.S. fund would produce a 1.32% expense ratio (Division of Investment Management, 2000). In 2002, that still stood at 1.12% for a randomly drawn U.S. stock fund. That’s despite clear evidence of not-so-great performance after fees across the board—especially since Reg FD. (Quick tangent: yes, fees for the biggest funds have come down; the “active stock fund” industry’s asset-weighted average now stands at 0.66% vs. 1996’s 1.08% (James Duvall, 2023)  This gives us hope that, slowly but surely, the “closet index” problem is being solved by market forces – a topic we’ll discuss a bit later).

It’s estimated that global mutual fund revenue is around $364 billion (on around $52 trillion in assets under management), and we’d guess a bit over half the revenue is in the U.S. alone. (PWC, 2023)

You mentioned that it’s not designed well for investors. What do you mean?

The cartoon says most of it. The industry generally has talented fund managers and analysts, but it weighs them down with constraints, bureaucracy, and unnecessary costs. If we wanted to redesign the industry to work better for investors rather than fund managers, removing as many of these as possible would be helpful. Additionally, the fund industry needs to get much better at learning how to sell investments – a topic we’ll address a little later.

But even still, if you look at the performance table below, you’ll notice that, before fees, funds actually do alright. That might surprise many people because it doesn’t seem like it’s reported very often. Nowadays, it seems like the mainstream headline is that active managers really suck because investors in their funds don’t do as well as they could. They’re not completely wrong, but there is a lot of nuance to that. And we intend to cover some of that nuance below.

So let’s get into it…

Sidenote: When Adam joined JSA, we celebrated his breaking away from the “institutional handcuffs” by having him literally smash a pair of toy handcuffs on his first day.

The table illustrates an important point. Funds, before fees, seem to add value, but once you add in the fees in 4 of the 5 categories, the net return to the investor (what an investor would actually earn) is negative. That’s why we think the design is a little like a car with flat tires. Or a sprinter that ties cinderblocks to her feet. Bad design. They go slower than they should. The investor is worse off, and that…stinks.

What is Closet Indexing?

I’ve given this topic its own header because of how important the “closet indexing” problem is. I’ve highlighted (in red) “Closet Indexer” active share, because of how flawed that specific type of fund is. “Closet index funds” charge similar fees to the industry but make little-to-no attempts to generate better returns. In part 1 we mentioned that you can invest in the US S&P 500 for around a cost 0.02% per year, so why would you pay 0.44% for the same thing (you’ll just get 0.42% worse results per year)?

These funds are a scourge for investors but are massively profitable for the fund industry. Unfortunately, they still represent about 1/3 of what’s considered “actively managed” mutual funds and almost half of the industry’s assets. If you’re a skeptic, you might call these funds a big lie. That’s not wrong. Yuck. Gross. Disgusting.

What Do We Think Are The Biggest Fund Flaws?

Whew. Let’s take a big breath, pause, and then get into the “design flaws” within the fund industry. Cue up your best song playlist because we do not intend to hold back.

1. Investors Pay the High Cost of “Shelf Space”

BIGGER IS BETTER—for fund companies but not necessarily for investors. The math just works. If a fund has $50 billion dollars and an expense ratio of 0.66%, it generates an incredible $330 million in fee revenue for the fund company. Three hundred and thirty MILLION DOLLARS!!!

Clearly, the incentive for funds and fund companies is to get as big as they can—to GATHER ASSETS. Fund companies often refer to “distribution” as their key to growing those assets. What they mean is: try to get as many people as possible to invest in their funds.

• Who sells them?
• Can they get into a 401k at a large company?
• Can they get consulting firms to sell the funds?
• Can they pay for favorable treatment at large wirehouses (financial firms that we would all recognize)
• And so on….

When you look at the menu of choices inside your 401k, have you ever wondered how those choices got there? Chances are it was a competitive situation, and that’s what we’re talking about—the competition for “shelf space.” 401ks are just one area of “shelf space”, but there are others. And there’s probably way more than we even know about this.

Investment performance is usually secondary. Yeah, sure, fund companies love it when their funds outperform—because it gives them something to sell—for a while. But that’s fleeting. Generally, they care more about distribution and growing assets because the economics of holding more assets is just simply too good. Shelf space in the investment world works just like the aisles at Walmart, Target, or your local supermarket. If your products (funds) take up the most space, your product gets bought, not necessarily because it is good (it might be) but simply because it is on the shelf.

The thing is, this game for shelf space doesn’t likely add any value to the individual investors in the funds at all. It’s simply for the fund companies themselves. You don’t have to take our word for it—Alpha Architect has a nice writeup of this “conflict of interest” problem here (Wesley Gray, 2015).

2. Investing Constraints – Style

We’ll start this section with a picture known as the “Morningstar Style Box”, which puts stocks into a tic-tac-toe style from big to small and value-to-growth (Equity is a word that often means the same as Stock).

Maybe you’ve seen this before when trying to pick a fund. There are small cap, mid cap, large cap stocks and value, blend, and growth stocks.

Okay, fine. But often, many of the really great stock investments in history have lived in many of those boxes in their lifetimes. Monster Energy, Southwest Airlines, Intuitive Surgical, Amazon.com, Netflix—they’ve been small, value, large, and growth in their lifetimes. No matter what box they’ve checked, they have delivered for investors.

But if you are a fund manager tasked with managing a particular fund in one of those 9 boxes, going outside of that box can come at a penalty—you stand to lose assets under management because you may no longer fit in your supposed box.

And smaller funds make less money. It may not matter what your skills say what the right thing to do might be, investment-wise. So, a conflict can exist wherein your fund must stay in the box, no matter what your research or intuition might suggest. Stay in your box because your business depends on it.

That’s just not an optimal way to invest or make investing decisions. But this box sits atop the entire fund industry, and it is extremely powerful for fund managers. Even Morningstar itself has a news item on its own website that discusses some of the challenges with the box they invented! (Lee, 2014)

3. Investing Constraints – Size & Liquidity

There are two components to the size problem. But since we’re on the topic of the style box, let’s start there because it’s related. The same thing applies to value-blend-growth as it does to small-mid-large styles. Fund managers often find a very strong business incentive to stay within their box, even when research and intuition point them to a good investment outside their box. As a result, quite often, an investment idea that a manager may otherwise think is a good idea simply doesn’t make it into their fund because it “breaks the rules.” Once again, we can point to Morningstar’s own news item on this one.

The second problem with size exists as a fund gets bigger. A big fund can start to face issues with liquidity (Joseph Chen, 2004). In our earlier example, we mentioned a $50-billion fund, which, to be fair, would be awfully big. But some of those exist; let’s just do a little math here.

If this fund’s really smart people found a great investment and wanted to make the investment 2% of the fund, the fund would need to buy a billion dollars of the investment—ONE BILLION dollars.

That’s not always easy to do because the size constraint can kick in. What if the company’s entire value is only 10 billion dollars, and it takes two years for the company to trade 10 billion dollars? Well, that would mean the company only trades 19 million dollars a day, and buying a billion dollars is going to be a problem—it would take 52 trading days. Yes, there are ways to beat that (outside the scope of this post), but the point is the liquidity issue for big funds can be a real issue.

So, the investment could be off limits because it’s too hard to buy, and holding that much may also be considered risky if it needed to be sold very quickly. That’s even if the managers or analysts came across the idea and thought it was a good one. The likelihood this gets in the fund is super-low.

But stay tuned……because the fund’s managers may get to buy it for themselves ☹.

In general, small is an advantage from a pure investment-selection perspective. In our experience, this is pretty well-known among institutional investors. Kingsbridge Partners has a decent writeup on this topic, though their focus is geared more towards the hedge-fund universe (Kingsbridge Partners, 2021).

Hedge fund or mutual fund —the conclusion is the same…flexibility and the ability to be nimble are advantages, period. That’s because you can use analysis, creativity, and talent to make money quickly.

4. Overdiversification

There’s good evidence that the top 25(ish) ideas in most funds do quite well (Alexey Panchekha, 2019) (Miguel Anton, 2021).

What’s weird is most funds invest in way, way more than 25 holdings—sometimes over a hundred—and those additional holdings usually come at a great cost. That’s terrible grammar, but it’s intentionally bad to drive home the point—if you follow any of our linked sources, you’ll see that the results of holdings beyond the 25^th holding tend to generate abysmal results. Really, really bad.

Now, those additional, value-destroying holdings could be in a fund for many reasons. But mostly, it’s probably because there became “too many cooks in the kitchen.”

Why? You might think that fund managers are the only ones deciding what to buy or sell. And we would argue that’s true in the best funds. But many funds have other influences, too. That’s because “the business of investing” isn’t optimized to make decisions. Here are just some of those influences we’ve seen make an impact on fund manager’s buy/sell decisions that have little to do with what they think might make a good investment:

• The risk department wants a fund to work differently because of volatility or “factors.”
• As mentioned above, the “Style Box” pressure can force managers to “stay in their lane” (this often comes from investment consultants, fund company executives, or the manager’s own paycheck incentives)
• Consensus decision-making—funds often try to appease their internal constituents like other fund employees and analysts. Decision-making by the dozen generally doesn’t work in this business. But it happens a lot.

So what happens is funds often own too many investments. And more often than not, it hurts their performance. It might seem silly, based on the evidence. But it’s true.

5. Fund managers and analysts – “The P.A.”

That was a lot, so let’s sum it up. Again, if you look at the cartoon—the fund world is full of people with good intentions and, quite often, lots of talent. They generally WANT to invest as well as they can. They’re usually smart and capable. But the business of investing—especially in the mutual fund world—doesn’t typically allow those people (in aggregate) to deliver real value to the investors buying their products. It’s too bureaucratic and constrained. But it is quite profitable, so change is slow.

So let’s say you’re one of these talented investors in one of these jobs, and you happen to encounter something you think can be a good investment. But what if that investment doesn’t follow “the rules”?

You ask your local compliance officer if it’s okay to buy it for yourself in your “Personal Account”—otherwise known to industry participants as “Your P.A.” Once they give you the go-ahead, you can make your purchase.

This is everywhere. Fund managers and analysts often invest in all kinds of things they don’t (or can’t) invest in with the funds they manage.

Now, to be fair, there can be some truly good reasons for this. But….and we can’t prove this because the numbers will never be available….but we’d guess that something like 2/3 of that is because of the aforementioned constraints. Maybe it’s company size or style. In many cases, the manager or analyst isn’t allowed to invest in their idea because it doesn’t fit, but they think it’s a good idea, so they purchase it for their personal portfolio.

That’s not very well aligned with the fund’s investors, is it?

6. Lack of skill when selling portfolio holdings

If you’re a fund manager or analyst, you refer to working on the “buy-side.”  That’s an interesting description because it does a very good job of telling the story of the skill that has been predominantly honed over the years by most of the industry—that is, learning what to buy. And fund managers are pretty good at it, not just because their highest-conviction ideas tend to do well, but we can also see this because, before fees, the industry’s numbers are not too bad.

Let’s say that, before fees, a fund was to beat the market by 0.5%, and yet can show that it loses 0.8% per year because its managers are not very good at selling. That would mean that it out-earned the market by 1.3% due to its buying skill (the very skill that the industry is centered around).

Of course, if the fund charged 1% a year to investors, it would be a losing proposition. But, if it could just erase its selling-skill problem—make it a zero—then it would be a winner by 0.3% (1.3% skill minus 1% fee is 0.3% better per year).

It’s not a mistake that we chose 0.8% per year lost due to this hypothetical fund’s lack of ability to sell well. It turns out that funds, on average, lose something like 0.8% per year because they sell terribly (Klakow Akepanidtaworn, 2021). If we tack on the average fee of 0.68%, then you get to nearly 1.5% of costs due to fees and, well, being bad at selling stocks (not sure what else to call it).

There’s nothing like starting an investing race 1.5% in the hole…that’s a lot of ground to make up with other skills. Starting that far behind doesn’t win. It stinks.

Now, you might think that an industry that is highly credentialed and decently incentivized to get this right would do a better job, right? There’s a boatload of money to be made. But that hasn’t been the case, and we suspect that’s for three reasons (We’ll speculate here):

• The industry remains very highly profitable without closing the gap. Why change?
• Awareness of this issue is likely quite low, in fact. It’s hard to describe why the industry doesn’t do a better job at studying its own decision-making, but we’d point back to how profitable it is.
• In firms where awareness might be better, building a culture that is good at breaking its own ideas requires a level of disagreeableness and conflict within its team that is culturally difficult for people and/or organizations. Arguing tends to breed avoidance. But it shouldn’t. Investors pay the price.

It’s important to state that not every fund has all of these flawed characteristics. But overall, those 6 criticisms are quite fair of the industry (there are more). Our personal experience suggests they’re widespread. Frankly, we could even come up with a few more problems (especially how the industry defines risk), but we believe these 6 are the most important for any fund investor.

Does the fund industry really have to be designed that way? We don’t know, but we doubt changes will be made anytime soon. The economics, bureaucracy, and regulations (which we didn’t touch on above) make it what it is.

So you can buy index funds and avoid these issues, or seek out a truly active manager with the right characteristics. The former is easier than the latter, which is why the index fund has been winning market share for decades. Easy peasy. But we’d contend that good active management also deserves consideration, too. It’s just hard to identify what that is. We’ll get there, so please keep reading.

Are all funds designed badly?

No. We believe this is where it starts to get really interesting.

Many funds can (and have) chosen to design themselves to be better. It doesn’t mean they work out better (we’ll touch on this in a bit), but they try. If you’re looking for clues that might suggest that a fund is constructed well and wants to add value, here are a couple of key characteristics to look for:

• High active share (above, say 80)—this indicates the fund is trying to “win”—see below
• The fund manager has a significant investment in his/her own fund
• Low (or no) turnover of people managing the fund
• Long-term focus—not much change in holdings over time (aka “low portfolio turnover”)
• Best Idea Focus
• Staying “within capacity” (i.e. allowing the fund not to grow in size past the point where it can’t perform as well)

Consider this—we think that the best-performing fund we’ve ever heard of—Renaissance—run by math wizard Jim Simons, earned 66% per year (before taxes and fees) for over 20 years (Zuckerman, 2019). It had a rule that it was never allowed to grow in size because they knew that if they let it do so, it would hurt returns.

Wait, so most of the work, research, evidence, and articles recommending using passive investing or indexing are simply to avoid badly designed active management funds?

Yep. Pretty much.

That’s why we think the invention of the index fund has been awesome for investors and society. It’s saved investors tremendous amounts of money and helped them get better results. But it’s probably done that because it avoids the problems above and doesn’t charge much. That’s it. It just turns out those design flaws are quite expensive for investors, and index funds flatten them, for the most part.

Of course, index funds are not perfect, and, as we pointed out in the first part of this series, all investment decisions are still active in some way.

Plus, there’s the math part that means, by definition, an index fund cannot possibly do better than its benchmark. That’s because an index fund typically has a tiny fee while tracking its index. Better is not possible. And that’s fine. Just understand that math!

How can I separate funds into “active” and “not active”?

The modern measure for how much a fund “tries” to win for its investors is called “Active Share.” The closer it is to 1.0, the more active it is—aka, the more it really tries.

In a paper written by the original Active Share authors, this chart appears (Martijn Cremers, 2016). While the authors would tell you under 60% (0.6) is definitely not active, we’d argue that you could probably increase that more. Whether you choose 60% or 75% as your threshold, you probably need to at least throw away something like 30 to 50% of all funds—that is, they aren’t active, but they’re probably charging fees like active managers.

This is often referred to as “Closet Indexing.” We think these funds are among the worst. They charge high fees but make little to no effort to add value for investors. This would be more like a car without an engine or running a sprint carrying 50-pound dumbbells. In both examples, you have a bad design to accomplish the goal. That’s crummy, and you should avoid such funds.

So, truly active funds do well?

Not necessarily, but your chances of doing well with truly active funds are probably better than what you’ll read in the mainstream. In fact, if you layer on what we believe to be the “good” characteristics above—that same paper shows that those types of funds do tend to show much better results than most. But, not always—we can point out some poor funds, also.

And it’s important to note that just being very active (trying to win) is no guarantee that a high “active share” fund (one that’s really trying to do better than markets) will turn out to do well (Andrea Frazzini, 2016).

If you really want to get into a well-written examination of the evidence, it’s hard to do better than this post by Larry Swedroe posted over at Alpha Architect (Swedroe, 2017).

If you could design a better actively managed system for investors, what would you change?

• Make closet indexing illegal. Seriously. A closet index fund offers little value to its investors. Worse yet, they give the industry a black eye.
  • In lieu of making closet indexing illegal, we would settle for significantly enhanced disclosure or regulation of these types of funds.
• Let the talent be the decision-makers. Funds usually have far too many voices involved when making investment decisions. Analysts, multiple managers, marketing / sales, investment consultants, etc. Decision by bureaucracy in managing funds simply kills performance.
• Plug the “selling skill” hole. This one is on the fund companies themselves. They could choose to do this but years of inertia focused on “what to buy” is hardwired. If there’s a real skill flaw, it’s this one.
• Create a better alignment of interests. We prefer that fund managers have significant “skin in the game,” and that would be our preferred method of aligning investors and managers. This is akin to “eating your own cooking” or having the pilot on the plane and not flying from the ground with a joystick. You want the incentives to work. If personal investment doesn’t work for some reason, I’d still want all managers to have the very best alignment they can have. There is simply far too much “I own this in my P.A.” going on in fund management. This means the manager owns something personally (in their Personal Account) but not their managed fund. Ick.
• Drastically reduce the role of “investment consultants”
• Kill the “style box”

Unfortunately, with the business model of money management, getting bigger equals more profits. So, there will always be the incentive to grow assets, which often conflicts with better investing. We don’t know how that can be balanced perfectly, but we do know that the current system focused on closet-indexing and expensive distribution costs doesn’t work well for fund investors, as a whole.

This is why investors have been revolting (selling) for years, and they’ll probably continue.

Why do investors stay with poorly performing funds?

In most cases, we’d bet the investors simply don’t know the fund isn’t built well. Here are a few ideas:

• “Shelf space” competition, say, inside a 401k, has crowded out other, better options
• Investors don’t know or aren’t aware of underlying fund expense
• Understanding investment performance can be tricky
• Finance is boring, and many don’t invest the time to understand some of the above

How does Jacobson & Schmitt Advisors think about these topics for its own investments?

The short answer is that we are keenly aware of the conflicts between the business side of investing and the “trying to make good investment decisions” side. Our firm and core investment strategy are designed with these issues in mind, and we’ve tried our best to reduce their influence on the way we invest. For example, JSA partners are invested alongside our clients (we have tremendous “skin in the game”).

Of course, we can’t engineer the “bigger = more profits” part out of our company, either. But we do vow to keep the core JSA investment strategy within its size capacity because, hey—our money is in it too. Should we ever get to a point where things need to change, we’ll have to think about how best to structure things so that our clients can continue to get value for what they pay, which we think should always be the point.

Summary

Now that you have a better understanding of the mutual fund industry, here are a few things you can do if you’re an individual investor.

• Know your mutual fund’s active share and expenses. You can research both on the website https://activeshare.info/#/. Consider selling funds with low active share or high expenses.
• Work with an advisor that invests alongside you. After all, you want their incentives to be the same as yours.

 

Read the Value of ACTIVE Investment Management – Full Series

• Part 1: ACTIVE versus Passive
• Part 2: Why hasn’t ACTIVE management worked (for individual investors)? (This post)
• Part 3: Striving for superior ACTIVE returns (what JSA does differently)

References

Alexey Panchekha, C. (2019, October 03). Enterprising Investor. Retrieved from CFA Institute Blog: https://blogs.cfainstitute.org/investor/2019/10/03/the-active-manager-paradox-high-conviction-overweight-positions/

Andrea Frazzini, J. F. (2016, January 6). Deactivating Active Share. Retrieved from AQR Capital Management: https://www.aqr.com/-/media/AQR/Documents/Insights/Journal-Article/Deactivating-Active-Share.pdf

Edward Nelling, V. L. (2018, December 14). Do More Active Funds Still Earn Higher Performance? The Effect of Regulation Fair Disclosure. Retrieved from SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3300086

Joseph Chen, H. G. (2004, May 1). Does Fund Size Erode Mutual Fund Performance? The Role of Liquidity and Organization. Retrieved from SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=372721

Kingsbridge Partners. (2021, February 11). Fund size and performance: why small funds are the best performers. Retrieved from Kingsbridge Partners: https://kingsbridgealts.com/fund-size-and-performance-why-small-funds-are-the-best-performers/

Klakow Akepanidtaworn, R. D. (2021, July 20). Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors. Retrieved from SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3301277

Lee, S. (2014, November 12). The Uses and Misuses of the Style Box. Retrieved from Morningstar ETF Education: https://my.morningstar.com/my/news/132199/the-uses-and-misuses-of-the-style-box.aspx

Martijn Cremers, A. P. (2016, July 21). Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently. Retrieved from SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2498743

Miguel Anton, R. B. (2021, April 21). Best Ideas. Retrieved from SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1364827

Swedroe, L. (2017, June 15). Active Share: Does it Predict Fund Performance? Retrieved from Alpha Architect: https://alphaarchitect.com/2017/06/active-share-predict-fund-performance/

Wesley Gray, P. (2015, March 11). Distribution Economics: Understanding Wall Street’s Conflict of Interest Problem. Retrieved from Alpha Architect: https://alphaarchitect.com/2015/03/understanding-wall-streets-conflict-of-interest-problem/

Zuckerman, G. (2019). The Man Who Solved The Market: How Jim Simons Launched the Quant Revolution. Penguin Random House.