Why you should be a passive and not an active investor Part II: (almost) all active fund managers underperform their indexes and benchmarks

Note: this post is focused on general public investors and on public markets

Active investing is any investment product in which a man or machine actively makes decisions regarding the selection and allocation of the portfolio of investments. It is a product that is evolving all the time. All funds that have a fund manager, a portfolio manager, are included in this category.

Let me tell you right now that active investing has always worked, and always will. Markets are not fully efficient. One need only look at the number of billionaires that finance has created to realize that there is a lot of money to be made on markets. Skeptics will tell you thee managers’ billions are only investors’ money due to fixed management fees — fees of 2% per year on the funds/money they manage is common (2% per year of the money you invested with them are their annual management fees). But you can calculate the silliness of these comments for yourself. To earn $ 1 billion and become a billionaire, assuming a management fee of 2% per year, a fund manager would need to manage $ 5 billion for twenty years. The truth is, a lot of that money comes from what’s called performance fees, which are typically 20% in more sophisticated products: the managers keep 20% of the capital gains/performance/returns they make for you. The other 80%? They went to the investors. For every billionaire fund manager, many investors have made lots of billions with him/her. [at least until the manager starts losing their money including the money he/she made for them over the years, which typically happens as firms grow ever bigger and/or start new investment mandates which are different from what they were historically good at]

And there is even a select club of managers, called the 30/30: those who have produced annual returns of 30% or more, over 30 years or more. Legends like George Soros or Stanley Druckenmiller are part of it. The fund managers in this club, in 30 years of management, managing eventually 12 billion dollars for investors, has never had a year of negative performance. Yes, he became a billionaire while practicing his craft, but he made many more billions in profits for his investors. If you think it’s incredible, it is. But this is nothing compared to the mythical Medallion fund, managed by the famous mathematician Jim Simmons. Founded in 1982, the fund has annual returns of over 80% since its inception. Think about it: every year, year after year, dotcom crash and Great Financial Crisis included, this fund has generated 80% earnings for its investors. Closed to external investors for a long time, in early December 2017 this fund sent an email to the firm’s employees, informing them that they can all increase their own capital invested in the fund by 50%, but with only a few weeks to send the money. A Bloomberg article tells how employees frantically called their extended families to reunite the family gems and invest them in the fund before it closed again…

We have seen that there are fund managers who make more than 30% per year over more than 30 years for their investors, and some even more than 80%! And yet, I advise you to forget about it. Alas, these managers are almost all hard closed to additional investors, if they haven’t kicked out all external investors already (most of them have). But why don’t I encourage you to enrich yourself with the next such great manager, who still accepts new investors today?

There are three reasons for this :

1. Almost all of the best managers in the world only accept institutional clients such as big pension funds, insurance firms, or banks. You and I, the general public with our 5,000 dollars, simply do not have access to these funds. They are literally forbidden by financial regulators to market to us and the general public and to let us invest in their funds. And although their minimum investment is often $ 1 million for example, in reality the investors they are interested in are investors who can invest several hundred million dollars at a time.

2. Almost all of the best funds in the world are closed to further investment. All major products in the so-called statistical arbitrage category for example, a highly complex algorithmic strategy, are closed to new investors (Barclays, 2016). I know of pension funds managing $ 160 billion that are literally begging these managers to take another $ 100 million into one of their smallest funds, and they get turned down every year. So you and I — we can forget it.

3. Furthermore, many of the best investors in the world sooner or later decide to only manage their own money. George Soros, Stanley Druckenmiller, Medallion, whom I mentioned above, have all returned all the investors’ money and now manage only their personal money — and maybe their employees’ money if they are lucky. This is a pattern that is becoming more and more common.

But let me please take a step back and generalize the active investing industry with you. This industry, like the start-up industry, is extremely rightly skewed as it’s called in statistics:

Indeed, the statistics on the hedge fund industry are bloody:

Cambridge Associates, a leading investment consultancy, estimates that out of 15,000 hedge funds in the world, maybe 200 are capable of generating robust returns (alpha in industry jargon, defined as better / differentiated returns)

- Most hedge funds generate negative alpha, which means that most hedge funds lose money for their investors compared to the investment benchmarks (targets) they are trying to beat over the years i.e. compared to the US stock market if it’s a US equities hedge fund, or compared to the Japanese stock market if it’s a Japanese equities hedge fund

- Of 355 US equity mutual funds in 1970, only 3 (less than 1%) delivered statistically significant and consistent performance through to 2005

- 86% of investment funds active in Europe underperformed their benchmarks (what they were trying to beat as an investment target, typically something in which investors could have invested with much lower fees) over a ten-year period

- 100% of active funds sold in the Netherlands underperformed their benchmark over a period of 5 years

The research supporting these statistics is immense, and the findings overlap across teams and geographies from around the world. What does that mean ? The conclusion we draw is this:

in this space there is a huge amount of mediocre funds;

the average fund is mediocre; and

there are a few stars, who generate almost all of the industry’s returns.

When looking at such a rightly skewed distribution, we have two options:

1. we think that we have a very important advantage in selecting the investment funds that are on the right of the curve, the stars (the 30/30 on the graph). And in this case we should absolutely do it!

2. we don’t think we have any particular ability to identify these stars, and then we forget about this entire industry. The average fund/manager in this industry loses money so we definitely would not want to invest in the average. And a few funds deliver almost all of the industry’s returns, meaning if you cannot be invested in these few, you won’t be able to get any of this industry’s upside/profits.

The people who try this out in the hedge fund world, for example, are fund of funds managers — funds that only invest in hedge funds (and not in stocks, bonds, commodities, FX…). However, in addition to making it their full-time job, their due diligence on a potential investment can easily take 6 months, after years of actively monitoring each hedge fund, and this process involves several teams that can have 50–100 people working there. One such person, whom I respect a lot, told me that he has never invested in an investment fund without meeting and interviewing the management team at least 7 times. And be aware that very few funds of funds manage to generate returns for their investors. This is why the fund of funds industry is not doing well, having gone from 1.2tn under management to around 400 billion in the last ten years.

We saw in a previous post that markets are probabilistic by nature. And that therefore every professional investor manages enormous uncertainty from day to day in his portfolio. Now I have explained to you why your ability to choose and invest in, the best fund managers, is almost zero. Investing in active funds therefore amounts to multiplying the very weak predictive power of the best managers in the world (remember excellent ones can predict markets with 50.1% accuracy for example), by your almost zero ability to identify these fund managers. So you multiply almost 0 by 0 to get your probability of receiving good returns by investing in active funds.

This is why I don’t try my hand at selecting active investment funds in a personal capacity, even though I work in this industry. In my personal portfolio, I have no advantage, or even access, to identifying the stars of the industry, and the average is horrible. You have to be honest in life. This is why I like passive investing versus active investing, as a base strategy for most of us.

[caveat: I do invest in some of my friends’ funds, and funds that I have known while working professionally in the investment industry]