My general view (explained here) is that investors should use passive strategies in asset classes where it is difficult to beat the averages and active strategies where it is probable that the averages can be beat. Unfortunately, the active vs passive debate in many asset classes hinges on biases, dogma, and platitudes. Anecdotes and misused statistics abound, while rigorous questioning and examination are much harder to find.
Below are some questions that are commonly asked when evaluating whether active management can succeed in a particular asset class. Each is problematic in some way and also used (and the answers overplayed) by both the passive and active camps. Hopefully, the below is helpful in cutting through the BS and developing a framework for evaluating management style.
1. How many managers beat their benchmark in any given year?
The problem with the above question is that it is impossible to separate luck from skill. The number is likely to be higher in markets with higher volatility or more randomness. Therefore, we might ask:
2. How many of this year’s outperforming managers beat the market in consecutive years?
On the surface, this is a good question. However, it completely ignores the magnitude of outperformance or underperformance. Is it better for someone to gain 5% three years in a row or to get two years of 12% and one year of -2%?
3. We can look at active manager alpha over rolling 3-, 5-, 10-year periods, which should account for magnitude of gains of losses and focus on total return.
Yet, like any of the previous metrics, rolling returns vary over time. A particular manager or strategy might do well in one 10-year period and terrible in another. However, the data may show that it is consistently easy or difficult to outperform in a given asset class consistently through various regimes.
This is also a good place to pause and point out that questions #1-3 may lead to an aggregated answer, but can miss pockets of persistent outperformance. For instance, it is possible for subset of managers to consistently outperform in markets even if most underperform. That’s why #4 is important.
4. Shifting from asset classes to individual managers, it’s best to dig into the portfolio’s historical data and understand what drove performance in past years. This process is called “return attribution.”
Reviewing past performance and attribution is helpful, but certainly not prescriptive. Evaluating portfolio construction, strategy, historical returns and attribution provides a baseline understanding, but portfolios evolve over time and the future will inevitably unfold differently than the past. However, investors can understand a manager’s process and judge whether the returns were due to skill or luck and, ultimately, whether past success is repeatable or not.
The above is just a brief summary of some commonly asked questions and why they are problematic. As I mentioned, hopefully it is helpful in calling someone’s BS. We’ll dig deeper into specific asset classes over the next few weeks.