Everyone is guilty – Charles Ellis on underperformance of active managers

(Aside – Charles Ellis is brilliant and those interested in the active vs. passive debate should be sure to pick up his book “Winning the Losers Game: Timeless Strategies for Successful Investing.” Additional disclosure: Ellis serves as a director to Vanguard, whose products we recommend for client portfolios.)

In the most recent Financial Analyst’s Journal, the publication of the CFA Society, Charles Ellis has a wonderful writeup about the underperformance of active managers of mutual funds, institutional funds, and the professionals and individuals who hire and fire these managers.

The culprits, as identified, are:

Investment Managers: Well intentioned professionals who believe deeply in the value they offer as active managers, but give little energy to self-evaluation. All managers believe they have an “edge,” some insight to the markets or their specific sector which will lead to outperformance.  These managers are practically always forward-looking, promising a bright future for their investors and ignoring the real results of the past.

Investment Consultants (that’s us): We’re the ones managing managers. We are  paid to evaluate style, performance, philosophy, execution and results of the Investment Managers.  Ellis points out that 1) predicting future performance of managers is next to impossible which leads to 2) over-diversifying managers in hopes that one manager’s underperformance does not wipe out a portfolio’s return. This over-diversification typically leads to higher fees due to lost discounts from institutional managers.

Eventually, this process of evaluating managers’ performance will lead to the firing of those managers with recent poor performance and the hiring of new managers with excellent recent performance – certainly no consultant would recommend to a client the hiring of a manager with a poor recent track record.  This Buy-High-Sell-Low pattern repeats indefinitely.

Ellis continues to discuss Investment Committees, Fund Executives and others who are guilty of continuing the perpetrate the idea that active managers can add value.  The full article is here for those interested:

http://www.cfapubs.org/doi/pdf/10.2469/faj.v68.n4.2

It is always encouraging to see a CFA build a case for passive management.  CFAs by nature are typically stock pickers and fund managers, and for one to lead a charge against actively managed stock portfolios takes some courage. This is an excellent read and I highly recommend it.

 

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