Passive insights for active management

By Jayson Forrest

Craig Lazzara, CFA is a Managing Director and Emeritus Global Head of the Index Investment Strategy Group at S&P Dow Jones S&P Dow Jones Indices
Craig Lazzara, CFA - S&P Dow Jones Indices

Craig Lazzara (S&P DJI) provides his thoughts behind why active managers face severe and continuing performance challenges when investing.

 

Passive insights for active management  Craig Lazzara S&P DJI

With more professional investors and managers chasing alpha, investing is getting harder. The capability of active managers today is much higher than it was, say, 30 years ago, but the problem is, today’s managers have to compete against people who are equally capable

Craig Lazzara, CFA

In a market environment characterised by skewed returns (which is every market) and relatively concentrated portfolios — which is what active managers do — you’d expect that most managers will underperform by a little, which will enable a few to outperform by a lot

Craig Lazzara, CFA

Most active managers underperform most of the time, with any outperformance tending to be temporary. This was the key view of Craig Lazzara, CFA — a Managing Director and Emeritus Global Head of the Index Investment Strategy Group at S&P Dow Jones Index — who cites S&P DJI research to argue that index investors have an above-average chance of achieving above-average investment results.

“Active managers are smart people. They work hard, are well trained, and are incentivised to do well, but nonetheless, most of them don’t. So, why is active management so difficult?,” asks Craig.

As  part of a wide-ranging discussion on passive and active management at an IMAP Independent Thought Roundtable (in association with S&P DJI), Craig suggested that there are three core reasons as to why active management is difficult:

1. Cost;

2. Professionalisation; and

3. Skewness of returns.

Cost

Craig believes cost contributes to the difficulty of active management. Referring to 2022 data from the U.S., the average expense ratio for actively managed U.S. equity funds was 66 bps, while the average for index mutual funds was 5 bps.

Professionalisation

According to Craig, it’s important to understand there is no natural source of alpha. In order for one investor to be above average, another investor has to be below average. He says the total outperformance of the winners must equal the total underperformance of the losers. And the source of the winners’ positive alpha is the losers’ negative alpha. This makes active management challenging.

“With more professional investors and managers chasing alpha, investing is getting harder,” says Craig. “The capability of active managers today is much higher than it was, say, 30 years ago, but the problem is, today’s managers have to compete against people who are equally capable.” 

Craig uses an analogy of a lion catching the slowest zebra in the herd. Once the lion has caught the slowest zebra, the speed of the herd naturally increases. And so it gets harder and harder to be above average.

“It’s analogous in investing,” says Craig. “When assets move from active to passive, it’s the least capable active managers who lose the most assets

Skewness of returns

In terms of skewness of returns, Craig says outperformance is generally driven by a few stocks, which contributes to the difficulty of active management.  Skewness of returns strengthens the case for diversification and owning more stocks. “The probability of outperformance rises when portfolios hold more stocks.”

Craig says where you really see skewness of returns is when you look at multi-year data. He refers to data from the S&P 500 (2003-2022), where the median stock was up 93 per cent and the average stock was up 390 per cent. Why? Because a small number of very big stocks, like Amazon and Apple, pulled up the average. “What that means is that in this period, only 18 per cent of companies beat the index.”  Craig believes return skewness does handicap active managers, because stock selection is harder than many people think.

“In a market environment, characterised by skewed returns (which is every market) and relatively concentrated portfolios — which is what active managers do — you’d expect that most managers will underperform by a little, which will enable only a few to outperform by a lot,” he says.

Dispersion does give us a way to measure the potential value of stock selection ability. If returns are tightly bunched — that is, they have relatively low dispersion — an active investor will find it particularly difficult to construct an index-beating portfolio. In such circumstances, the case for passive investing is especially compelling

Craig Lazzara, CFA

Continuing challenges

For these three key reasons, Craig believes active managers face continuing performance challenges from index funds.

He adds that when looking at active management, investors shouldn’t overlook dispersion, saying that generating a return in excess of the benchmark is particularly difficult if the gains or losses in the underlying stocks are tightly bunched around the benchmark. Therefore, dispersion provides a way for investors to measure the opportunity for active managers to add value.

According to Craig, stock dispersion can provide a tailwind for skilled stock pickers, but he also believes it’s a double-edged sword. While there is greater opportunity for stock pickers when they get the call right, there is also greater opportunity for embarrassment when they get the call wrong.

“Dispersion does give us a way to measure the potential value of stock selection ability. If returns have relatively low dispersion, an active investor will find it particularly difficult to construct an index-beating portfolio. In such circumstances, the case for passive investing is especially compelling,” says Craig. 

“And remember, concentrated active portfolios — which many active managers favour — reduce the likelihood of outperformance. This is something investors need to be mindful of.

About

Craig Lazzara, CFA is a Managing Director and Emeritus Global Head of the Index Investment Strategy Group at S&P Dow Jones Indices.

He spoke on ‘Passive insights for active portfolio managers’ at an IMAP Independent Thought Roundtable (in association with S&P DJI).

 

 

 

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