Podcast Summary
Shift from active to passive investments in US markets: The trend towards lower cost investments, specifically passive and ETFs, is dominating the mutual fund and ETF space in the US, with large cap and large cap growth seeing the most significant shift away from active and high cost investments.
The trend towards lower cost investments, specifically passive and ETFs, is dominating the mutual fund and ETF space. According to Jeff Ptak, the head of global manager research at Morningstar, there has been a significant shift in market share from active to passive investments in the US. This shift is due to a number of factors, including the opening up of platforms, unbundling of services, and a focus on cost. Large cap and large cap growth have been the biggest victims of this trend, seeing the most flight out of active and high cost investments. However, there are still areas where active management continues to be believed in more than others. Overall, the industry is moving towards lower cost investments, and this trend is likely to continue.
Shift from Active to Passive US Equity Investing: Despite the trend towards passive investing, active management may regain popularity during market downturns or when style leadership, market trends, and dispersion favor it.
There has been a significant shift of assets from actively managed US equity styles, particularly large cap and large cap growth, into passive investments such as total stock market trackers like those offered by Vanguard and S&P 500 index funds. This trend towards low-cost investing is expected to continue, but there may be periods where active management becomes more popular again. Three factors have been holding active funds back in the US equity market: the nature of style leadership, market trends, and dispersion. When the style in which an active manager specializes is leading the market, the index to which they are compared tends to outperform, making it harder for active managers to add value. The prolonged bull market has also made it difficult for active managers to shine. Dispersion, or the spread between different investment styles, has been low, reducing the payoff for active managers who deviate from the index. However, if these factors were to reverse, such as during a bear market, active managers may experience a resurgence in popularity. A study found that only 1 in 12 surviving funds outperformed their benchmark on a dollar-weighted basis, taking investor timing decisions into account.
Evaluating Active Fund Managers: Fees, Ownership, Tenure, and Turnover: Fees, manager ownership, tenure, and turnover rate are essential factors when evaluating active fund managers. Cheaper funds are more likely to survive, manager ownership and tenure show commitment, low turnover reveals insights, and understanding the fund family's structure provides context.
When evaluating active fund managers, fees, manager ownership, manager tenure, and turnover rate are important factors to consider. Fees are crucial due to the higher likelihood of survival for the cheapest funds in a given category. Manager ownership and tenure are significant indicators of a manager's commitment and belief in their strategy. Low turnover rates for equity managers can reveal insights into their investment process. Lastly, understanding the fund family's structure and focus can provide context for potential risks and complexities. It's essential to note that these factors should not be the only considerations when assessing active fund managers, but they can serve as a solid foundation for the evaluation process. Additionally, the speaker mentioned that a clear minority of managers invest large amounts in their own funds, and this can be a strong signal of confidence in their strategy.
Impact of investment firm's involvement on fund performance: The investment firm's commitment to the investment strategy and their own investment can significantly impact a fund's performance. Both boutique and larger firms have advantages and disadvantages, and tenure and team management are also important factors to consider.
The involvement and commitment of the investment firm or manager to the investment strategy can significantly impact the fund's performance. In some cases, firms may not invest their own money in the same jurisdiction as the fund, and this could raise concerns about their level of commitment. Regarding the size of the firm, both boutique and larger firms have their advantages and disadvantages. Boutique firms may face challenges in terms of scale, continuity, and team management, while larger firms could potentially face distractions and lack the single-minded focus that a boutique firm might offer. Tenure is another factor to consider, as a manager's long tenure could mean they are nearing retirement and may not be around for the entire investment horizon. However, relying too heavily on a single investor can also be risky, and team management can help mitigate this risk. Additionally, it's important to note that winning funds don't always look like winners in the short term, and some of the best performing funds may have long periods of underperformance. The Sequoia Fund, for instance, is a well-known example of a fund that has had significant underperformance at times but has delivered strong returns over the long term.
The Behavior Gap: Underperformance in Successful Funds: Successful funds can underperform for extended periods. The behavior gap, common among top-performing funds, emphasizes the importance of patience and long-term commitment. Diversified, controlled environments like target date funds exhibit smaller gaps and reduce investor anxiety.
Investing in funds, especially active ones, requires patience and a long-term perspective. The discussion highlighted that even successful funds with impressive track records can experience extended periods of underperformance. For instance, Sequoia, despite its distinguished discipline and research-intensive culture, faced underperformance for over a decade. This phenomenon, known as the behavior gap, is common among top-performing funds, with even the best ones experiencing 10-year periods of underperformance. Target date funds, a type of asset allocation product, are an exception, as they often exhibit smaller gaps between investor returns and fund returns. This is due to their situational advantages, such as being offered in a controlled environment like defined contribution plans or as part of a broader advisory solution. Additionally, their diversified nature helps to reduce investor anxiety and the likelihood of inopportune purchases. Understanding the behavior gap and its implications is crucial for investors. It emphasizes the importance of staying committed to a long-term investment strategy, even when faced with underperformance, and highlights the benefits of investing in diversified, controlled environments. For those who find the required patience and resolve challenging, index funds may be a more suitable alternative.
Why Indexing is a Better Choice for Most: Challenges of consistently selecting active funds lead to better outcomes from indexing. Fewer trades and actions result in better investment results. Prepare for long-term commitment and thorough research for active management.
Index investing is generally a better choice for most individuals due to the challenges of consistently selecting successful active funds. Active funds can be streaky and require significant research and commitment. If an investor is not willing to put in the effort, they are likely to achieve better outcomes by indexing. Additionally, fewer trades or actions tend to lead to better investment results. For those who insist on actively managing their investments, it's crucial to be prepared to live with the decision for an extended period and do thorough research beforehand. While there are opportunities for quality active managers, the success rates are low, and it's essential to consider factors like fees, turnover, and manager tenure. Beyond these quantifiable factors, demonstrating a manager's resolve and understanding their investment process are crucial qualitative aspects of evaluating a good active strategy.
Understanding a manager's turnover rate: Low turnover rates can indicate resolve, careful consideration, and a long-term perspective. Metrics like ActiveShare and Tracking Error are helpful, but not definitive for investment decisions.
Understanding a manager's turnover rate can provide valuable insights into their investment strategy and approach to markets. Managers with low turnover rates may exhibit traits such as resolve, careful consideration, and a long-term perspective. However, metrics like ActiveShare and Tracking Error should not be the sole basis for investment decisions. These metrics can be helpful in guiding research, but they are not definitive. ActiveShare, in particular, can be useful for understanding a manager's approach to the investment craft, their opportunity set, and their benchmark awareness. However, it's important to note that ActiveShare can be sensitive to the chosen benchmark and should not govern the diligence process. Instead, it should inform and guide research, helping to uncover deeper insights into a manager's investment philosophy.
Understanding the true cost of actively managed funds: The cost of actively managed funds goes beyond just the expense ratio. The level of activeness within a portfolio and the moat-building strategies of fund managers can significantly impact costs to investors.
The cost of actively managed funds goes beyond just the expense ratio. The level of activeness within a portfolio, or the Active Share, can significantly impact the cost to investors. Morningstar recognizes this concept and suggests using resources like activeshare.info to compare the adjusted expense ratios of different funds. Additionally, asset managers or fund managers can build a moat around their business or process to outperform in the future. One way to achieve this is through economies of scale, which provide cost advantages. Another way is by cultivating a research-focused culture and attracting the right type of clients. Examples of firms that have successfully built moats include Vanguard, Dimensional, and Capital Research.
Developing a following and investing identity contribute to investment management success: Cultural factors like developing a following and investing identity, distribution networks, and conveying value to customers are crucial for investment management firms to build a successful business.
Building a successful investment management business involves more than just achieving high returns and scale. Cultural factors, such as developing a following and investing identity, can also contribute to success. Distribution is another key factor, and firms with a global reach can build a moat around their business. However, investors today are increasingly focused on low costs, so effective distribution strategies should prioritize conveying value to customers and aligning expectations. Firms like American Funds, Dimensional DFA, Vanguard, and Ishares have effectively leveraged their distribution networks to build strong followings among advisors and other investors. These firms have overcome initial skepticism and resistance to establish themselves as trusted partners in the industry.
Effective communication between investors and clients: Primecap Management's long-term focus and alignment with shareholders sets them apart through structured incentives and analyst ownership
Effective communication between investors and their clients is crucial for success in the investment industry. I was particularly inspired by my experience researching Primecap Management, a Pasadena-based firm known for their long-term focus and alignment with shareholders. Primecap sets themselves apart by structuring incentives that look beyond short-term performance and allow analysts to manage a sleeve of the portfolio, fostering a sense of ownership and commitment. As we look to the future, it will be interesting to see how active fees and their structures evolve to better align the incentives of managers and shareholders in the prevailing asset-based fee paradigm. Primecap's innovative approach serves as a valuable example for the industry.
Aligning incentives between active managers and investors: Performance-based fees can incentivize active managers to focus on long-term performance, but lack of transparency could hide risks or underperformance, so finding the right balance is essential.
The trend in fees for active funds is heading downwards, and investors are increasingly moving towards passive investments due to the fee gap. To align incentives better between active managers and investors, the speaker suggests performance-based fees as a solution. However, this needs to be structured properly to effectively incentivize long-term performance. While performance-based fees have their merits, such as making managers more thoughtful about capacity management, there are also potential downsides, like the lack of transparency. Transparency is often seen as a positive, but in some cases, it may not be ideal. For instance, hedge funds with high fees and a significant performance-based component may not be as transparent as other investment vehicles. This lack of transparency could potentially hide risks or underperformance, making it difficult for investors to make informed decisions. Therefore, striking the right balance between transparency and performance-based fees is crucial.
The importance of balancing transparency with patience and long-term perspective in investment management: Over-monitoring investments can lead to frequent trading, resulting in a significant gap between dollar-weighted and actual returns. Focus on thorough research and long-term commitment to minimize behavior gap and maximize investment returns.
While transparency is crucial for effective investment management, it can also lead to detrimental behaviors if taken to an excessive level. Over-monitoring of investments can result in frequent trading, leading to a significant gap between the dollar-weighted return and the actual return of investments. This issue is particularly prevalent in growth funds or sector funds with impressive runs, where investors may be tempted to make hasty decisions based on short-term performance. To mitigate this issue, some suggest implementing penalties for withdrawals or using entry and exit fees judiciously. However, these solutions may not be feasible for everyone, and the active management community may rely on such investor mistakes to generate alpha. Instead, investors should focus on the importance of thorough research and long-term commitment to their investments. In conclusion, transparency is essential, but it must be balanced with patience and a long-term perspective. By avoiding the temptation to over-monitor and over-trade, investors can potentially minimize the behavior gap and maximize their investment returns.
Influx of assets into a strategy can be a warning sign: Assess investment thesis and manage client expectations when assets influx, recognize underperformance may be part of potential outperformance, and expand investment classification beyond value-growth with factors like momentum and quality.
When there is a significant influx of assets into a strategy or investment, it may be a warning sign. This has been observed in the past with popular mutual funds and liquid alternative funds gathering massive assets, leading to a shift from investment thesis to a story with tag-along effects. It's crucial for investors and advisors to pause, assess their thesis, and manage client expectations accordingly, acknowledging that underperformance may be part of the price for potential outperformance. Additionally, the value-growth dichotomy, which has been a pervasive way of categorizing investments since the 1990s, is being challenged with the rise of new factors like momentum and quality. Morningstar, in response, has expanded its commercial risk model to include numerous factors beyond size and value-growth, recognizing the need for more sophisticated ways to classify securities and attribute their performance. One of the most memorable experiences in the professional career of the speaker was witnessing Elliot Spitzer unveil market timing allegations against mutual fund complexes in 2000, marking a significant moment of scrutiny for the fund industry.
Morningstar's ethical response to industry scandal and the importance of kindness: Morningstar prioritized investor protection during a financial scandal, and the speaker emphasized the importance of kindness in both personal and professional life.
The financial industry, specifically Morningstar, responded admirably during a time of scandal, putting investors first and warning them away from firms engaging in unethical activities. This moment was pivotal in the industry's history and a memorable one for the speaker in his career. Kindness was also discussed, with the speaker sharing the kindest thing someone did for him professionally and the nicest thing he's done for others. He expressed gratitude towards former colleagues at Arthur Andersen for taking a chance on him and allowing him to learn from them. Personally, he strives to make every day better than the last for his family and teach them empathy and understanding for different circumstances. As a music lover, he recommended checking out the LA punk band X, active in the 80s, and a band with a "very, very pithy name," which wasn't specified in the text.
Discover influential alt rock records beyond the popular ones: Explore 'Nowhere' by Ride, a lesser-known but influential alt rock album from the era, alongside 'Wild Gift' by X for a rewarding listen.
X's recommendation for music enthusiasts interested in the alt rock era and its signature walls of sound should include the records "Wild Gift" by X and "Nowhere" by Ride. While "Wild Gift" is a well-known and great record, Ride's "Nowhere" is an often overlooked but influential album that showcases the inspirations for the sounds that came to define the alt rock genre. My Bloody Valentine's "Loveless" is another famous record from this era, but Ride's "Nowhere" offers a rewarding listen with its hooky melodies and complex background layers. Overall, this conversation provided valuable insights for various listeners, including financial advisers, investors, and money managers, highlighting the importance of exploring lesser-known but impactful works.
