The Playing Field Has Leveled for Active Managers
In relative terms, the best have declined, while the worst have improved.
The Paradox of Skill
Last week's column, "The Problem for Active Management Isn't Indexing," discussed the paradox of skill.
The paradox being that as a competition becomes fiercer, its winners appear less impressive than those of the past. Ted Williams secured the 1941 batting title by hitting .406. Last year's American League champ, Jose Altuve, hit 60 points lower. The 1896 Olympic marathon winner finished seven minutes ahead of the silver medalist. The 2016 titleholder won by one minute. Where have all the good men gone?
The answer, of course, is that the good men are better than ever. The stopwatch definitively indicates that 2016's marathoner, Eliud Kipchoge, is history's best. No such proof exists for baseball, but it's a fair assumption that with today's game drawing from a larger population base, accompanied by improved training methods, that the 2018 version of Ted Williams would not bat .400.
The logic applies to money management as well as sports. Since the 1980s, the percentage of investment assets managed professionally has risen. In addition, the number of candidates registered for Chartered Financial Analyst exams has grown exponentially. Thus, more monies than ever before are run by certified professionals. Thus, concluded the article, the rewards for investment-management abilities have shrunk. What once was excellent is now only good.
This column takes that argument a step further. The problem for active mutual fund managers is not just that there are more competitors, and those competitors are better trained, but also that the field has leveled. Four conditions that once permitted winning investment managers to stay ahead of the also-rans have been eroded, if not eliminated entirely.
One is technological advantage. Thirty years ago, only large companies could afford mainframe computers. Investment firms that had the scale to employ mainframes, the budget to buy the costliest databases, and the quantitative wherewithal to use their data findings successfully enjoyed a significant edge on their smaller rivals. They could supplement their traditional, fundamental analysis with insights that boutique firms could not match.
This opportunity faded as personal-computer networks ascended. The PC revolution had a twin effect. First, it boosted the boutiques' processing power so that they could accomplish similar tasks. Second, it democratized the databases. Using PCs, data publishers lowered their costs and thus were able to make their products more widely available. Information that previously had been held closely was disseminated.
At the same time (and probably not coincidentally), hedge funds boomed. Many used quantitative techniques. These hedge fund tactics created additional competition for active mutual fund managers. So, too, did their habit of raiding fund companies for talent. The manager who moved from a conventional money-management firm to a hedge fund not only increased the amount of assets run in that fashion but also spread the quantitative word. Once again, that which once had been known only by a few became known by many.
A similar process occurred with fundamental research. Back in the day, investment managers hunted for details that others overlooked. For example, somebody following shoe companies would survey store managers about their recent sales activities. Doing so might yield insights about shoe-industry trends that would only trickle down to income statements months later.
This activity could benefit both the giant investment managers and the small. The behemoths not only could afford to do their own work but also received the best service from Wall Street's banks (which have since reduced their research efforts). Meanwhile, if the boutiques picked their spots, they could acquire in-depth, specialized knowledge on a handful of industries, and they could profit by investing heavily in those sectors.
Those opportunities have diminished. They have not disappeared--it is always be possible, whether through intent or accident, to know something that hasn't yet affected a stock's price--but they have become much harder to come by. The Internet era flat-out destroyed Encyclopedia Britannica's franchise. It hasn't inflicted as much damage on investment sleuthing, but it certainly has not done that occupation any favors, either.
The Inside Scoop
A third equalizer has been corporate communications. Once, corporate executives would commonly drop hints in institutional-investment meetings about the outlook for their company's next earnings report. Or, perhaps, the success of their new products. These comments might occur during conference calls with multiple parties, or within private sessions while visiting a major investment firm. Either way, they revealed helpful information that was not yet public.
These "whisper" comments were criticized for giving professional investors an unfair edge on Main Street buyers, a charge that was certainly true. Less discussed was that such guidance aided some money-management firms at the expense of others. Those organizations that were fortune enough to be on the inside, whether through asset size or through personal connections, enjoyed informational superiority over those on the outside. Along with technology and specialized research, insider information was a competitive advantage.
That, too, is largely gone. Since the mid-'90s, the SEC has cast a stern eye on guidance. Not being in the room where it happens, I cannot personally testify how corporate communications have changed. Nor have portfolio managers directly confessed that they now receive fewer tips, since that would be tantamount to admitting their previous favors. Anecdotally, however, the practice seems to have been greatly reduced.
The fourth and final item is IPO "flipping"--the practice of receiving an early allotment of an initial public offering from an investment banker and then selling it almost immediately. Historically, such tactics fueled the top-ranked performances of many small-company growth funds. However, the IPO marketplace being less frenetic than in the past and (once again) the SEC increasing its scrutiny, the air has pretty much gone out of those tires.
There is one bright side to this otherwise unpleasant news: The leveling of the playing field works both ways. It is true that the relative results of the most skillful players have declined. But it is also true that those of the least skillful have improved. Today's worst fund managers, relatively speaking, are better than those of the past.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.