Stock market indexes are hard to beat, arguably impossible, over the long term. Active managing is the process of selecting stocks in an attempt to outperform the broader index. The most common example today is probably the S&P500, but active managers will try to outperform their regional index, such as the FTSE100 or STOXX600 depending on where they are. They will also try to outperform on a thematic basis, such as by focusing solely on technology, energy, innovation and more. Leaning towards growth or income also provides active managers with benchmarks specific to an investment philosophy, but why is it so hard to outperform the market?
This article will explore why active managing leads to underperformance of passive investing over an investment lifetime, and why you should consider if actively managing your portfolio or investing in actively managed funds is the right choice for you.
Human Intervention
There’s no denying that the inclusion of human input inevitably leads to error. Separating emotion from investing is easier said than done, and even the best of the best can fall foul of this mistake. Only a handful of active managers such as Peter Lynch or Stanley Druckenmiller have ever outperformed the index over their investment lifetimes, which cemented their legendary status. Knowing when you have made a mistake and moving on from a stock position is essential to good returns in active management. No one likes to exit a position at a loss. Many people will think to themselves “I’ll get out as soon as I breakeven”, ultimately only to see the stock fall further as their losses mount.
Doubling down on a losing position to lower your average while the company fundamentals deteriorate or cutting your winning positions for a small profit without letting them run hinders active managers performance. Actively managing a portfolio does not mean you should adopt a ‘trader-like mindset’ to the markets, which some unfortunately do. In doing this, you lose sight of a long-term investment approach, which simply does not happen when investing in passive index funds. This leads us on to problem number 2 of active management underperformance.
Frictional Costs
Frictional costs are the costs you incur for making or executing a transaction. These could be commission fees, exchange rate fees, spreads, and other costs. Many investors may think they are using a commission free platform to manage their portfolio; however, these costs can be hidden indirectly in the form of wider spreads and less favourable terms when investing in funds. Brokerages that offer quality services for commission on transactions typically provide discounts to ongoing management fees and fund costs in exchange.
Frictional costs can add up drastically when active managers move in and out of positions when trying to beat the market. Incremental costs hinder total returns. The more you trade, the higher the frictional cost. Investing in passive index funds is a ‘set it and forget it’ strategy, which lets you invest periodically and ride the wave of the broader market. With lower ongoing costs or fund management fees, not only do you incur little to no frictional costs of investing passively, but you also pay less over a sustained period, allowing you to keep more of your returns.
Single Stock Exclusion
Probably the biggest contributor to active management underperformance is exclusion of stocks that generate immense market outperformance. In the past 10 years or so, these companies have been the likes of the mega cap FAANG stocks, as well as high growth markets such as renewable energy and innovation. Now that these companies have growth so much and contribute such a large weighting to the index, if an active manager excluded even one of these stocks, it could have crippled their returns relative to the index.
Take the example of 2021, where the S&P had a monumental double-digit run.
If an active manager did not include companies such as Nvidia, Microsoft or Enphase Energy in their portfolio, it was highly likely that they underperformed the index. Now the counter argument is that if they constructed a portfolio only of these big winners, then they would have had a monstrous year of outperformance but picking the right stock every time is impossible for professional portfolio managers, let alone the average retail investor.
Investing passively means that you benefit from the monumental rise of the best companies in the world without single name risk exposure. This is why I have such a high concentration towards index funds such as the Fidelity World Index tracker, comprised of over 1500 stocks worldwide, as well as the S&P500 and FTSE Index in my portfolio. In fact, I recently discussed my top 5 funds to invest in for 2022 and explained the benefits and cost differences between active and passive funds. If you want to check that out, you can click the link below.
Fast forward one year to 2022 and the macroenvironment completely shifted. If an active manager did not have energy stocks in their portfolio, which was the case for most, after a decade of sector underperformance, then they would have severely underperformed in the first half of 2022. The big winners of 2021 were the worst of the worst in 2022. An active manager would have had to have called the top in the growth stock momentum trade to switch out to inflationary, energy and value stocks to continue to outperform. If they tried to chase the momentum only a few months later, they would fall further behind as the growth trade became popular once again in the second half of 2022.
Most fund managers can’t do this due to mandates, sector allocation rules and the sheer size of the funds they manage, so expecting this is unreasonable. This leads us on to our next problem for active managers, which is the constraints that come with a larger portfolio to manage.
As your portfolio grows and is still actively managed, it’s harder for investors to deliver the same returns as they did when they were smaller and nimbler. They either keep excess cash, which diminishes the total return of the portfolio, particularly when in a high inflationary environment, or they are forced to put money to work in investments that they don’t have a high degree of conviction in. Moving down the quality spectrum when investing invites risk and moves from an investing-centric approach more towards speculation. This was prevalent in recent years with the inclusion of SPACs, cryptocurrencies, and a flurry of IPOs for low-quality companies with no real profits or cash flow generation.
When compared to passive investing, portfolio size is irrelevant. Capital is invested in a consistent and regular manner across a regional or global index. What is great about index investing is that the index itself is self-sustained. If a company’s fundamentals deteriorate and the stock price falls, it can be removed from the index in favour of a growing company with positive fundamentals. A lot of movement can happen under the surface of an index, but the passive investor is not exposed. As history shows, over a long-time horizon, stock market indexes grow consistently at a high single-digit rate, outpacing inflation.
Another reason that active managers underperform is that they try to time the market, which is nothing more than speculation. This can happen many ways, such as moving to higher levels of cash, which increases frictional costs, or by using derivatives to hedge their investments. These can be expensive instruments that active managers use to try to time downturns in the market. These eat into returns and can become particularly damaging if done at the wrong time. As Warren Buffet famously says, time in the market beats timing the market.
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