What do famous names like Benjamin Graham, Peter Lynch, Warren Buffett and a few others have in common?
They are all great active managers who consistently beat their benchmarks. Their performances have left a lasting mark on the history of financial markets and continue to fuel the appeal of active strategies. Unfortunately, these stars shine in solitude.
In the long term, passive-style solutions deliver significantly better results than active ones. Figure 1 shows that, over time, many active managers fail to outperform their benchmarks and, by extension, passive formulas. Even the best cannot maintain their lead for long. Why is the leadership so short-lived?
Source: S&P Dow Jones Indices. Data as of 30 June 2023
An active manager can only outperform when others underperform. Although this point is controversial among academics, investing is a zero-sum game. Given a certain benchmark (which has zero alpha), the positive alpha of the winners equals the negative alpha of the losers. Among the latter, the worst performers will exit the market.
Eventually, as passive managers’ assets grow, the space for active managers to succeed shrinks. William Sharpe demonstrated: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that refute this principle are guilty of improper measurement.”¹
So, the chances of active managers beating their benchmark become smaller and smaller as time horizons increase. This is nothing new. A statistical sample is more robust the larger it is. The well-known SPIVA study systematically demonstrates these aspects and helps to answer the question that many ask: is it worth investing in active rather than passive strategies?²
As Burton Malkiel said in The Random Walk Guide to Investing: “It is true that when you buy an index fund, you give up a chance to boast at the golf course that you picked the best-performing stock or mutual fund. That is why some critics claim that indexing relegates your results to mediocrity. You are virtually guaranteed to do better than average. It is like going out on the golf course and shooting every round at par. How many golfers can do better than that? Index funds provide a simple, low-cost solution to your investing problems.”
Nevertheless, beating the market and outperforming in both absolute and risk-adjusted terms remains attractive and continues to drive active strategies’ commercial success.
Nowadays, the new active ETFs – although they were quietly born some 15 years ago – are a steadily growing sector. This was inevitable and predictable given the flexible nature of ETF vehicles, which can host many types of strategies, not just the passive ones for which they were born.
How should an experienced ETF buyer react to this important piece of news? Should he remain sceptical, knowing that passive investing – with its lower tracking error – is more reliable? Or should he be clear-eyed about the opportunity to deliver better performance for his clients?
A very tricky question indeed. The answer can only come from what we know about alpha, the ingredient that, for better or worse, separates active from passive management.
Is alpha a compelling source of value for investors? The answer remains to be determined if we look at the last 50 years of academic research and empirical verification of the results.
Is alpha what investors want from their investments? Probably not, because the average person does not know what it is. Is it worth paying higher fees for something as unstable as sporadic? Probably not, because investing is not gambling. The debate on these issues is lost in time as there is no scientific evidence to support it.
Outperformance is an alchemy of luck and skill. “Demonstrating the ability to outperform repeatedly is the only proven way to differentiate a manager’s skill from luck.”³
In short, active management is a game where players fail more than they succeed. Nevertheless, we cannot dismiss the idea of using active ETFs in portfolios altogether. That would be a wrong and potentially self-defeating choice. Based on this principle, no one would have invested in the funds of active managers who renowned for their exceptional skills and results. And none of these great leaders would have gone down in the history books as having beaten the market.
However, the integration of active strategies into passive terrain is now an undeniable fact of life. It is therefore up to the new active ETF issuers to prove that they can deliver the outperformance that justifies their approach (see Figures 2 and 3. Both charts refer to active and passive ETFs that are widely available in Europe. For each of them, data start from launch of the active ETF).
Figure 2: An example of how two fixed income ETFs, one passive and one active, have performed since the second's launch date
Source: Banca Patrimoni Sella. ETF names have been intentionally omitted.
On the other hand, ETF buyers need to study and monitor them carefully to take advantage of any opportunities. Objective assessments are becoming more and more crucial. For now, it is just a challenging task. Sadly, data are not yet statistically sufficient for careful selection. Luckily, the level of transparency in active ETF portfolios is increasing, at least in Europe, in line with current regulations.
If history is any guide, the introduction of new valuation models for the active strategies of these ETFs may be closer than we think, probably also thanks to the increasing use of artificial intelligence. A new challenge is now upon us and only time will tell.
Edoardo Mezza is director and Filippo Arena is a private banker at Banca Patrimoni Sella
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To read the full edition, click here.
1 Sharpe, W., The Arithmetic of Active Management, The Financial Analysts’ Journal Vol. 47, No. 1, January/February 1991. pp. 7-9. Copyright, 1991, Association for Investment Management and Research Charlottesville, VA 2 Lazzara, C., Shooting Hoops with Michael Jordan: An Allegory, Sep 29, 2022, Indexology Blog 3 Soe, A. M., and Poirier, R., Does Past Performance Matter? The Persistence Scorecard, S&P Dow Jones Indices, January 2018.