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Investment Management

The investment management world of today can be divided into two broad categories of management style, each reflecting a fundamentally different belief system regarding how modern capital markets behave. These two schools of thought are generally referred to as active and passive management.

Active management is the traditional way of building a stock portfolio, and includes a wide variety of strategies for identifying companies believed to offer above-average prospects. 

Regardless of their individual approach, all active managers share a common thread: they buy and sell securities selectively, based on some forecast of future events.

Passive or index managers - the terms are often used interchangeably - make no forecasts of the stock market or the economy, and no effort to distinguish "attractive" from "unattractive" securities. 

Portfolio adjustments are made only in response to fundamental changes in the underlying universe of stocks - for example, a new company such as Google joins the ranks of large company stocks. 

Passive managers often construct their portfolios to closely approximate the performance of well-recognised market benchmarks such as the FTSE-100 index (large U.K. companies).

When first exposed to the concept of passive management, novice and experienced investors alike tend to dismiss the idea as hopelessly naive. How is it possible that a "mindless" strategy of buying and holding every stock can deliver higher returns than selecting only the most attractive stocks for purchase? 

Isn’t it obvious that some companies have better prospects than others, and will thus be more profitable investments? Won’t careful research by skilled analysts ensure superior results?

To construct a market-beating portfolio, active managers must identify mispriced stocks. 

First, active managers must have information that is not only accurate, but not shared by other investors. 

Second, the manager must be willing to share this information with their clients. 

Third, in order to profit from this insight, other investors must act upon this information at some future date, causing the mispriced stock to change and reflect its “real” value. 

Fourth, in order to add net value, the “excess return” must exceed the cost of information gathering, trading and potentially higher taxation. 

Fifth, the manager must repeat this process over and over again.

In a world where information is rapidly disseminated, and use of “inside” information illegal, this is a tall order.

In such a world, gaining a sustainable advantage over other skilled participants in a hotly competitive marketplace is extremely difficult. 

To be successful, active managers must consistently find mispriced securities.

A multitude of studies have reached the conclusion: the average actively managed fund does no better than the market after fees, transaction costs, and taxes.

As shown in the charts below, of the 2,231 actively managed US equity funds operating at the beginning of 2005, 30% of the universe disappeared during the five-year period to December 2009.  

By year five, just 1% of the funds had consistently outperformed their respective benchmarks.

Despite the strong evidence against active strategies, some people still believe that, as a group, active managers can add value. The challenge comes in identifying winning managers in advance. Some investors attempt this by choosing managers with strong past performance.

Historical evidence shows that past top performing active fund managers show little correlation to top performing managers over subsequent periods.

The slides below show the performance of the top 30 UK equity mutual funds over five year periods from January 1996 - December 2000 through to January 2006 to December 2010. They compare the performance of the initial five year period against the subsequent five year period.  

During these periods most winning managers failed to repeat their superior performance.

Warren E. Buffett
Chairman and CEO, Berkshire Hathaway, Inc

“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.”

Warren E. Buffet, Chairman’s Letter, Berkshire Hathaway Corp. 1996 Annual Report, February 28, 1997. Available in www.berkshirehathaway.com/annual.html (accessed May 21, 2007)

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