Introduction
Percentage of Funds/Fund Assets Outperforming the S&P 500, 5-Year Basis
Source: MarketWatch
“We have been here before”: this is the obvious message of the preceding chart. Substantial
underperformance by active management has typically occurred near market tops, which are often
characterized by a narrowing of market breadth in which a select number of stocks drive a disproportionate
amount of the market’s performance. Today’s “must-own” FAANG stocks are eerily reminiscent of the Nifty Fifty
of the bull market that ended in the early 1970s. In most of the prior cases, the stocks that led the market on the
way up (which were typically expensive and under-owned by active managers) significantly underperformed the
market on the way down, contributing to the outperformance of active management.
The preceding chart also suggests that now is a good time to bet on active management, as whenever
active management has underperformed to such an extent (at the recent low, less than 10% of active
funds/assets outperformed the market over the prior 5 years), it has historically been followed by a pendulum
swing to another extreme where the majority of active funds/assets outperformed. In fact, we may have already
seen the turn; in the year ending June 2017; over half of all U.S. equity mutual funds outperformed their
benchmark.
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Passive Investing Impacting Institutional Asset Management Business
The trend toward passive investing has materially impacted the world of institutional investing as well.
This well-documented migration of assets has impacted a wide range of actively managed mutual funds and
hedge funds. The mixed performance records of actively managed funds, combined with a relatively higher fee
structure, has shifted fund flows from actively managed products to passively managed products for several
consecutive years. This trend becomes quite evident when one examines the recent actions of several state
pension systems. We were particularly struck by an article from the October 19, 2016, edition of the
Wall Street
Journal
titled “What Does Nevada’s $35 Billion Fund Manager Do All Day? Nothing.” The article describes the
investment approach of the Nevada Public Employees’ Retirement System, which has now shifted all of its
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Robin Wigglesworth, “The return of the stock picker,”
Financial Times
, September 24, 2017,
https://www.ft.com/content/294de4ec-9eb2-11e7-8cd4-932067fbf946.
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Introduction
assets into low cost index funds—a focus that appears to place greater emphasis on management fees than on
performance. The article further indicates that this situation is far from isolated in the pension industry and that
U.S. public pensions now have about half of all equity allocations placed in index funds (more than double the
level from a decade ago). In our view, the Nevada pension system story and similar stories across the country—
such as the Oregon Treasury CIO’s commentary referenced earlier—suggest that a passive investing bubble
may be taking shape among institutional investors. During a multi-year period of strong equity market
appreciation, most investment products will post positive results, and it becomes increasingly challenging for
active managers to outperform benchmarks in such an environment. However, this shift to indexing could have
severe ramifications during a market correction, as passive products are unable to deviate from benchmarks.
Although institutional investors are generally better informed than their retail peers, we believe that both groups
will be at risk for significant losses during the next market correction as passive products continue to blindly
purchase the broader market indices.
“Closet Indexing” and the Pressure to Perform
The underperformance of actively managed funds relative to benchmarks can be problematic on
multiple levels. In addition to failing to achieve a superior return for investors, this performance shortfall creates
headwinds for actively managed funds in the form of outflows and reduced management fees. These
considerations can cause some fund managers to alter their investment approaches in order to close the
performance gap, resulting in actively managed funds with holdings and position sizes that closely resemble
their benchmark. “Closet indexing” is far from a new development, but the market dynamics of recent years
(where most active managers have failed to beat their index) may cause underperforming managers to feel
increased pressure to engage in this practice. During 2016, for example, nearly two-thirds of actively managed
large-cap funds trailed the S&P 500. Closet indexing can be destructive on multiple levels, in our view, both for
clients and for active managers. However, we would expect this reality to continue unless index-based returns
enter a period of extended performance weakness. Unfortunately, it may require a significant market correction
for the pitfalls of this strategy to be fully exposed.
In our view, closet indexing represents a scenario in which the interests of the fund manager and the
investors are not fully aligned. A closet index fund continues to charge clients the higher fees associated with an
actively managed strategy, while ultimately delivering returns that are unlikely to materially deviate from the
returns offered by lower-cost passive products. According to Morningstar, the average expense ratio for passive
funds is 0.17%, compared to 0.75% for active funds. Consequently, it could be argued that an active manager
with a closet index strategy is collecting over 50 basis points in additional fees for creating little or no
incremental value for shareholders. This practice may be particularly appealing to active fund managers who
already possess significant economic scale (firms with high levels of AUM and fees), who seek to minimize the
potential economic risks to the firm and its employees that can results from benchmark deviations. Fund
performance characteristics such as a high R-squared and a low tracking error relative to a benchmark can
often be indicative of a closet indexing approach. We would argue that the practice of closet indexing fails to
satisfy the fiduciary duty that all investment managers should be adhering to.
“That dynamic creates a powerful incentive for managers to mimic the market. If they
don’t take extra risks, their funds won’t fall much more than the market during a downturn and
will go up nearly as much during any rise. So long as the market goes up more over time than
the amount of money that disgruntled investors pull out, the fund managers won’t jeopardize
their own paychecks.”
– Jason Zweig, Wall Street Journal, October 28, 2016
The building pressure to mimic indices has significant ramifications for individual stocks as well. Stocks
that are prominently represented in well-recognized indices are likely to have higher degrees of institutional
ownership as a result of this trend. Consequently, purchase of such securities will tend to reflect index-oriented
considerations (e.g. a fund manager choosing to buy a security mainly because it is part of his/her benchmark),
while the underlying fundamentals of the underlying companies have a diminished relevance for the institutional
buyer. Until this trend abates, a concentrated group of large-cap companies will continue to serve an ever-
growing role within the indices and will receive further support from institutional investors regardless of valuation
or any other fundamental issues. The often discussed FAANG stocks now represent about 7% of the S&P 500,
while the 50 smallest companies in the S&P 500 now account for less than 1.5% of the overall index. Clearly,
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