Index-Besotted Institutions Miss Out on Good Deal: Stock Pickers

Art by Katherine Streeter

The investing world is giving its heart to passive investing, and some major institutional investors have been swept along with that feeling. But actively managed investing retains a devoted following among many, who feel that done right it can outpace an index strategy.

“Our active managers have consistently outperformed their benchmarks,” said Marcus Frampton, CIO of the Alaska Permanent Fund (assets: $69 billion). The sovereign wealth fund has 70% of its portfolio actively managed.

Upshot: Despite finance industry trends, a good dollop of active management might do institutional portfolios a lot of good going forward. Those who minimize it could be missing an opportunity. But the tricky part is finding the right stock pickers to enlist, as many of them don’t make the grade.

The prize will go to managers who can find undervalued jewels in the underbrush, individual stocks that can vault aloft better than a broad equity collection can. Emerging markets, which have temporarily lagged amid the pandemic, and health care, now getting a lot of attention, are “ripe for active managers,” said Amrita Nandakumar, president of Vident Investment Advisory, which has a sizable institutional clientele. The reason, she indicated, is that investing in them requires special knowledge and research.

But let’s face it: Not everyone possesses such gifts. Small wonder active management in general usually trails the passive portfolios, which is why indexes have become so popular. Plus, an active approach is more expensive than the simple autopilot regime of passive funds.

Passive investments made up 37% of the US market accounts in 2018, Moody’s Investors Service calculated. And this year, Moody’s projects, US investors will see index strategies reaching 50%.

The result is a mixed bag for institutions, which often wrestle with the active-or-passive question in their asset allocations. Among the five biggest US pension funds, the California Public Employees’ Retirement System (CalPERS) is 68% passive, joined by the California State Teachers’ Retirement System (CalSTRS) at 69% and the New York State Common Retirement Fund at 86%. On the other hand, preferring an active orientation are the Florida State Board of Administration (SBA), at 65%, and the New York City Employees’ Retirement Fund (NYCERS) at 60%.

CalPERS, the nation’s largest pension fund ($440 billion), recently took a seven-league stride toward passive investing. In late 2019, it fired a bunch of external active money managers and transferred $14 billion into internally managed index funds.

The program’s CIO at the time, Ben Meng, said he was tired of index returns beating his active investments. Of CalPERS’s public equity portfolio, as of last June 30, index investments made up 68%, and active just 2%, according to a CalPERS report. The rest is in so-called factor investing, which in effect is passive as it adheres to rules in asset allocation. Over a three-year period up until then, the index holdings had surpassed active ones, although the difference wasn’t a blow-out, 6.6% annually versus 6.2%. (CalPERS’ goal is a 7% overall return.)

Interestingly, in the 12 months leading up to mid-year 2020, a timespan punctuated by the February-March market plummet, the fund’s active investments surpassed passive, 5.2% to 2.1%. And CalPERS commented approvingly that the remaining active managers, presumably the best achievers before the purge, had done better than their benchmarks.

Passive Aggressive

Year in, year out, a small amount of active funds beat their index benchmarks, as measured by Standard & Poor’s, Morningstar, and others.

S&P Dow Jones Indices show that, over 15 years ending June 30, passive mutual funds skunked actively managed funds, where only 12.8% outperformed index benchmarks. The situation was little better for international stocks (15.3% outran the market). Investment grade corporate bonds did the best, with almost a third outperforming passive investments (31.5%)—an outcome analysts attribute to better picks available in the often opaque world of fixed income.

Actively Managed Funds Aren’t Even Close to Beating Indexes

15-year period ending June 30, 2020
Passively managed Actively managed that beat their benchmark

12.8%

15.3%

31.5%

US Stocks

International Stocks

Corporate Bonds

(Investment Grade

Intermediate)

12.8%

15.3%

31.5%

US Stocks

International Stocks

Corporate Bonds

(Investment Grade

Intermediate)

12.8%

15.3%

31.5%

US Stocks

International Stocks

Corporate Bonds

(Investment Grade

Intermediate)

12.8%

15.3%

31.5%

US Stocks

International Stocks

Corporate Bonds

(Investment Grade

Intermediate)

Source: S&P Dow Jones Indices

During the pandemic, the trend toward passive has held up. Burton Malkiel, the Princeton economist and arguably the founding father of index investing, declared last year that that the market’s fluctuations made active investing a fool’s errand—so putting your money in an index vehicle is more sensible.

He looked askance at the legions of young novice investors who are trying their hand at active investing via the Robinhood service. Malkiel, author of the classic 1973 book, A Random Walk Down Wall Street (now in its 12th edition), said, “All the evidence is that day traders in general lose money.” 

Hedge funds, which are by definition active managers, have seen their share contract among institutional portfolios’ alternative assets, which overall are on the rise. EY’s annual study showed hedge funds were just 23% of alt allocations in 2020, down 10 percentage points from 2019. One big reason is that hedge funds have trailed the S&P 500, a situation that only recently seems to have reversed (although many question its staying power).

An overall institutional study of the active-passive split hasn’t been done, but there’s no doubt passive has been on the march. In a 2017 NEPC survey of endowments, one-fifth of respondents had more than 30% of their portfolios passively managed. Over the previous three years, 42% of them reported increasing their index allocation. The attraction to passive was lower fees (39%) as the leading reason, followed by poor active performance (26%), and the difficulty of finding and hiring strong active managers (4%).

The Active Voice, Unjustly Muted

When times get tough in the markets, as they did during stocks’ spectacular descent last February and March, active does its best. During the 2020 bear slide, active did a lot better than usual. Research firm Morningstar found that active mutual funds beat passive ones in the correction, 52% to 48%.

Even though the odds are that active investing will come up short compared to passive, the trick is to find those managers who have good long-term track records exceeding their benchmarks. As David Druley, CEO of investment firm Cambridge Associates, put it in a 2017 article, “In aggregate, active investment managers underperform. The imperative, then, is to find the few managers and strategies that deliver excess returns (after management fees).”

“Very few people can dunk a basketball, but every good NBA player can,” said Barry Mandinach, head of distribution at Virtus Investment Partners. His firm serves both individual and institutional investors. “So we have hundreds of good active managers” who can turn in superior performance.

Above all, great active performance requires manager skill. Look at the celebrated active investors of the past 100 years: Warren Buffett, Benjamin Graham, Peter Lynch, George Soros, John Templeton, Julian Robertson. They all possessed superior instincts and analytical powers, and they were able to best the market consistently.

If they lacked those qualities, a 2019 Hotchkis & Wiley study argued, then “Warren Buffett’s chances of beating the market on a risk-adjusted basis would be no different than Jimmy Buffett’s, so all of us investment professionals might as well set sail to Margaritaville.”

Consider the exchange-traded fund (ETF) launched in 2016 called TrimTabs US Cash Flow Quality, which has beaten its benchmark, the Russell 3000, since inception. The 100-name fund is one of the rare ETFs whose portfolio is actively managed. It screens for stocks with robust free cash flows, plus solid balance sheets and a dropping share count, due to buybacks, which can aid price appreciation. The fund minimizes turnover, thus eliminating a chronic problem for active ETFs: sharpie traders gaming a fund’s portfolio changes. “Good luck to them,” said Bob Shea, CEO of TrimTabs Asset Management.

Of course, not every active strategy is engineered to blast off for the stars. Take SGI Large Cap Equity, an active mutual fund that owns a good amount of tech stocks but also has appreciable stakes in defensive sectors such as health care and consumer staples, per research house Morningstar.  

Over the past five years, the fund has trailed its category by around 1 percentage point—but it topped the benchmark in 2015 and 2018, both not-great years for stocks. “Institutional clients buy us for defensive purposes: They pair us with other strategies,” said Matt Hanna, a portfolio manager at Summit Global, the fund’s sponsor.

For many institutions, especially the bigger ones, doing their active management in-house is desirable. Cost is the big reason to shuck outsourced asset management, noted Keith Brainard, research director at the National Association of State Retirement Administrators (NASRA): “It’s a better deal for them to set up their own funds.”

Active management allows managers to zero in on up-and-comers with business advantages that aren’t yet widely known. One example is Bill.com Holdings, said Christopher Armbruster, senior research analyst at Kayne Anderson Rudnick, which manages money for institutions.

Stock in the company, whose cloud-based software automates back-office financial operations, has almost quadrupled since its late 2019 initial public offering (IPO). While it has not yet turned a profit, revenue is burgeoning. The outfit can cut a small business’s spending on receivables in half, he said.

Where active management does the least well, according to a Morgan Stanley report, is in large-cap investing. That’s because big stocks are the most widely followed. Better results, the firm contended, come from international stocks or small-caps, as they offer better, and unheralded, pickings.

Interestingly, sometimes the active-passive divide isn’t as stark as one might think. ETFs, which most often cover indexes, offer traders the ability to “do active trading of passive funds,” as Noah Hamman, CEO of AdvisorShares, put it. (His firm has launched several actively managed ETFs, which have fared pretty well.) Hedge funds frequently employ ETFs to short the market or pieces of it, contributing to the funds’ remarkable trading volume.

Some index construction can allow active traders to game their rebalancing.  The Russell indexes “have strict disciplines that can be exploited,” said Matt Egenes, client portfolio manager at Barrow, Hanley, Mewhinney & Strauss, a value-oriented shop that manages a lot of institutional assets.

At mid-year, when FTSE Russell announces additions and subtractions, hedge funds and other canny investors have placed their bets on the changes. This exercise involves gauging a number of factors in the stocks possibly affected, including market capitalization, trading volume, and share price.

Index Hex

Are index funds, as a breed, innately superior? Hardly. Some aren’t what they are purported to be, a representative of a market or a market segment, critics say.

There’s a basic question about the indexes’ ability to actually track the market, or a significant part of it. This past year, the top five stocks ended up with almost a quarter of the S&P 500’s weight. Even when a big chunk of the market was down, these giants pulled the entire index to record levels. Are Apple, Amazon, Facebook, Microsoft, and Google parent Alphabet the market? Uh-uh.

Many observers have decried the prominence of these fast-growing tech names as distorting the market’s performance. In 2020, the S&P 500 (which represents 70% of the entire market’s value) climbed 16.3%. An equal-weighted version of the index increased by half that much. With this method, No. 1 Apple is weighed the same as oil rig maker TechnipFMC, No. 500.

The situation is even more muddled for the Russell indexes, in particular the Russell 1000 Growth Index and its companion Value Index, critics say. The first step to sorting stocks for each, noted a Barrow, Hanley study out last month, is via projected earnings growth, historical sales expansion, and price to book.

After those measurements, 35% are put in the growth index and 35% go to the value one. The remaining 30% are split in half, with one allocated to growth and the other to value. The unfortunate outcome for value index investors, the study concluded, is that they “are buying the growth stocks that simply didn’t fit into the growth index.”

Presented with these findings, FTSE Russell commented that value and growth are relative measures and so the firm "cannot have static views of value (or growth) characteristics." Its answer is to split the market in two. "As the entire index becomes more growth-y on a capitalization-weighted basis," it  added, "more stocks will have growth characteristics based on static measures." The company pointed out that it also sponsors pure-play funds, such as the Russell 1000 Growth, which don't include stocks with partial exposures to the two styles.

The concept that led to index funds was the efficient market theory: The combined knowledge of market figures, from analysts to money managers, is distilled to ensure that stock prices are where they should be. By extension, it is virtually impossible to try to beat the market.

But sophisticated investors know that this theory has holes in it. Some markets are far less efficient than others. That’s why Florida SBA uses a pastiche of passive and active strategies—passive for the more efficient areas, active for the others. “Active management is utilized in markets which are viewed as less efficient and where risk is rewarded,” said Alison Romano, the fund’s deputy CIO.

Sometimes, big winners simply aren’t in an index. Tesla is a good example. No matter what you think of its future or of its often outlandish leader, the electric car company’s stock has ascended 17-fold over the past five years. Only within the last month did it join an index, the S&P 500. “That’s why we’re proponents of active investing,” Alaska’s Frampton said. Otherwise, “you’d miss the Tesla run-up.”

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