Eugene Fama Is Wrong…Relatively
“The question is, when is active management good?
The answer is ‘Never.’”
–Eugene Fama, Morningstar ETF Conference
on September 18, 2014
English philosopher Thomas Hobbes suggested that good and evil are relative, depending on what an individual seeks and avoids. In other words, an act can be good in some circumstances but evil in other circumstances.
The same principle can apply to your portfolio when deciding between passive and active investments. As index investors we think you should avoid actively managed investments. However, as you seek to reach your financial goals, there are a few circumstances in which an actively managed fund may work better than an index fund in your investment strategy.
In that sense, you could consider University of Chicago finance professor Eugene Fama wrong, relatively speaking, in regards to his comment above from the 2014 Morningstar ETF Conference.
Of course, Fama, who won the Nobel Prize in economics for his work on the efficient markets hypothesis, was generally emphasizing the point that investing in the market is a zero-sum game. For an active fund manager to win, another active fund manager has to lose. And, since passive and active investors as a whole earn market returns less costs, passive investors generally outperform since their average costs are lower than active investors over a long time frame.
This is what William Sharpe, another Nobel Prize recipient, calls the “simple arithmetic” of active management.
That’s not to say some active fund managers never beat the market. However, few active fund managers display the skill to generate risk-adjusted expected returns consistently over time that cover their costs, according to Fama and his colleague Kenneth French in their paper, “Luck Versus Skill in the Cross Section of Mutual Fund Returns.”
Therefore, your portfolio should favor low-cost index funds over expensive actively managed funds. But, that doesn’t mean a fund that is actively managed is never good for your portfolio.
Some actively managed funds share the same characteristics that attract investors to index funds: low cost, broad diversification and low turnover. (It’s worth noting here that any investment – passive or active – in your portfolio should be able to generate an expected positive real return over time.) In effect, they are similar to an index fund but do not track an index. At times, a low-cost actively managed fund can provide a better opportunity to earn the returns of certain risk factors and asset classes.
Risk factors are the inherent risks that account for a stock’s return. They include the size of the company and the company’s price-to-book ratio, or valuation. Since risk and return are related, small company stocks are riskier, so investors demand a higher return; value companies have low earnings growth, making value stocks riskier and expected to generate higher returns.
Your investment strategy may fundamentally overweigh your portfolio to specific risk factors. Basically, that means investing a greater portion of your portfolio to stocks that exhibit a certain risk factor in hopes of attaining the expected extra return in exchange for the additional risk.
This is the essence of the Fama-French Three-Factor Model, created by none other than Eugene Fama and Kenneth French. However, fundamentally overweighing a fund efficiently to a specific risk factor may be better achieved through some active management. Another reason to choose an actively managed fund might be because a low-cost, broadly diversified index fund is not available in certain asset classes that make up your asset allocation. Or, the index it tracks may not sufficiently capture as much of the market.
One such circumstance is municipal and high-yield bonds, which can be illiquid and fragmented as they trade on numerous trading floors or virtual spaces instead of one or two primary venues like the New York Stock Exchange. They are particularly difficult to represent with an index. Plus, the index funds that do track those indexes may have durations that don’t align with your investment strategy.
To better illustrate, let’s compare these two anonymous municipal bond funds:
Source: Table by Jacob Schroeder, Data from Bloomberg
*Avg. option-adjusted duration as of 9/30/14
Which fund would you rather use to build your portfolio? Fund B is cheaper and appears to capture more of the market than Fund A. Additionally, Fund B has a lower duration than Fund A, so Fund B is less sensitive to changes in interest rates. It turns out Fund B is the actively managed Vanguard Intermediate-Term Tax-Exempt Fund Admiral Shares. Fund A is the index-tracking iShares National AMT-Free Muni Bond ETF.
Fama is certainly right that the average investor is better off with a more passive, index-based investment strategy, as shown by his research. But, it’s not always good to be dogmatic. In certain circumstances actively managed funds can make sense and allow you to still follow the core principles of an index investing philosophy. If it helps you reach your financial goals, then never say never.
Photo credit: "Nobel Prize 11 2013" by Bengt Nyman - Flickr: IMG_7460. Licensed under Creative Commons Attribution 2.0 via Wikimedia Commons